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China’s Bubble Trouble

July 16, 2010


The stock market weakness of recent months has been widely attributed to the ongoing
drama in the euro-zone, but the setback owes as much to concerns that China’s runaway
property market is set to reverse direction, and precipitate a sharp slowdown in economic
growth.
The bears argue that the Middle Kingdom’s inflated property prices are reminiscent of
Japan’s real estate bubble during the latter half of the 1980s, and believe that the Chinese
authorities via accommodative monetary policy and a quasi-fixed exchange rate, are in
danger of repeating the same mistakes made by their Japanese neighbours two decades
ago. A similar outcome would undoubtedly prove disastrous for the global economy,
given that the developed world already stands on the edge of a deflationary abyss, but are
the bears’ worst fears truly justified?
The private residential property market is a relatively new phenomenon in urban China.
Indeed, until housing policy was reformed in the late-1990s, the allocation of apartment
units to most urban households was determined by employers, primarily government
institutions and state-owned enterprises. The government gave birth to a market-oriented
housing market in 1998 through the privatisation of the existing urban housing stock to
current occupants at heavily discounted prices. The development of a commercial
housing industry was encouraged by the state, and the resulting boom in residential
construction was supported by the emergence of mortgage finance, as the commercial
banks began to offer loans to individual buyers.
The commercial housing industry developed quickly, supported by rapid growth in
mortgage lending, and private home ownership had become the norm by 2003. Structural
factors including favourable demographics, increased urbanisation, rapid income growth
and high household savings rates underpinned the buoyant demand. However, urban
house prices began a rapid ascent in 2003 that continued through 2007; price gains in the
major cities between 2002 and 2006 averaged 30 per cent a year, and the continued
upward momentum in 2007 forced the authorities to implement various administrative
measures and financial policies in an effort to depress speculative investment demand.
The actions taken included an increase in the down payment requirements on second
home purchases from 30 to 40 per cent, a hike in the mortgage rate on second home
purchases to 1.1 times the standard rate, an order to the commercial banks to control their
lending to property developers, and the introduction of new rules that made it harder for
foreigners to invest in Chinese property. The restrictive measures introduced proved
successful, as the pace of price increases slowed from its peak in late-2007, and house
prices eventually turned south, as the global financial crisis inevitably undermined
demand.
House price weakness proved short-lived and the decline relatively modest, as a sharp
economic slowdown demanded a shift toward more accommodative policies. Fiscal
stimulus equivalent to 13 per cent of GDP, massive credit expansion, and a reversal of
the restrictive measures that were implemented in 2007 contributed to a turnaround in the
housing market’s fortunes. The credit expansion saw property development and
consumer mortgage loans surge by roughly 40 and 50 per cent respectively in 2009.
Negative real interest rates, high savings rates and controls on capital outflows increased
the relative appeal of private housing as an investment vehicle. The volume of
transactions increased substantially in the major cities, and the surge in demand saw
house prices resume their upward trajectory and surpass their previous peak by the
autumn. The positive momentum continued during the early months of this year, and
prices registered a record year-on-year gain of almost 13 per cent in April.
The Chinese authorities were forced to take measures to curb speculative investment once
again, as the elevated prices in the major cities, at roughly 10 to 15 times average
household incomes, kept rural migrants out of the market and contributed to heightened
social tension. Down payment requirements on second home purchases have been raised
to 50 per cent, the mortgage rate on second home purchases has been increased to 1.1
times the standard rate, and loans for third home purchases have been forbidden.
Meanwhile, the land available for public housing development has been substantially
increased; the objective is to address the shortage of affordable housing that has proved
socially divisive.
The deliberate attempt to check the advance in urban house prices is beginning to have an
effect, as house values dipped month-on-month in June for the first time since the spring
of last year. Concern is now mounting that prices could slip by some 30 per cent before
the end of the year, and there are fears that the resulting increase in mortgage
delinquencies could lead to financial instability.
Though house prices may well drop sharply in certain pockets of the market, but the fears
seem overblown given that loan-to-value ratios averaged just 34 per cent from 2003 to
2009, and still relatively low 66 per cent by international comparison during this year’s
spring. Thus, a substantial drop in prices is required before homeowners find themselves
in negative equity. Furthermore, property loans account for 25 per cent of the banking
sector’s total loans – a fraction of the equivalent number across Ireland’s banks, and
mortgage lending is equivalent to just 15 per cent of GDP, as compared with a figure of
almost 80 per cent at the US housing market’s peak.
The upward trajectory in Chinese housing prices simply does not look like a dangerous
bubble; urban prices have advanced by 75 per cent over the past decade, and 15 per cent
since last spring. Given the structural factors underpinning demand including
urbanisation and high income growth, alongside the restrictions on supply arising from
limited land availability and high population densities, price advances of this magnitude
do not appear outlandish.
House prices are sure to weaken following the government’s deliberate attempt to cool
the market. A property-induced crisis appears unlikely however, as homeowners have
considerable scope to absorb significant price losses, and commercial banks do not
appear to have dangerous levels of exposure to mortgage and property-development
loans. The Middle Kingdom will muddle-through.
www.charliefell.com
The views expressed are expressions of opinion only and should not be construed as
investment advice.
© Copyright 2010 Sequoia Markets

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