What if China were a bubble? Not just a few patches of excess here and there, but an economy-wide bubble, like Japan in the late 1980s.
And what if, when it burst, the result wasn’t a couple of years of slow growth and some bad loans? What if we got a Japan-style slump instead?
It could be a disaster. One of the main sources of growth for the world economy would collapse. Its trading partners would take a big hit. And a prolonged slump would probably cause major security issues within China. We’d remember the fall-out for many years to come.
But there’s something else you should note about this theoretical Chinese bubble.
It would also surely rank as the most widely predicted bust of all time …
The consensus is not bullish on China
Every time I hear critical analysts dismiss the ‘Panglossian consensus’ on China, I have trouble recognising what they’re on about. Because as far as I can see, the bulk of opinion is quite negative towards China, not bullish at all.
Take Standard & Poor’s latest yearly emerging market fund manager review. Of the managers surveyed, only a couple were overweight China – the rest were neutral or negative. Sure, it’s a small sample of 34 managers. But even so, it suggests that China mania isn’t exactly raging unchecked.
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Imagine the results if you’d asked fund mangers their views on tech during the dotcom boom. Or real estate agents during the property bubble. You’d have been knocked down by a stampede of rip-roaring, turf-pounding bulls.
Or take a more flippant example. Google “US housing bubble” and you get about 394,000 results. This is for an English-speaking country that had an undoubted bubble which has firmly burst, but which was not predicted by the consensus beforehand.
Now try “China housing bubble”. That gets you about 316,000 results, while “China property bubble” gets 651,000 hits. By comparison, “UK housing bubble” turns up 67,000 pages and “Dubai property bubble” finds 43,000.
So if China does turn out to have a huge real estate bust, a lot of people will be able to claim they foresaw it all. And that’s one reason why I doubt it’s a true bubble.
This time, real estate genuinely is local
Obviously, there’s some excess in Chinese real estate. Prices – both flats and development land – have soared in Tier 1 cities such as Beijing, Shanghai and Shenzhen after the past year. In some cases and some types of property, we’re talking 50%-100% increases – albeit after a sharp drop in 2008/09.
But this is not a nationwide issue. Official data shows much smaller changes elsewhere. And a recent survey of property developers by Standard Chartered backs that up. Selling prices for new flats in Tier 2 and 3 cities typically rose by 10-20% from mid-2009 to March 2010, developers reported. That may sound a lot by developed world standards – but bear in mind that the economy and incomes are growing at a similar pace.
Property speculation is obvious in some of these cities, including the Tier 2 and 3 ones. The Standard Chartered survey suggested that around 30% of recent purchases are for investment. Travelling around, you’ll see largely empty buildings where the flats have been sold and are clearly being held solely in the hope of capital gains.
But as I’ve written before, this is not quite as irrational as it seems. Opportunities for investment are limited within China’s underdeveloped financial markets and capital controls. Real estate is seen as a solid place to park your cash. It beats low bank deposit rates or the casino that is the local stockmarket. And keeping it empty actually makes more sense than renting it out, because in China – like many Asian markets – many buyers prefer to own homes that have never been occupied before.
There seems little doubt that future demand for property is going to be strong. While many critics focus on the amount of housing that’s been built, a huge amount of the existing stock is old and of poor quality. Residents want to upgrade to something better when they can afford to.
But will incomes grow strongly enough to make these speculative purchases profitable? After all, there’s a big overhang of investment property to eventually come on to the market.
This is a very valid question. And my guess is that the answer is ‘no’. Too many people are investing in high-end property. The average emerging middle class or urban worker needs something more affordable.
But the important point is that these purchases are not being funded through 125% buy-to-let mortgages. Instead, they’re funded through cash or through mortgages with a loan-to-value ratio some way below the purchase price.
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Debt-fuelled bubbles are very damaging when they burst. The asset falls but the debt doesn’t. But as long as debt stays under control, property prices can be very volatile without doing permanent harm. This is quite common in Asia, with Hong Kong being the extreme example.
The government has its eyes open
Crucially, the government is aware of the risks of a widespread bubble and is keen to keep it under control. Regulators clamped down hard on lending both to buyers and developers earlier this year.
The restrictions have led to sharp falls in prices, sales and construction in the Tier 1 cities. But Tier 2 and 3 cities seem to be much less affected. This, like the initial rise in prices, suggests that any excess was mostly confined to a few hotspots.
What’s more, China’s banking regulator has just told its banks to stress test against a 60% fall in property prices in key cities. Some will undoubtedly see the mention of a fall like that as very negative. But I think it’s a good thing. It’s better to see a regulator that intends its stress tests to be stressful, rather than a continuation of the pretence that Greece can ever repay its debts.
(And it’s not just China that takes these things more seriously. Taiwan’s banking regulator is now said to be telling its banks to test a 25% fall in home prices. Asia is increasingly outdoing the West in realism and pragmatism.)
This doesn’t mean I’m optimistic on Chinese banks. Obviously a real estate bust in the hottest markets could create more bad loans. There’s also the problem of lending to local government projects, as I discussed here: Why you should avoid Chinese banks
Another area I’ve mentioned before is loans made through ‘trust companies’ that are then sold on to investors. (Trust companies are a more loosely regulated type of Chinese financial institution vaguely akin to hedge funds or private equity groups.) Supposedly the banks have no remaining liability on most of those. But in practice, if there was a substantial default problem, the banks that distributed them might be told to make good the losses.
But again, regulators are getting to grips with this. Banks have been told to report on their local government risks. Preliminary leaks suggest that around one-fifth of these projects – which are mostly infrastructure and public works – may go bad. And they’ve been told to stop working with trust companies.
I think it’s quite clear that bad loans will rise in the Chinese banking system. The big banks are already raising fresh capital. More will probably be needed. And sorting out the small banks will be a big headache.
One reason I’m not keen on investing in the banks – even though they’ve been looking cheaper – is that I fear the government might force some industry consolidation, dumping some of the problems on the large banks. National interests will trump shareholder interests in state-controlled firms in the end.
Expect a slowdown, not a depression
We should be prepared for all this. We should expect prices to fall quite sharply in some overheated cities as long as the government keeps policy tight. And latest announcements like the stress test don’t suggest they’ll be slackening any time soon.
Speculators could lose money. And the economy will certainly notice the impact of any real estate crunch. Construction is a significant part of GDP and employs a lot of migrant workers. The government can probably compensate for this somewhat by pushing more construction of lower-end housing, which is badly needed. But that won’t close the gap entirely.
However, it’s important not to overstate the scale of this. This is not a nationwide problem like Japan in 1990 or the West today. And seeing headlines about these issues should be encouraging. It means that they are being noticed and can be dealt with. We didn’t see many headlines about subprime lending until 2007 or Greece until 2009. The fact that these problems were overlooked for so long is why they turned out to be so enormous.
Obviously, we should also be prepared for much worse. No investor should have all their money in emerging markets, nor all their emerging market investments geared to China. (I wrote more about A portfolio to withstand any financial crisis a couple of weeks ago). But overall, the more bad news stories I see about China, the more optimistic it makes me that things will turn out okay in the end.
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