A Real Estate Bubble in China?

WASHINGTON – Japan had its real estate bubble in 1989. America had its “dot.com”, “new economy” bubble in 2000 that caused (have we forgotten?) the NASDAQ crash –a crash from which the famed tech stocks never recovered.  Note that today the NASDAQ is still about 50 per cent below its peak of over 5000.

And this bout of made in the USA insanity was finally followed by “the bubble of bubbles”: the fantastic real estate price explosion of 2003-2006, followed by the historic implosion of 2007-2009 whose painful consequences we are still digesting –with no real end in sight, in terms of financial sector devastation, banks losses, record numbers of foreclosures and still depressed home values.

A bubble in China?

And now China, it seems, is having its own version of a real estate bubble. Come again? A bubble? In China? But how is that possible?

China is supposed to enjoy the benefits and wisdom of a “guided economy”. Its state capitalism, its mix of government owned banks and state owned enterprises, (SOEs), is supposed to be immune from the excesses of free wheeling market capitalism, a system in which unchecked private sector greed and speculative fevers are, (supposedly), the root cause of periodic cycles of boom and bust. In China, a steady hand at the helm is supposed to apply all the necessary forces and counter forces that will guarantee the continuation of the country’s never ending growth and sustained, remarkable performance.

Yes, according to some

Well, superior performance notwithstanding, according to many observes, in China we have the making of a real estate bubble, as real estate has been singled out by private investors as the most promising, “safe” sector for high returns, so much so that now there is just too much investment in this sector, driven mostly by expectations of even higher valuations down the line.

Prices are very high, while there is no way that the market will be able to absorb so many high end properties at sky high prices, once investors wish to resell their investments in the hope of realizing good profits. While there is nothing like unanimity among China watchers on this controversial issue –is what we see really a “bubble”? –those who believe that there is a bubble are hardly just a few uninformed fear mongering pessimists. Just to give and example, a recent Google search for “China Real Estate Bubble” resulted in more than 4 million entries.

Many believe this theory

In the US, a strong voice warning about this bubble is James Chanos, head of the New York based, 6 billion Kynicos fund. Chanos earned his reputation as a shrewd short seller by identifying correctly the fraudulent nature of the old Enron energy trades. He explains his “China bubble” theory in some detail in a recent Fortune magazine interview, (Chanos Vs. China, by Bill Powell, December 6, 2010). For similar views on this, the English Version of the German news magazine Der Spiegel had a long report on the same issue not too long ago. (China’s Real Estate Bubble Threatens to Burst, by Wieland Wagner, August 3, 2010).

What is going on?

So, what do these analysts see? They see in China a real estate market for investments properties, (as opposed to people buying houses as their primary residences), in which both prices and supplies keep going up without any real connection between the amount of properties being built and snatched for investment purposes and the ability of the market to absorb this glut, once these properties will be offered for resale at higher prices, by investors who intend to realize a profit. According to these observers, the emerging disconnect between the volume of properties built and sold at higher and higher prices and the market fundamentals has all the features of a bubble.

Real estate: the safest investment

But why real estate as the choice investment for well to do Chinese? Simply stated, because property is viewed almost universally in China as the safest form of investment. However, in recent times, the buying frenzy has driven demand and thus prices up, fueling more incentives down the line to promote and realize more construction, so that it will feed this seemingly inexhaustible demand for these coveted, “safe” investments.


As in any speculation, this trend makes sense only up to the point in which there will be more and more buyers chasing these properties, whatever their prices. But at some point someone will realize that, beyond the speculators, there is no real market for these overvalued properties, as their prices are beyond the reach of the average wage earner in China. According to Chanos and others, we are approaching the point in which this disconnect between valuations and viable market prices will become apparent.

Again, let’s keep in mind that most of these properties are held as non rented property, with the expectation that, as the market keeps rising, they can be resold at a higher price. The bubble will burst when the new would-be buyers will decide that prices are too high and that real estate investments, at these prices, no longer make any sense.

Not a repeat of the US story

The China bubble is not at all an exact replica of what happened in the US. In fact, it is totally different. The players are different and so are many of the market dynamics. For this reason we should not expect the same chain of events that unfolded in the US beginning in 2008 with the emergence of sub prime mortgages as the weakest link in the chain of the real estate frenzy and ending with the unprecedented government bail out of major banks, mortgage brokers and insurance companies. No, the major Chinese banks are not going to fail.

Still, a bubble is a bubble

Still, some “bubble fundamentals” are the same. Because of sustained demand for more and more real estate as choice investment, construction in China took a life of its own, delivering an extraordinary amount of properties that were snatched by eager buyers who were and are convinced that putting money into properties for resale was their best bet to make money, while holding a “safe” investment. As a result, we have in China a glut of high end, overvalued properties that cannot possibly be resold at a profit, any time soon. Given current trends, in China we are going to have lots of investors holding and later on being forced to liquidate at a loss overvalued properties for which there is no market.

In the US the banks absorbed the losses

In the US, the ultimate punished “investors” ended up being not so much the owners of the real estate but the mortgage brokers and the banks that issued/bought the mortgages, (and the hapless financial institutions and pension funds all over the world that kept buying these US “triple A” rated securitized mortgages). In the US, as many overextended borrowers could not make the payments, the banks ended up repossessing properties that insolvent borrowers had to vacate, as they lacked the income to pay the mortgages they were given in the go-go years of “no documentation loans”.

In this foreclosure tidal wave, even in the best cases, the US banks took and are still taking heavy losses because the sales of foreclosed, discounted properties in general do not allow them to recover the amount they had lent to the borrowers. So, that money is gone. A foreclosure glut, in the meantime, depressed property values across the board, thus lengthening the crisis of this once thriving US economic sector.

No similar banks exposure in China

Unlike America, in China there is no mortgage related crisis. Most people still buy cash for their properties. Mortgages are not so common and certainly when they are granted, they do not come with 100 per cent financing. Borrowers are required to put significant money down. So, unlike the US, the Chinese banks are not confronted with a potential wave of defaults and the likelihood of losing unrecoverable loans in foreclosures, as most borrowers must have significant equity in the property that is financed by the bank.

Real estate as value investment

And yet, if we agree that there is indeed going to be a bubble burst, with significant losses of property values, there is still going to be financial pain. Let’s see how this may happen.

Most Chinese buyers paid cash for properties sitting empty as the units were purchased as investments. It is customary in China to do so. Empty properties are kept as others would keep gold, as investments in something that is supposed to have “intrinsic value” and destined to appreciate over time. Except that “intrinsic value” does not equal “intrinsic price”. In gold, as much as in other commodities and real estate, while there is some “intrinsic value”, prices have a way of changing, especially when there is a market glut, and/or when prices have been driven up too much by a buying frenzy.

Mistake to believe that property will always go up

Chinese real estate investors soon enough will realize that, given the construction boom that produced a gigantic oversupply of both housing and commercial real estate, their prized capital investments are valued much less than what they bought them for. Simply stated, over supply of investment properties will end constant appreciation and eventually, when the reality of a glut will sink in, there will be price declines. As investment properties in China normally are not rented but kept empty for easy resale, they are a good bet only in the expectation of a market going up. If it goes down, then it is just like any other speculative investment. “You bought your gold coins at 1,400 dollars an ounce. But gold is now worth 1,100 an ounce. Sorry, I guess you bought at the wrong time”. Of course, in the case of real estate, a property can be held and rented, thus generating income. But then one has to accept the rental going rate which is likely to be low, given the prevailing Chinese wages.

Valuations are not sustainable

Well, the Chinese real estate market has yet to go down. In fact, it keeps creeping up. But, according to many observers, a correction is inevitable, as the oversupply is manifest. When people will see that their investments do not appreciate, then problems will start. The investors may sell at a loss, causing further market declines, or they may absorb the loss. Either way, savings and values will be destroyed.

Again, this is not going to be like the US, as the Chinese financial system is not exposed in the same way as the US banks were exposed to non performing mortgages. We have seen that lending practices in China are quite different. We are not going to see the equivalent of Countrywide, once a US giant mortgage supplier, going under, simply because there are is no Countrywide equivalent in China. And no need to bail out the likes of Citibank or Bank of America because of their overexposure to real estate lending gone bad.

The roots of the problem: making the numbers

But let’s see how all this got started. It would appear that it all got started because of the standard Chinese central government practice of determining, ahead of time, GDP growth targets, thus generating pressure across the board to meet or exceed those targets. This pressure led many key local officials to bet on construction as a relatively easy way to achieve high growth numbers. So, there seems to be a public policy root cause for this phenomenon. The Chinese public policy practice of a top-down setting of ambitious macro growth targets created a fixation on growth for growth’s sake, without too much thinking on possible long term ramifications. The focus on real estate as the best way to make the numbers is viewed by many observers as the basic catalyst justifying, indeed pushing, more and more construction projects.

Half of China’s GDP growth due to construction

Let’s step back a minute. In the West we are used to thinking that most of China’s GDP growth is due to its export oriented manufacturing, all the consumer goods that we end up buying at Walmart. Well, in large part this is true. But, according to many calculations, the still extraordinarily buoyant export sector accounts for about 50 per cent of annual growth. The rest of the growth comes –yes, you guessed it– from real estate. And thus construction accounts for about 4 to 41/2 per cent of annual 9 per cent GDP growth.

Real estate deals are the simplest way to grow the economy

In summary, from the perspective of local officials under pressure to meet their growth numbers, it turns out that real estate deals, whereby local officials sell land to construction companies so that they will build all these properties, is the simplest, fastest and most lucrative way to engineer growth, get revenue and make the numbers.

Furthermore, proceeds from housing deals are often used by local authorities as collateral to finance infrastructure projects, such as highways, ports and so on. And the magic in all this is that real estate deals were and are fueled by strong demand for housing as investment. So Chinese real estate developers could go ahead with their building plans, comforted by the pledges of investors only too happy to snatch all these new properties.

Real estate is the default investment as other instruments are too risky

And why is there such a strong focus on property as investment, as opposed to other vehicles? Well, in part this is because stock market investments have proven to be treacherous in China. Too many ups and downs. And money in the bank gives almost no interest. Therefore real estate seemed to be a good bet. Historically the market has always gone up. And so, buying a condo, or two or three, (but there are accounts of rich people holding 30 or 40 properties), and holding them until prices would go up and then resell them seemed to be a good strategy to increase one’s wealth.

From investment to speculation

Except that too many people thought the same thing at the same time. Now, because of the various incentives listed above, starting with the land deals at the local level, there is an exceptional glut of properties that sit empty, while at some point their owners will start looking nervously at valuations. The issue is of course what will happen when prices start declining –and how fast.

Can the glut be absorbed?

But is it going to be bad? One might argue that, even though there may be a glut, eventually a market of hundreds of millions of people looking for new urban housing will take care of this problem. Millions of Chinese families moving into cities from the country side will need accommodations; and so, sooner or later, the housing glut will be mopped up. Well, it is not so simple.

As noted above, most of the housing stock built and held as investment is relatively high end, and thus financially beyond the reach of the average Chinese wage earner. Rural people coming into cities may want to access these properties. But they are mostly poor. The current prices are simply too high for most of them. And so, confronted with declining prices and no buyers, the investors may have to choose to either hold on to their diminished assets or to liquidate them at a loss. By the same token, when the market will stop going up, the incentive for other would be investors to keep buying will wane.

The end of the party

As soon as it comes, the understanding that “it is all over” will arrest the gravy train. There will be no more demand for new, high end investment properties. The construction companies will have no new customers and thus they will stop looking for land. And local party officials will lose the land deals and thus the main instruments that made it possible for them to make the yearly 8 to 9 per cent growth numbers. And there will be losses for financial institutions as well, although not the big national banks.

Local banks will lose money

The losers will be among the “local government funding vehicles”, or LGFVs, that provide a critical link in this real estate investment process. According to Chanos and others, many local lenders that provided liquidity to the local governments on the expectation of future gains coming from the real estate bonanza will be stuck with non performing, real estate related, loans. Most likely the government will have to take them over. How bad is this going to be? Who knows.

One thing is for sure: there is no correlation now between the prices at which these properties have been sold to investors and the ability of the Chinese market to absorb this huge supply at current or higher prices. Once the speculative bubble is burst, the market will have to find its own level, based on old fashioned demand and supply. So, people will lose money. The local financial institutions sitting in the middle between the local governments and the developers will lose money.

Cascading effects

So, the emerging Chinese middle class will see its net worth shrink. And the state will lose as well, to the extent that it will have to take over and recapitalize the LGFVs, the local banks saddled with non performing loans tied to the real estate frenzy. And there will be lots of foreign losers in this mix as well. Indeed, this fire has been stoked by significant speculative capital coming from abroad.

Overseas Chinese and others

Many Chinese expatriates wanted to participate and so they sent money into China and bought into the bubble. Other Western investors followed suit. All of them will be burnt, just as everybody else. Further removed but still very much connected to this market, you will find commodity exporters from Brazil to Australia, whose buoyant sales to China were largely tied to China’s construction boom and it voracious appetite for aluminum, iron, copper and everything else that is needed for construction. Once the bubble will end, expect fall in demand for those goods and lower profits for the commodity suppliers.

Of course, the scenario may unfold in a variety of ways. The pain may be sudden and intense; or it may be mitigated by public policy measures aimed at softening the blow.

In conclusion…..

So, what are we to make of all this? Assuming that James Chanos and all the others are right and that there is indeed a bubble that will burst, with consequent massive financial losses, the cautionary tale is that nobody as yet developed an economic model that comes without any room for perverse speculative opportunities. Not even the supposedly different and in many ways extraordinary Chinese have managed this achievement.

In the US, people crazily thought that they could use their real estate as an ATM machine; whereby they could keep extracting equity (via home equity loans) from supposedly ever appreciating properties to finance a life style that they could not otherwise afford. The historic American crash has had enormous repercussions not just for the real estate market but for the entire economy. Indeed, over leveraged US consumers now need to save money in order to re balance their accounts. As the US consumers have much less discretionary money to spend, they cannot buy much, thus slowing down the entire economy.

In China, it is very different. Real estate became the piggy bank, the place to store savings. Fine idea in principle. But the recent buying frenzy led to overvaluations and oversupply of non marketable properties. These investors will also lose money, as the market value of their properties will be much lower than what they expected.

In the end, the real investment is in productive activities

In the end, the morale of this story is rather simple. In a well functioning, balanced economy, there are no sure fire, “great investments”. Instead there should be a multiplicity of “decent investments”. A balanced, good economy should offer investors decent return opportunities in a variety of sectors. And portfolio diversification should be the best approach –as all financial planners keep reminding us. Any economic system in which investors believe that there is only one good sector in which to invest “everything” is somewhat dysfunctional.

Furthermore, and most fundamentally, any economic system that creates incentives for people to invest heavily in “get rich schemes”, as opposed to focusing on ways in which they can invest intelligently so that they can be better wealth producers, is a system in need of care and repair.

Sadly, as it turns out, nobody as yet has “invented” a system that will immunize its citizens against the temptations of “safe, high growth investments” as the easy way to huge riches. Nobody has –not even the surprising Chinese.

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