China: The Low Probability And High Impact Worst Case Scenario9 May, 2011, 18:19. Posted by Zarathustra
Tags: Crash, Economy, Recession
Two days ago, I look back the period of late 1980s of Japan when their real estate bubble was at its peak. I was interested in that period of time obviously because I see something similar happening. Specifically, in Hong Kong and China.
Despite having debunked many myths about why property prices rise in Hong Kong (including the myth about supply shortage, the fallacy of low interest rate, and the useless indicator of real interest rate), bulls are still trying to come up with reasons that prices will not fall, or even if it falls, it will be alright a few years later.
One of the big reasons that bulls use to explain why property prices rose (and will rise) in Hong Kong (and other places as well) is that rich Chinese buyers are investing in real estate everywhere, and they will continue to do so for the next 10 years or so. True, it is happening right now, and this has been happening for a few years at least. Previously I cited a study by Bain & Co. about the fact that many rich Chinese people are seeking to emigrate to other countries for legitimate and/or illegitimate reasons. No one now knows for sure how big the capital flow out of the country will create, but asset prices for the receiving end of these capital flows would rise, and the origin will suffer if the outflow is huge.
The situation now is akin to the period when Japanese investors were buying properties in the United States in the late 1980s, helped by the fact that they were rich (thanks to loose monetary policy that was used as a failed attempt to prevent Japanese Yen from appreciating too much) and that the US dollar depreciated against the Japanese Yen after Plaza Accord in 1985. That was similar to what is happening now, as the Chinese Yuan a.k.a. renminbi is slowly appreciating against the US dollar, with which the Hong Kong dollar is pegged, and the monetary policy of China has been too easy for the past 2 years.
The question is whether that will go on for another 10 years or longer. My response is: probably not.
People Are Too Used To A Fast-Growing China
Bulls are still suggesting that Chinese buyers will continue to invest in properties in Hong Kong for the next 10 or even 20 years. That is contingent on the continuous strong growth of the China’s economy for the next 10 to 20 years. If the economy slow significantly any time soon, that will not happen.
Bulls tend to see no reason why the China’s economy will not grow strongly for the next 10 or 20 years. That is very understandable of course, as human beings have short memories, and the recency effect guarantees that human beings can only remember the more recent events they lived through. And indeed, China has been growing strongly for 20 years or more, so we have a whole generation of people who only remembers a China that grows strongly.
However, I see no reason why a significant slowdown is impossible. China has been growing uninterruptedly for 20 years or so, and this simple fact should remind us that a slowdown is not at all inconceivable. The only questions are when that will happen and how significant the slowdown or recession will be.
Don’t Overestimate The Chinese Government Ability
My view on the Chinese economy is extremely cautious. I believe China is overly relying on fixed-asset investment. Sure, it sounds like a cliché because everyone says that, but it is true. This model is unsustainable, and the Chinese government knows that very well, that is why they have taken various measures to counter that. But despite the fact that the Chinese government has greater control over the economy than the United States or other free-market economies have, it is easy to overestimate the ability of the government in controlling the economy.
China today is not China 10 or 20 years ago. In the late 1990s, the Chinese banking sector was in a crisis much bigger than the one in the United States two years ago, yet Chinese banks were operating as usual because these banks back then were 100% state-owned, so as long as the government told the banks to lend, these banks will lend even though they may have some pretty awful capital ratios. Now, all biggest state-own banks are listed, and they are being tested every day on the stock markets in Shanghai and Hong Kong. Shareholders would dump the shares long before these banks reach the level of bad debts anywhere close to the crisis levels in late 1990s.
In short, this is just another example of “this time is different” syndrome. The reasons of “this time is different” is that this is China. Despite most people’s confidence in the government as far as engineering a “soft-landing” is concerned, I am much less confident in that.
Correction In Property Prices Should Not Be Surprising
People who are still bullish on China’s property disregard the fact that home prices in China are too expensive for average workers, and huge corrections should not be surprising. It is easy to make such a comment that a city like Beijing has almost 20 million people and because it is the capital city, so high property prices is not a problem at all. To make these apartments affordable to majority of people, however, the income of an average worker has to increase very substantially. Let’s assume for a moment that income has to double. Even though the income growth is very high in China, it would take almost 4 years for the income to double if the annual growth rate is 20%.
I agree that there is big demand for better housing, but these newly built apartments are just way too expensive for majority of people. So rich folks own many apartments and leave them empty. They bought these properties in hope that they can sell these properties at much higher prices in the future. They have forgotten, however, that those who really want these apartments are those who can’t afford them. So how can these people expect to profit from selling apartments to people who are poorer than themselves? Either income has to rise at a much faster rate, or property prices will have to fall to make them affordable.
It might be true that many of these property owners have very low leverage, so that the chance of a US-style housing collapse is low. Yet debts are in elsewhere: real estate developers and local governments. Real Estate developers now have lower profit and higher debts, and some local governments have started to feel the pain of a quiet real estate market. In the other aspect of the economy, the Ministry of Railways are losing money and taking on large debts. So home owners will not be the first group to get hit by the cooling of real estate market, rather, the real estate developers will. As the central government is stepping up their efforts to provide affordable housing and tighten monetary policy, there is no surprise to me that the China’s real estate market may correct significantly. And that is going to be bad for the economy because the economy is arguably relying on the real estate sector too much.
Involuntary Monetary Tightening: The Low Probability And High Impact Worst Case Scenario
The nature of today’s banking system makes the whole economic system vulnerable. Fractional-reserve banking system allows banks to create money through credit creation. However, money creation can go in reverse direction and become money destruction if the economy slows and credit qualities of borrowers deteriorate. In that case, the banking system, not the central bank, will tighten the screw of the economy.
Now, the People’s Bank of China is now tightening monetary policy. As far as curbing general prices level and property prices are concerned, there has been very little success so far. Sooner or later, however they will succeed as long as they can hold on to its tightening stance. When they succeed, however, real estate developers are the most likely candidates to feel the pain of cooling property market, their credit qualities will deteriorate. Although it sounds unlikely today, financial difficulties in any real estate developers can set off a chain of events, which will lead to credit tightening by the banking system, and that will then exacerbate the downturn.
One thing that may be comforting is that, although I have little confidence that the government and central bank can engineer a “soft-landing”, I have higher confidence that in the event of a “hard-landing”, the government and the PBOC will be quick to respond. The strategy will be no different from the United States: quantitative easing, and the Chinese may be even more aggressive in that. Whether that will work is a separate question, of course.
When the Chinese economy slows, I think there is very little reason why those folks will still be buying properties overseas (including Hong Kong). I know that has been the prevailing trend for the past few years, yet we are too used to predict the future based on what is happening recently. As a result, the worst case scenario is bound to be inconceivable for most people, and as the worst cases happened, they have never failed to surprise or shock most people.