Beyond Property Bubble

China's property bubble has peaked. In the Tier I cities the prices are unlikely to reclaim the peaks in late last year (e.g., Shanghai) or the first half of this year (e.g., Beijing and Shenzhen). The prices in some Tier II or III cities may make new highs, like the froth in the second board (创业板) after the main board is down 60% from the peak. The property bear market may last five years. At the bottom the price will likely fall by half, reaching average price per square meter at about two months of average salary then. The land prices will fall much more. In the hottest land market in Zhejiang the land price may fall by 80%.
The turning point is due to (1) tightening liquidity, (2) policy direction, and (3) supply and demand balance. Because of the loose monetary policy around the world, China doesn't face capital outflow pressure. China’s positive consumption trend can continue to attract capital. Hence, the bubble will likely deflate gradually. There are periods of Indian summer-the prices and transaction volumes perking a bit. Like the stock market's march from 6,000 to 1,600 between 2007-08, the property market will behave the same way though in slow motion.
China's economy will be affected less than expected. Many interested parties have been spreading fear by arguing that the economy would collapse without the property bubble. Yes, the economy will slow. But, with consumption, exports, and infrastructure rising at pretty good paces, the economy will perform quite well in the coming decade. Further, the property sales volume will drop much less than value, limiting the impact on GDP. With falling property prices and rising wages, Chinese masses will be much happier. People's happiness, not GDP growth rate per se, should be the ultimate goal of economic development anyway.
China's liquidity is tightening, though slowly and from a high level. The tightness reflects more the nature of credit demand than the supply level. The credit demand is overwhelmingly from the state sector and the speculators. The former is driven by funds availability rather than cost of funds. Last year's credit boom led to numerous new projects. They demand more credit to continue. Hence, even if credit supply grows at the same pace as before, the credit condition feels tighter due to more demand. Inflation expectation drives the speculators' demand for credit. Their inflation expectation is so high that their demand for credit is unlimited at the current interest rate. The property tightening measures have kept away some of the demand. Otherwise, the credit condition would be much tighter.
The government monetary and credit policies are clearly on the tightening side. Inflation is high and rising. To prevent an inflationary catastrophe, the money supply must grow slower than nominal GDP. The government's intention seems to be moving in that direction. The market, however, is moving faster. China's household contribution to banking liquidity seems to be close to zero, i.e., debt and deposit grow by similar amounts. The credit condition is tightening even if the government doesn’t want.
The other two main sources of liquidity are trade surplus and inflow of hot money. With rising commodity prices and double dipping of the western consumer economies, China's trade surplus isn't likely to rise. The hot money inflow seems to be slowing, though not reversing yet. The US's strong pressure on China to appreciate Rmb isn't causing the Rmb futures prices to rise dramatically in the NDF market. The reason for the market's subdued response reflects the psychological change in the financial community. The foreign exchange market with $4 trillion turnover per day is by far the largest market and involving most liquidity. The money has been chasing the Rmb story for years with little return. The fatigue seems to have set in, i.e., the market won't put money down on expectation alone. The Rmb premium in the NDF has been a leading indicator for China's forex reserves. And the change in forex reserves is the most important indicator for liquidity. The slower inflow of hot money is having a significant impact on liquidity.
An asset bubble requires liquidity to rise exponentially to sustain it. This is why no bubble lasts forever, because there won't be enough money to feed it one day. In an emerging economy, a bubble usually occurs when the global liquidity is plentiful. The symptoms for loose global liquidity are mainly a weak dollar and low US interest rate. It is not a coincidence that China's property price has risen since 2002 when the dollar went into a bear market. An emerging market bubble usually bursts when the US economy recovers and the Fed raises interest rate. What occurred in Latin America in 1980s and Southeast Asia in 1990s fit this model.
China's situation is different. It is big enough to affect the US economy. Hence, the US's interest rate partly depends on China's situation and vice versa. It is a twin star situation, not a star and a satellite. The equilibrium path is contingent on the policy decisions in both. As long as China's exchange rate doesn't appreciate big, the liquidity in China ebbs rather than evaporates. If the Rmb moves up big, the market may shift to Rmb depreciation expectation. It would be a powerful force for capital outflow, which would cause a collapse in liquidity and property. I don't think that China would move the currency big anytime soon.
On the other hand, the Fed isn't likely to raise interest rate quickly on a recovering economy. The US economy simply faces too many headwinds to see a strong recovery in five years. Only inflation would force the Fed to increase interest rate slowly and reluctantly. The inflationary pressure on the US depends on how quickly China's property bubble deflates. If it were to burst like in Hong Kong in 1998, commodity prices would fall big and the inflationary pressure on the US will ease, which would give the Fed more room to increase monetary stimulus, which would support China's property.
China's tightening bias nudges its property market downwards, which decreases the need for the Fed to tighten. But, the inflationary pressure is still there, just not accelerating fast enough to force the Fed to raise interest rate now. The Fed may need to move only by mid-211. When the US interest rate is high enough in 2012, say above 3%, China may face capital outflow pressure, but not intense enough to produce an adjustment like Hong Kong in 1998. The property prices in the Tier I cities are 10-15% off the peak and will likely decline by another 10-15% by end of next year. When the US's interest rate is high in 2012, the prices may decline by another 15-20%. The market may languish for another three years afterwards.
The policy direction is preventing the property bubble from making one last surge. A bubble can crash under its own weight. It happens when the bubble expands quickly. For example, NASDAQ surged quickly from 3,000 to 5,000. The A-share market surged from 3,000 to 6,000 in 2007. Without the policy bias, China's property market could surge quickly despite of tightening liquidity condition, because the speculators would pay more for credit to get it, i.e., the last hurrah would be accompanied by rising interest rates. But, when the interest rates are high enough to weigh down the speculative drive, the bubble bursts. This is the scenario I envisioned before. As the government isn't removing the credit restrictions on multiple property purchases, it is not likely anymore. Hence, I think that the property market will experience slow leak over many years rather than explode in one go.
The supply situation isn't like to cause the bubble to reflate. The residential properties under construction are around 3 billion square meters. At Rmb 10,000/sq m (my guesstimate), the purchase cost is Rmb 30 trillion. The current money supply is about Rmb 70 trillion. It's likely to rise by 50% or Rmb 35 trillion over the next three years. The property supply valued at current prices means very tight liquidity condition. The supplies are too big to be accommodated at the current prices.
The multiyear property adjustment gives the government an opportunity to promote consumption to keep the economy on a steady growth path. This is entirely possible. The view that China's economy cannot survive a property burst is totally wrong.
First, the negative effect of declining property prices is primarily on local government revenues. This is about how money is allocated, not how big the pie is. There are other ways to allocate money to local governments. Issuing bonds, for example, is one way. Further, many, probably most, local governments are spending too much. Many small cities shouldn't develop at all. Their prosperity is the result of investment itself. When the investment is done, such cities don't have the economies of scale to generate jobs. Their populations will dwindle, as people move to big cities for jobs. It would be good for them to receive less money. Hence, lower land prices would be good for the economy.
The property sector itself may not affect the economy so negatively. With declining prices, the demand from speculators will dry up. But, the genuine users will step in when the prices are affordable. The market keeps talking about inelastic demand. It is really propaganda. The current prices are so high that the people who need properties cannot afford it. Only affordable prices can generate demand from end users. Hence, the production volumes don’t need to decline much. The direct impact of declining property prices on the economy could be quite limited.
Declining property prices doesn't necessarily mean the destruction of property developers either. Declining land prices could completely offset the declining property prices in terms of profit impact. But the business model of the industry would change. Land appreciation so far accounts for all of the industry's profits. The quality of the property development itself is marginal in importance. Quality reputation will increasingly determine profitability in future. Many nationwide developers with good reputation would emerge over the next decade. The industry will be healthier and stronger due to the coming adjustment.
Second, the declining property prices will have a big positive effect on consumption. The people who need properties are saving to chase the prices. So far they haven't been able to. When the property price doubles, an average household needs to postpone purchase by ten years to save up. When the price declines by half, the consumption growth rate could accelerate by 5 percentage points, adding 1.5-2 percentage points to GDP growth rate. The accelerating consumption will lead to a boom in investment in consumption industries, which may add another one percentage point to GDP growth rate. The consumption's impact on employment is no less than construction. The service sector employs most people. Consumption stimulates service demand most effectively. Hence, the property adjustment won't lead to an employment crisis at all.
Lately everyone I speak to talks about property prices going up again. It sounds like a repeat of what occurred in 2007 and 2009. The talks are likely to remain so. The liquidity and credit conditions were loose and getting looser then. The property market surged in the past on declining mortgage interest rates and down payment requirements. At present the credit restrictions on multiple property purchases remain. The mortgage interest rates are significantly higher due to smaller discounts off the policy rates. The current transaction volumes in Tier I cities may be up 100% from the bottoms reached four or five months ago but are still much lower than the averages of the last three years. Unless the sales volumes are above the averages, the prices are unlikely to move up substantially. In the current liquidity environment there isn't enough money for the sales volumes to rise so high at the existing prices. The volumes can go above the averages only at lower prices to decrease the required credit support.
Despite the adverse liquidity condition the bullish sentiment on property remains prevalent. The world is full of horror stories from the property bubbles. Ireland is running budget deficit above 30% of GDP due to the cost of bailing out the banks that lent recklessly during the bubble. Spain's debt was just downgraded due to its weak government finance after its property bubble burst. The US's unemployment rate has doubled and the government deficit tripled to 10% of GDP since the property bubble burst in 2007. We are not talking history here. The economic calamities due to property bubbles are playing out before our eyes everyday. Why would so many, including so-called experts and some government officials, believe it would be different in China? What motivates the bulls is probably self interest. They are benefiting from it now and won't be around to suffer the consequences, just like the Wall Street traders and bankers in the US bubble.
China's banks will likely suffer most as the property market goes into a bear market. If the banks don't deal with the bad debts quickly, the economy could suffer more than just the direct impact from a slower property industry. Fortunately, the government balance sheet is strong enough to recapitalize the banking system quickly. Out of the total lending of Rmb 45.7 trillion probably one third is to property and related industries. It is possible that the banking system would suffer Rmb 1.5-2 trillion in total losses due to bad debts from declining land prices. The banks are raising capital by issuing stocks. It would alleviate the capital shortage ahead. But, when the banking system does suffer capital shortage and cannot lend, the government should move quickly to recapitalize it. China has the resources to contain the property market problems from spreading into the economy as a whole.
Rising wages and declining property prices will greatly help the consumption development in the coming years. Other reforms must occur for consumption to truly become China's growth engine. First and foremost, legal, regulatory, and institutional reforms must be undertaken to guarantee food security. While property is the biggest economic and social issue now, food safety is a close second. The government has been responding to food safety crises but has not built an institutional framework strong enough to prevent them.
Water pollution and overuse of pesticides and fertilizer in agriculture are the biggest problems to food safety. Unless agricultural practices are regulated effectively, all other efforts are not that meaningful. Of course, the processing industry should be regulated. Most companies, if not all, engage in price competition. It is the main strategy for survival. Without survival, one could hardly build a brand. But, price competition means that no one has the resources to build a brand. Hence, the industry is stuck in a vicious cycle. It takes years of tight regulation for the industry to shift into a virtuous cycle: the most important assets are brands and, without brands, one couldn't survive.
Second, education has become a huge cost in the household budget, perhaps the third highest after housing and food. China's education is state-controlled and is supposed to be free and of low cost. In really, schools and teachers exact all sorts of tolls from parents. Unless one's parents pay up, the student may be treated poorly. Indeed, favors for money permeate the system for enrollment into good schools or even universities. The practice brings discredit to the whole system.
Government-funded education system is supposed to be cheap but low in quality. A privately funded one is supposed to be expensive but high in quality. China's system suffers the disadvantages of both. China's education system behaves like a for-profit monopoly. The immediate solution is to open the system to market competition.
Third, like education, China's healthcare system stirs up the same fear among the people. China has numerous medicine manufacturers. They don't have intellectual properties, brand their products like candies, and sell through hospitals. Their success depends on sharing their profits with hospitals and doctors rather than the quality of their products. This is why healthcare is so expensive and low in quality. Again, the immediate solution is open the system to private capital competition. Reforming the existing system would take too long.
China's economic system is geared towards government investment and exports. It is a partnership between the Chinese government and multinational companies. Other elements in the economy, both on the demand and supply side, have been marginalized. As the existing system cannot prosper in the coming decade due to weak global demand, efforts must be made to elevate the importance of other components of the economy.
The global economy may be entering a lost decade. China can prosper on its own and make a big contribution to the global economy. But, structural reforms are necessary to achieve this goal. Otherwise, China could experience a lost decade too.
Andy XIe is an independent economist based in Shanghai, and former Morgan Stanley star chief Asia-Pacific economist.

from - http://en.21cbh.com/HTML/2010-10-25/1NMDAwMDIwMjc1NQ.html