Readying for Financial Bubbles to Burst
By Andy Xie
Small troubles regarding trust products and the property market will be worth enduring if major economic gains can be made
Some financial accidents, e.g., trust products defaulting, may occur in the coming months. Their impact on the real economy will be limited. As the land bubble deflates, the resulting reductions in production costs and consumer prices should support the real economy by boosting exports and consumption.
When a few financial incidents occur simultaneously, the sense of panic may spread. The impact, however, should be short-lived. China’s land bubble has become almost entirely a financial phenomenon. Its problems should be contained within a small though vocal community.
To minimize the panic from a deflating land bubble, the central government should prepare contingency plans for unwinding trust products, property developers and local government financing vehicles.
The biggest mistake that the government can make is to, in a moment of panic, use taxpayer money to bail out all failing financial products or institutions. The resulting financial burden would limit the government’s ability to pay for the forthcoming reforms to rebalance the economy and launch a new growth cycle.
If China leaves the bubble economy behind and embarks on another wave of reform and opening up, its per capita income could top US$ 20,000, excluding inflation, by 2030, making China the largest economy in the world.
The Land Bubble Deflates
China has experienced rapid increase in land prices in the past decade. Some of it can be justified by income and productivity growth due to the country joining the World Trade Organization. Most of the increase is a bubble phenomenon. While household income may have tripled in a decade, the average land price has risen by over thirty times. Whatever income growth is to come cannot justify the current price of land. Nor can a supply shortage. China has no shortage of land. High-rise urbanization makes demand for land quite low relative to the population. The sustainable land value is probably 70 to 80 percent below current levels.
Any bubble occurs due to excessive monetary growth. An added condition in emerging economies is a stable exchange rate. Both conditions occur when an economy is taking off and the dollar is weak. It happened in the 1980s in Latin America and in the 1990s in Southeast Asia. The last decade was China’s turn. The dollar peaked in 2002 and began a decade-long decline. China’s economy took off at the same time, as the country joining the WTO attracted a massive amount of FDI and reallocation of manufacturing to it. The combination allowed China to increase its broad money supply at 19 percent per annum for a decade while the exchange rate appreciated. China had rapid monetary growth before 1994, but experienced currency devaluation with it.
China’s land bubble is deflating for the same reasons as elsewhere. First, the spurt of productivity growth after joining the WTO is tapering off. The country’s exports are facing a saturated market. Further productivity increases must come from improving value added, not from mere quantity expansion. Second, the dollar is returning to strength. The combination will cause monetary growth to slow sharply. The odds are that China’s broad money growth rate would be less than 10 percent in 2014, half of the average in the preceding decade. A land bubble requires more and more money to support it. Slowing monetary growth is sure to trigger a bursting.
The Next Five Years
China’s property market will adjust similar to what happened in Japan and Taiwan rather than in Hong Kong or Southeast Asia. The former was gradual, and the latter fast.
In 1998, banks in Southeast Asia owed short-term dollar debts to Western banks. When the debts were not rolled over, these countries had to raise real interest rates enormously to contract domestic credit in order to pay off foreign creditors. Surging real interest rates caused their property markets to drop off a cliff.
After land prices peaked in 1992, Japan and Taiwan faced much less pressure because they did not have short-term foreign debt. Their land prices declined gradually and in waves, i.e., every recovery had lower highs and lower lows in both price and volume. To some extent they are still in this process two decades later. For example, the current recovery in Japan is likely to be short-lived too.
China’s land market reached a turning point last year. The reasons are, first, that the quantity expansion-based growth model reached its limits, and, second, that the U.S. economy began to recover and with it the dollar. The market recovered in the last quarter of 2012 and the first quarter of 2013, which was a bounce in a bear market. Now begins the second leg down. There could be another recovery in early 2013. Like in Japan and Taiwan, lower lows and lower highs in both prices and trading volumes will track every wave. China’s land price will reach bottom in 2017 at the earliest.
The bottom in 2017 is contingent on the country successfully reforming its growth model. If reforms are not carried out and money is used to keep afloat bankrupt financial products, developers and local governments, the price of land will fall for many more years. Two decades after its peak, Japan’s land price is still declining. It’s a lesson to all who believe that time alone will bring back every market.
Withstanding the Bursting
The debts in China’s property bubble are mostly held by local governments and property developers. Total household debt is one-third of GDP, compared to nearly 100 percent when the United States’ bubble burst in 2008 and Japan’s in 1992. On balance, the bursting of the property bubble will boost China’s household demand. The lower property prices will decrease the need for savings.
China is experiencing widespread shortage of blue-collar labor. The shrinking of the working age population will worsen the shortage. This is a major source of inflation. As the cooling property market decreases labor demand somewhat, it will not lead to serious unemployment and may decrease the inflationary pressure in the labor market.