Tuesday, June 7, 2011

FLG's Big China Real Estate Bubble Prediction

FLG sees that Withywindle just posted about China being a bubble.

Well, FLG has been talking about a real estate bubble in China since damn near this blog started. Why? China lacks a social safety net, so the ordinary Chinese has a bunch of reasons to save. But China also lacks a deep, liquid financial market. Thus, it's reasonable that the average Chinese would dump there savings into real assets, like gold and real estate. So, an over-investment in real estate is bound to occur and lead to a bubble. The questions that then pop into FLG's mind are two: 1) How long will the bubble last? 2) How bad will the pop be?

Jon Western writes over at Duck of Minerva:
In less than a generation China moved somewhere between 350 and 500 million people out of poverty and into a middle class lifestyle. An astonishing feat -- and one that has no historic precedent. Yet today, those middle class families struggle with three major household budgetary challenges -- affordable housing, school tuition, and health care. Housing is become particularly acute. Professor Li Qiang presented his research on housing reform and privatization since 1978 and the current state of housing challenges. Prices have skyrocketed in the past decade -- especially since 1998 when the government suspended its subsidization of China's housing stock and stopped direct provision of housing opting instead to offer cash subsidies to workers to find private sector housing. This has led to rising inequality in housing consumption as well as a new homeless population. Furthermore, while the financial industry is largely protected because of strict regulations and high downpayment requirements (a problem that ironically exacerbates the challenges to reduce domestic savings rates and jump start domestic consumption among young males), the housing prices -- especially in urban cities -- are at all-time speculative highs and many analysts now anticipate major price corrections that could well send significant shock waves through the economy.

FLG emphasized the last two sentences because they are key to understanding the effects of a Chinese housing bubble. The key is leverage. The dotcom bubble burst, but wasn't so bad because most people weren't leveraged. Sure, people weren't happy to see their 401k drop, but assets they owned dropped in value. Not assets they borrowed money to buy. As FLG has written before, this is a key distinction. If you lose a bunch of money on a stock, that hurts. But you move on. If you lose a bunch of money on a stock that you borrowed money to buy, then that's panic mode time for most people.

The problem in the US was that residential real estate was highly exposed to leverage. Thus, global financial crisis ensues. China, on the other hand, requires high down payments. While this "exacerbates the challenges to reduce domestic savings rates" it does, as the author also mentions, "protect the financial industry." (BTW, FLG is far less concerned about the strict regulation than leverage.) Thus, the fallout from any potential bubble should be less, at least in financial and economic terms, than what happened here in the States.

The interesting phrase, at least to FLG, is "price corrections that could well send significant shock waves through the economy." As he just wrote, FLG thinks the amplitude of the economic and financial waves won't be as large as here in the States. Moreover, he also believes that the obstacles to taking on leverage, in this case high downpayment requirements, will lead to less drastic unwinding. Instead of the lending carpet being pulled out from under the next round of borrowers, people in China will gradually have more and more trouble getting to the downpayment thresholds. Unless, of course, those barriers are exogenously lowered.

See, but here's the interesting part, again at least to FLG, what if the significance isn't in the financial/economic amplitude of the waves, but in the political ones. It could be that even a smaller economic fallout, for our purposes let's call it something more like the dotcom bubble than financial armageddon, is enough to undermine the bargain the Communist Party has tried to strike with the people -- sustained economic growth in exchange for sustained power.

So, here's FLG's big prediction -- China's real estate bubble will be small in comparison to the recent real estate-based unpleasantness; however, the political ramifications within China will be much larger than the economic effects. FLG isn't sure we'll be talking about Spring in the Middle Kingdom quite yet, but who knows.

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