Talking Point

Tower blocks and treadmills

Debate heats up on whether China is world’s biggest “bubble”…

No longer on a roll? The government wants to slow the property market

“I can calculate the movement of the stars, but not the madness of men.” This was the justification given by Sir Isaac Newton when he lost a fortune investing in the South Sea Bubble nearly 300 years ago.

With subsequent bubbles, smart people also got suckered in, thinking ‘it’s different this time’. The dotcom bubble may have turned every sensible investment rule on its head, but that only made everyone bolder in their bets – since every pundit was screaming that the internet rendered all prior wisdom out of date. Fast forward to 2006 when many sage commentators thought the US housing bubble was sustainable. Why? Because sophisticated financial engineering was repackaging risk like never before.

In both cases, the bubble popped.

So what about China: the world’s greatest ever growth story? Some are claiming it’s a bubble. But it must be different this time, right?

James Chanos, founder and president of the hedge fund Kynikos (“cynic” in Greek), doesn’t think so. He made his first fortune shorting Enron stock a decade ago. And now he’s predicting something nasty is ahead for Chinese property; “Dubai times a thousand – or worse” was the January sound bite.

More recently Chanos has been telling Bloomberg’s Charlie Rose that China is on a “treadmill to hell”. Its economy is hooked on real estate just as a heroin user is addicted to his fix.

So Chanos thinks he has found the next bubble on its way to bursting. But might it actually be a little more “different” this time than Chanos appreciates? Unlike America’s recent housing bubble – in which Alan Greenspan largely stood by and watched the unfettered markets do their work – the Chinese government can hardly be accused of a reluctance to intervene in its own economy.

And it looks to be well aware of the problem. In fact, this week Beijing made another attempt to take some of the steam out of the property “bubble”. It has just announced at least six new measures aimed at reining in prices and done so in dramatic fashion over just five days. Even the Shanghai index seemed to think something new might be afoot, falling steeply as a result.

A bubble or not?

Most commentators think property prices have been rising too far, too fast. But fewer have forecast the bleak outcome that Chanos anticipates (we have discussed why before, in WiC46). One major factor: the lower level of China household debt compared to many markets elsewhere.

Chanos could still be right, of course. A 30% year-on-year surge in credit for 2009, a Shanghai stock exchange that boomed 80% in the same period, and a property run up in selected cities exceeding 40% (and sometimes more) looks like a “perfect storm” for ‘bubble land’, according to recent HSBC research.

But, in the best traditions of measured analysis (Harry Truman’s plea for a “one handed economist” lives on resiliently) HSBC’s final assessment is that fears of a full meltdown are overblown.

Yes, Shanghai stock prices surged last year. But so did most markets globally, and China’s price-earnings multiples are still below their historical means. True, too, that some cities have been through a rapid spurt in home prices. But in those cities that house 95% of the urban population they’re up less than newspaper headlines might indicate, at an average of 8% to 12% in each of the past five years. That’s in line with increases in household incomes too.

But policymakers must be worried or why the new measures?

Officials will have been more than aware of GDP growth coming in at a higher-than-expected 11.9% for the first quarter. House prices were up 11.7% in March too, the biggest year-on-year gain since the National Bureau of Statistics started collecting data across 70 cities five years ago.

Efforts to slow the market ramped up four months ago. A 5.5% sales tax for properties sold within 5 years of purchase was re-imposed, banks were told to raise downpayment ratios for buyers, and developers were made to put down more cash on their land plot purchases. We also reported in WiC54 how the big state-owned firms had been told to stay away from real estate investment unless they had a core competency in the sector.

But the State Council clearly saw the need for more measures last week, including upping minimum downpayments to 50% on second homes, and demanding that mortgages be offered at no less than 1.1 times the benchmark borrowing rate – preventing banks from discounting their rates to win market share.

Mortgage deals for people buying third properties are even higher still, and banks have been told to turn down applications for third-home purchases in real estate hotspots – such as Shanghai – and for buyers who cannot prove that they have paid taxes in the city in which they want to buy.

Developers have also been hit with regulations designed to curb speculation. For example, the Ministry of Housing has vowed it will “punish” developers that “artificially” create supply shortages so as to pump up prices at their new developments. In future, property companies will have to start selling new apartments within 10 days of completing the buildings and receiving approvals; and disclose to the public a transparent list of which apartments are available and their prices.

Is it going to work?

The government seems to be gunning first for the speculators. About time, says Li Hong, writing in the People’s Daily, who warns that the industry is at a seesaw moment. On one end, the government; on the other, the growing legion of speculative investors.

Certainly, speculation is driving some of the boom, with new properties often kept empty for a quick resale. Scary data from the State Grid suggests that 65 million residences nationwide have shown no power readings for the last six months, says the Economic Observer.

If vacancies have reached such levels then LTCM’s James Rickards might be right to warn Bloomberg that China is in the midst of “the greatest bubble in history”.

Li’s opinion piece also makes clear that the “startling” price rises have taken affordability out of reach for many buyers. That chimes with the Chanos pitch. By his own calculations, an average new apartment is around a thousand square feet in size and built at a cost of $100 to $150 per square foot. This means that two-income couples (probably on a combined $7,000 or $8,000 a year) are often signing up to a $150,000 commitment. That sounds similar to an American on a $40,000 salary buying an $800,000 house.

“And we know how that ended,” he quips.

Beijing wants to avoid a similar fate…

One problem, says the Financial Times, is that the policymakers have been talking a tough game on property prices for a while. But their pronouncements have not had much impact on real estate values, which have just kept rising.

In fact, speculators have been emboldened by the policy “hesitation”, says Zhao Xiao at the China Economic Times.

But this time the message may have got through, if Monday’s stock market performance is anything to go by. The Shanghai index slumped almost 4.8% (the most in eight months) as the market absorbed the latest lending restrictions. Property stocks were down more, as analysts rushed out notes saying that this looks like a much more far-reaching initiative. Rumours even circulated of real estate portfolios being offered at discounts.

If it doesn’t work, what’s next?

One option is a property tax. The Economic Observer reported at the start of the month that a levy on existing homes (to be set by ownership status and location) was under consideration.

Another response would be an interest rate hike. The Nikkei newspaper believes a rate hike is overdue. It compares China’s situation today with Japan in 1972 when Prime Minister Tanaka launched his initiative to “remodel the Japanese archipelago”. Property prices had doubled by 1974, with the boom ending only when rates were raised.

Did disaster follow? No. Indeed, the Nikkei optimistically notes that while prices fell in 1975, Japan experienced only a “slight adjustment” in its overall growth trajectory – and tellingly Japan’s 1973 GDP per capita at $3,800 was similar to China’s now. At this stage of development, the newspaper reckons, there is massive pent up demand for new housing and social infrastructure – and these can absorb the bubble’s excesses.

Nevertheless policymakers will want to tread carefully. Land sales underpin local government revenues, and so support local employment and investment. Speculators know it only too well, says chinastakes.com, and worry less about major policy change in a context in which the nation’s local governments are in aggregate the biggest players “in the biggest housing market on the planet”.

If property prices fall too rapidly, the economy shudders too. Commentators estimate that anything from 20% to 60% of economic output is closely linked to the property sector’s health. The cement, steel and construction sectors would be hit especially hard by a rapid downturn. It is now largely acknowledged that a house price slump in late 2007 (when Beijing was trying to engineer a soft landing) pushed the wider economy into slowdown long before the Lehman collapse, and the global recession hit exports.

The problem, says the 21CN Business Herald, is that the economy is locked into a “steel-and-cement” development model. Worse still, Gao Shanwen, the chief macro-analyst at Essence Securities sees the conditions for an economic crisis within three to five years. Sounds a little similar to that “treadmill to hell” that Chanos has been talking about?

On the other hand, Jonathan Davis offers a contrarian view of the China bubble in an article in the Spectator. In commenting on whether to invest in a China fund, he notes: “One tried and tested rule in investment is that the bigger and more widely shared the worry the less likely it is to happen. Remember Y2K and the SARS epidemic? On this measure, if nothing else, investors looking at China should not have much to worry about.”


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