Is China next? C.P. Chandrasekhar

Though different, the Greek and the US public debt crises threaten a return to the Great Recession of 2008. The world is therefore savouring the reprieve provided by their temporary resolution. But before that ephemeral benefit could be enjoyed comes news of a potential new global economic threat from an unsuspected source: China.

Its source lies in the boom in China’s property market over the last few years, which gathered substantial momentum in the wake of the huge post-crisis stimulus provided by the government to the economy. With a significant share of that stimulus diverted to projects that increased demand for real estate, price increases have been so large that the spiral is now being identified as a bubble.

Moreover, that bubble, some observers expect, is likely to burst in the near future for three important reasons, among others. The first is that the huge, speculative investments made in this sector, especially in housing, to cash in on the price spiral, has resulted in excess supply in many markets, with housing properties lying unsold and unoccupied.

The second is that even as the problem of oversupply was beginning to be sensed in some quarters, the government strengthened its efforts to rein in the housing boom, partly to dampen speculation and prevent a bubble. This was partly because grossly unaffordable housing in the cities was making the government unpopular.

The government was also responding to evidence that its huge stimulus package aimed at moderating the effects of the global crisis was resulting in inflation in the prices of real estate. In addition, the housing and infrastructure boom was contributing to commodity price inflation. To address these issues, it sought to persuade banks to demand larger down payments from clients, increase mortgage rates and restrict lending for multiple housing investments.

Finally, there is the possibility that many who borrowed to finance their housing and real estate purchases may find it difficult to service their debt, since interest rates are being raised to cool an overheated economy. This could increase defaults and foreclosures, bring more housing property to the market, as well as limit additional demand.

Put together these developments are expected to result in a supply-demand imbalance that would reduce house price inflation and even trigger a fall in housing prices. That, in turn, is expected to prick the speculative bubble, leading to a bust in the form of a downward spiral of real estate transactions and real estate prices. The argument seems to be that since government intervention is occurring a bit too late, it is contributing to the onset of a crisis rather than stalling the forces responsible for the build up to the crisis.

Since the prolonged property boom in China had generated a fair share of sceptics who were expecting a bust, this kind of speculation has found much favour. It gained immediacy recently when housing price indices based on prices in 70 cities rose by just 0.2 per cent month-to-month in May and a lower 0.1 per cent in June. On an annualised basis, housing price inflation at 4.2 per cent was, in June, significantly below the 6.4 per cent inflation in consumer prices. The boom was indeed showing signs of tapering off. Was this the prelude to a slump? As if to answer yes, in April, rating agency Moody’s downgraded China’s property sector from stable to negative. This both reflected the mood among investors as well as served as a signal to the more nervous among them.

All this has proved enough for a growing sense of fear about China being the next epicentre of a crisis. A collapse of the property boom in China would have major repercussions domestically. To start with it could dramatically slow growth, since GDP expansion in China is driven substantially by investment, and investment is driven largely by construction, especially of housing and infrastructure.

The real estate market is also a major source of revenue financing state expenditures at the provincial level. The sale of land to developers is a major source of revenues for provincial governments, which then put the money to finance prestige infrastructure projects aimed at attracting investments and winning political attention. If the housing boom trips so will a lot of this infrastructure spending.

Also, a substantial amount of this state spending is financed by credit from the banking system, which tends to view the real estate owned by local governments as the implicit collateral that warrants huge lending. There has been much concern in recent times about the volume and quality of lending by the banks. The first official overall estimate of local government debt in China has placed it at Rmb10,700bn ($1,650bn), or close to 30 per cent of GDP. Clearly, banks lending to local governments have believed that these governments will not default because they have enough resources such as land to pay off the banks when faced with a crunch. The confidence in such judgements seems to be weakening, as reflected in the fact that some investors are moving out of stocks of Chinese banks that are not doing too well.

Fears about bank fragility also come from the direct exposure of the banks to the housing market and to real estate developers. Such exposure has been estimated at 20 per cent of bank advances. If this market sours, the hit on banks transmitted through provincial governments will only be compounding a significant level of direct damage. However remote that possibility, rating agency Fitch has decided to save itself from possible ignominy by warning Chinese banks of asset quality risk and declaring that there is a more than reasonable chance of a banking crisis by 2013.

Despite all this, China fears are by no means dominating the headlines. There is much happening elsewhere, in the US and Europe, to keep financial news enthusiasts preoccupied. Further, there are other factors indicating that China may not be anywhere near the brink of an economic precipice. Stress tests, though unreliable even in the best of times, have indicated banks can easily handle a property market downturn. The average Chinese household is not overly indebted with the ratio of household debt to disposable income placed at less than 50 per cent.

Moreover, house ownership even in urban, let alone rural, China, is not very high relative to the population of households. Urbanisation is set to accelerate, with 300 million expected to move to the cities over the next 20 years. With income rising and the government encouraging private ownership of housing, demand is likely to be sustained, even if not just for the luxury housing that is the market that is possibly losing some of its steam. Finally, housing construction is unlikely to slow because of the government’s decision to make the provision of subsidised housing one of its instruments to address the growing inequality in the Chinese economy. The state plans to deliver 36 million subsidised houses over the next five years. If it goes even a part of the way on delivering on that promise, the construction boom would continue.

All this said, the fear of a housing and real estate downturn in China is understandable. These sectors directly and through the contribution they have made to China’s growth have also partly helped prop up the global economy. They are the sectors that draw huge quantities of steel, cement, household fittings and accessories, the direct and indirect demand benefits of which flow to the world market. China is not just an exporter, but an importer as well. So everybody is interested in a stable China. Fortunately for the world, the state is still a major player in China. And the signs are that it is responding to the danger in more ways than one.

(This article was published in the Frontline, Vol. 28-No. 17, August 13 – 26, 2011)