Do the Property Dance Once More?
Caixin August 2013
Policies to prolong the bubble could lead to a financial crisis. Reforms that open the economy further to global competition are the better forward
The market is speculating that the central government is about to loosen up financing for the property sector. What this really means is that the banks may increase lending to developers for land purchases. Property developers are beholden to local governments. If they get loans, they will buy land to boost local government revenues. Essentially, bank loans would turn into local government revenue. When the local governments spend the money, it becomes a form of fiscal stimulus.
When the economy was growing rapidly, the property bubble was justified on reflecting high future income through extrapolation. As the economy slows, the justification is that the property bubble is needed to support the economy. Neither is meaningful unless monetary and/or credit policies are affected. The latter argument was undoubtedly a force in influencing the 2008 policy to massively boost credit growth. Even though this policy is the reason for most economic difficulties today, the same argument is being used again. If China tries the same policy, it will not produce the same results and may trigger a financial crisis quickly.
In 2008, the Federal Reserve was just beginning its unprecedented quantitative easing policy. The bearish sentiment towards the U.S. dollar allowed emerging economies to boost money supplies without worrying about devaluation. Further, China’s credit policy then was looked upon positively by the international community as contributing to stabilizing the global economy.
If China were to pursue the same policy now, the opposite would be true on both fronts. The Fed is about to begin its tightening policy. And the U.S. has a strong stock market and recovering property market to attract global capital. Emerging economies have to tighten monetary and credit policies to maintain their economic stability. A repeat of 2008 policy would immediately lead to capital flight and currency devaluation. The resulting inflation could totally destabilize the economy.
Further, there is consensus in the global financial market that China’s property market is a bubble. If some policy is introduced to prolong it, the negative segment would worsen, triggering massive short selling of the yuan. The resulting devaluation pressure would be self-fulfilling, leading to a financial crisis similar to Asia’s in 1997.
The Ponzi Scheme
The National Bureau of Statistics (NBS) says that in the first half of 2013 property investment, mainly spending by developers, rose by 20.3 percent, the volume of property under construction by 16.5 percent and property completion by 8.7 percent. These numbers are probably not accurate. But the pattern of land purchases growing faster than property construction, and construction growing faster than completion seems to fit anecdotal evidence. China’s property market has become a vast land game on small and declining final sales. It is like a listed company with a small proportion of floating shares. The share price could be pumped up very high through manipulation, a bank would take the illiquid shares for collateral at the so-called market price and the borrowed money is pumped back into the liquid shares.
The bounce in the property market that began in the last quarter of 2012 ran out of steam in the second quarter of the current year. But in some cities the land market is heating up again. This is partly due to the cash inflow from the sales before. But ramping up price expectations could be the goal. Some of the land sales may involve little cash payment. The odds are that the buyers could return the land with little penalty. Hence, the so-called land kings are just tools to scare people into buying now out of fear for higher prices later.
The NBS also says that nearly 20 trillion yuan has been poured into property development in the past three years. As the development cycle is about that long, the cost of the properties under development should be that much plus interest accruals on the loans. Plus taxes on sales and the net margin to developers, the sales value needs to be above 30 trillion yuan to sustain the market, or 60 percent of the last year’s GDP. The country’s total household debt is 18 trillion yuan. Massive credit expansion would be needed to clear the inventory. In the current global environment such credit expansion would likely lead to maxi currency devaluation and economic chaos.
The Bigger Bubble
While the residential bubble is well known, the commercial side has quickly become a bigger bubble. Most cities have commercial space per capita higher than in developed countries. Yet they are building much more. Purchase limits have been imposed on residential properties in recent years. Much of the speculative excesses have been diverted to the commercial side. This is why the building of commercial properties exceeds that of residential properties.
The hotel market is a good example. The overbuilding is apparent. The occupancy rate for hotels is low. Most are not making money. Yet so many more are being built. Banks will suffer a huge amount of bad loans in this market.
Individual investors have been speculating in retail properties. The average yield in this market has fallen to the same level as in the residential market. With so much more under construction, the rents will only fall further. Widespread bankruptcies in this market are quite likely in the coming years.
The ‘City Group’ Won’t Help
Most tier-two and -three cities already face market disaster. They have built a massive amount of properties without population growth. Even though their average prices are relatively low, about three months of wages per square meter, they cannot sell them. Properties are worth something if the people living in them can earn enough to pay off the mortgage loans. But most of these cities do not have the competitive industries to support a large enough workforce to justify the size of the property market.
The “city group” idea has become popular lately. It is a concept that links the cities that have trouble selling properties to the tier-one cities where the properties are still selling and for considerably more, say, five to six months of salary per square meter on average. Even if the tier-one cities can sustain their market, the concept won’t help the others. The substance of the concept is fast rail buildup to link these cities. Japan’s experience suggests that it would lead to population decline in tier-two and -three cities because as people have more opportunities to know the tier-one cities and are more motivated to migrate there.
The recent land market revival is partly driven by the falling fortunes of small cities and the continued property boom in tier-one cities. Most developers invested heavily in tier-two and -three cities after 2008 on lower land prices there. Many, probably most, of these developers will go bankrupt. The surviving ones are crowding into tier-one cities. While these cities have rising populations, the prices need to come down to connect with income to grow sales. The developers that have survived the downturn in the tier-two and -three cities may squander their remaining capital on excessively expensive land in tier-one cities.
A Weak Economy
In modern economic history no property bubble has survived a prolonged weak economy. China’s current economic downturn will last for years and end only after serious structural reforms that are yet to begin. I suspect that the adjustment will take five years. Even if the government wants to support the property bubble in a weak economy, there will not be enough resources to make it last.
The property bubble will take a big fall in the coming months. The troubles in the trust industry will be a catalyst. Without the funds from the trust industry as junior creditors, banks will not be able to fund many property projects.
Cutting taxes by 2 percent of GDP or 1 trillion yuan could stabilize the economy. As overcapacity permeates the economy, the spending from cutting taxes would have a big multiplier effect, possibly over two. Assuming that 70 percent of the tax cuts will be spent, the total stimulus effect could be 1.5 trillion yuan, sufficient to reverse the downward momentum in the economy.
Shifting spending power to the household sector would improve efficiency, too. In the past decade, spending power has been shifting to the government and state-owned enterprises. This is why businesses have been investing in guanxi, not product quality or new technology. The result is that, despite the nominal GDP quadrupling in a decade, few good companies have emerged. If spending power is primarily with the household sector, good companies will naturally emerge from market competition.
Most local governments are experiencing fiscal difficulties. They will oppose cutting taxes. Issuing fiscal bonds may be the only way to fund the cuts. When a property bubble bursts, increasing the fiscal deficit is necessary to cushion the economy during the adjustment period. Over time the solution should come from curtailing local government spending. The public sector has spent more money in the past five years than in the previous thirty with little to show for it. The economy has suffered serious problems from this spending, including the property bubble and overcapacity.
A Confidence Boost
In a bubble economy, momentum becomes the key to confidence. As long as the trend is up, more will jump in to sustain it. Such thinking is quite popular in China. When a bubble has run its course and is ready to burst, such thinking stops working. The country has reached this turning point. It would be unwise to waste money on manufacturing a price trend.
China still has a lot of growth potential. Wages and household consumption are low. The two could rise in a virtuous cycle. The potential is held back by wasteful spending and investment. For example, the rapid expansion in most cities since 2008 has been wasteful. When this is cut and spending power is shifted to the household sector, the basic condition for a virtuous cycle is laid.
One hurdle to the virtuous cycle is excessive bureaucratic control over the economy. Virtually every economic activity must be approved first by some authority. Rent seeking is an inevitable result. In an economy based on the rule of law, a business can start something as long as it conforms with the law. If the authorities find otherwise, they can use courts to handle the matter. China should shift to such a system. Government agencies should focus on law enforcement rather than dishing out approval.
One way to deepen structural reforms is to open the economy further to global competition. Joining the World Trade Organization brought a quantum jump in China’s economic efficiency, as numerous domestic regulations were revamped to conform with the WTO rules. The same could happen now. The bilateral investment treaty with the United States could open many markets not just to foreign capital but also to domestic private enterprises. A free trade agreement with Europe could eliminate most price distortions in the consumption market and help rebalance the economy.
After 1992, Japan did not reform and suffered two decades of stagnation. After the 1998 financial crisis, South Korea reformed quickly and has since become an Organization for Economic Cooperation and Development country. The path China should take is obvious.