China Economy: overheating or disaster in 2011?18 January, 2011, 18:44. Posted by Zarathustra
Tags: Economy, Inflation, People's Bank of China, Real Estate
What is going to happen to Chinese economy in 2011? Overheating, or disaster? Or is there a third possibility? I have written that China needs a recession to stop inflation, but I have also pointed out that the Chinese government does not want to see any slowdown (or recession or hard landing). The truth is, no government on earth is all powerful when it comes to managing the economy, and government actions may often lead to unintended consequences. The massive fiscal stimulus and overly loose monetary policy in late 2008 and 2009 has helped China to rebound strongly after the financial crisis, but the inflationary aspects of stimulus and the bubbles it fuelled are now haunting the government. Will policy tightening, then, produce an unwelcome (but necessary) consequence of economic disaster?
Photo: Benjamin Vander Steen
Money Supply growth out of control?
M2 Money Supply (Rebased, 2004 = 100)
Source: People’s Bank of China, St. Louis Fed
I have pointed out previously that the reason for high inflation in China is straight-forward: it is the out-of-control money supply. The disadvantage of keeping Chinese Yuan undervalued is that the Chinese government has no way to control money supply if money flow into the country. Expansion of money supply does not only manifest in inflation, it also helped to fund bubbles.
Real Estate Bubble?
70-Cities Residential Home Prices Index (yoy)
Source: National Bureau of Statistics
We all “know” about the real estate bubble in China. We all “know” how large it is. The reality is less than clear in China though. Official Statistics of home prices are showing increases over the last two years, but in no ways dramatic (13% year-on-year increase doesn’t seem to be a lot to me, who is accustomed to more dramatic rise and fall of Hong Kong property prices). And by the way, now we know that China statistics are not that reliable.
We often rely on anecdotal evidence when it comes to China real estate bubble. We have, for instance, the ghost city of Ordos, which looks completely empty despite the claim that their per capita GDP has surpassed Hong Kong in 2009 (they had some sort of celebrations for achieving this feat, if I remember correctly). There is the now-infamous New South China Mall, which is virtually vacant since its completion. We are never short of anecdotes of almost vacant residential housing with no lights on at night (like this, this, this, and this), but we have never had any concrete number of vacancy rates from official sources because they have never tried to figure out the situation. Some have suggested the government to make use of the Population Census to investigate the vacancy rates, but to one’s surprise, officials and experts were unsure about the definition of “vacancy rate” (although self-evident), presumably because they fear that the reality of vacancy, if made clear to the public, would be disastrous to the market (quite a conspiracy). So they argue that it is impossible to know exactly how high the vacancy rates are in China property market, because they don’t even know what it means.
Some people have taken another approach to look at the problem of real estate bubble by looking at how many electric meters in the country have no readings for 6 months. That investigation concluded that there are some 65.4 million flats which had no usage of electricity at all, which is an indication of vacancy. If This number is true, this is pretty mind-boggling because these vacant homes can house almost 200 million people or 15% of total population in China if we assume the average size of a family is 3 people, and the vacancy rate can be as high as 36%. Naturally, there are many people who disputed the numbers, claiming that to be ridiculous because it would require all homes built since 1995 to be vacant to accumulate that number of vacant flats, and certainly it does not make a lot of sense to claim that all homes built since 1995 are vacant.
So how large is the property bubble in China really? No one knows for sure, except that it is there. Andrew Lawrence of Barclays Capital has made it quite clear with his update of skyscraper index, which points to an amazing building boom in China, especially in supertalls projects. Official data, while unreliable, can also at least give us a glimpse of how much is being built. We can look at the construction start numbers, which have shown pretty strong growth except in 2008 as the financial crisis hit. However, new construction starts in terms of floor area in 2010 jumped 40.7% from 2009, which indicates a huge building boom after massive fiscal stimulus and ultra-loose monetary policy after the crisis.
All Floor Area Construction Start
Source: National Bureau of Statistics
So the overall picture, I think, is that there is a massive bubble here. With probably a very high vacancy (which no one knows for sure how high it is), and with a huge growth in housing start which means increasing supply in a few years time as constructions completed, there will be a supply overhang in the years coming. If the real estate bubble is going to go bust, it will be really ugly.
For the past 14 years or so, the compound average annual growth rate of fixed asset investment was 19%. It was way lower than the average GDP growth rate of about 13% over the same period. After the financial crisis, the massive infrastructure construction plans (e.g. high speed rail, etc) as a part of the massive fiscal stimulus programme helped to boost the fixed-asset investment to increase 30.1% in 2009. With more investment to come in the first year of the new five-year plan, investment is still going to grow very strongly.
Total Fixed Asset Investment
Source: National Bureau of Statistics
Even before the latest boost in 2009, China has produced some of the most impressive and largest infrastructure projects. China now has a massive expressways network which is just a thousand miles short of the United States system. You might want to have to look at the most daring and longest bridges ever built in human history, all in China. But this raises the questions that some of these infrastructure projects like bridges and expressways are going to be under-utilised and not profitable. Indeed, as local governments raise money from banks to fund some of the infrastructure projects via local government financing vehicles (LGFV), many of them have no hope that any of those projects will make reasonable return for them to repay the loans. They need a thriving real estate market to allow them to sell lands to real estate developers in order to have any hope to repay loans. At some point or another, we might realise how much money the government has wasted in building stuff that no one really use. And if the real estate market collapsed, these local government will need to be bailed out.
So, Overheating or Disaster? My Prediction
So what would be my forecast for 2011? I think the Chinese government is trying to achieve too many things at the same time, namely, to contain inflation and keep the economy growing fast. By attempting to achieve so many things, they are bound to perform policy adjustments in a manner which makes them achieving nothing at all. This year, the central bank will want to control the money supply growth rate to 16%. The People’s Bank of China has also raised reserve requirement ratio (RRR) for many times and raised interest rates twice, and I expect that to be continued. However, FT Lex pointed out, as I mentioned, that the Chinese central bank has been quite reluctant to raise interest rates as it wants to keep cost of funding low. Instead, it relies more on RRR to soak up liquidity. Raising RRR is not going to help matter because as interest rates are kept low, people will still find mortgages and loans at affordable interest rates.
The government has acted too late in its attempt to control inflation and asset bubbles, and they are not aggressive enough. Instead, they rely on administrative measures like price cap to control inflation, and impose various buying restrictions in the property market in hope to curb home prices. Those measures never quite worked, and as a reminder, the Hong Kong government’s various administrative measures over the past 20 years in curbing (and supporting) home prices have largely failed.
The later the government and central bank act, the more serious the disaster would be for the economy should they finally tighten aggressive enough. In 2011, I think one likely bearish scenario is that the government and the central bank will continue to tighten policy in hope to stop inflation and make homes affordable. But their piecemeal approach is not going to help the matter. The government may, at some point or another, recognise the need to tighten the policy more significantly. If aggressive tightening led to rapid slowdown of the economy and large drop in real estate prices, the government would then turn to expansionary policy again, which will not be helpful because the burst of real estate bubble often led to prolonged drop in home prices and deflationary pressure. When will that happen? No one knows for sure, but there are probably no bubbles that would not burst.
Alternatively, in a more positive scenario, the government may turn to expansionary policy even if there is only a slightest sign of slowdown. If that is the case, the problem of inflation and asset bubble will never be solved, and the country is either going to be overheating or in a stagflation. Eventually though, they have to let the bubble burst. Certainly, if you let the bubble to inflate larger before letting it bursts, the consequence will be even more severe when it finally bursts.
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