The China Real Estate Bubble

Jim Chanos Interview

You probably know that Kynikos Associates Ltd and its founder, Jim Chanos, are shorting property developers and building suppliers in China. In an interview that will soon air on the Charlie Rose Show, Chanos provided some information on the Chinese property bubble, as well as a contrarian opinion on the Renminbi.

According to Chanos, China needs to keep up the pace of property investment because up to 60 percent of its gross domestic product relies on construction. "They can’t afford to get off this heroin of property development. It is the only thing keeping the economic growth numbers growing." Chinese state and local governments are among the most leveraged to property-related borrowings among all government entities around the world. Chanos also said that the bubble may start to burst perhaps later this year or in 2011.

How the Property Collapse May Play Out

Most observers probably expect the property bubble to collapse and result in a banking crisis, although others remain optimistic that China can mop up the effects of any financial bubble without ill effects. Chanos said that China will "ultimately" have to nationalize a lot of the bad loans from the property bubble, and that its foreign currency reserves will be "one asset" available to clean up the banking system. It would be useful to know more about how the collapse will play out, however.

Several Years of Sub-Par Growth

A good source is a recent article by Michael Pettis, Who Will Pay for China's Bad Loans, which argues that China will have a heavy price to pay for its excessive investment in the property sector, but not in the form of a banking collapse. Pettis is worth listening to as an expert on Chinese financial matters, in view of his position as a professor at Peking University’s Guanghua School of Management, and a Senior Associate at the Carnegie Endowment for International Peace.

Pettis says that we can learn a lot from the situation a decade ago when China had a huge surge in non-performing loans, the cleaning up of which was to cost China 40% of GDP. Although China paid a very high price for this earlier banking crisis, that price came not in the form of a banking collapse but rather in the form of a collapse in consumption growth. GDP growth was trimmed by several percentage points as households cut back consumption and raised savings in response to government policies. Money transferred from the household sector to the banks served to fund very low lending rates and to guarantee sufficient bank profitability to rebuild capital, avoiding a banking crisis.

Because at that time US leverage was rising and the world growing quickly, the cost of the collapse in consumption was easily masked by China’s surging trade surplus. Today, however, the US and the rest of the developed world are deleveraging rather than leveraging up. If China cannot rely on growing exports, the only acceptable alternative will be to increase household consumption. The problem is, as Pettis says: "But since growth in household consumption has always been constrained by the growth in household income, it may be unreasonable to expect a surge in consumption when households are also required to clean up another sharp increase in non-performing loans."

Pettis's conclusion is that the price China pays for the present bubble may be several years of below-average growth.

Implications for the Renminbi

Despite recent widespread anticipation of an upward revaluation of the Renminbi, it is possible that a collapsing property bubble could lead to a decline in the value of the Chinese People's currency in dollar terms. In another report of the interview Chanos was quoted as saying: "Chinese exports aren't the problem here. And what if it turns out that by having to nationalize lots and lots of real estate bad debts, the RMB is devalued." It is interesting that the latest month's data from China did show that the trade balance has deteriorated sharply, although this announcement was, just incidentally, immediately prior to talks with Treasury Secretary Timothy Geithner about exchange rate and trade issues.

Property Debt Continues to Increase

In an online article for China International Business, former Morgan Stanley analyst Andy Xie described the massive size of the property bubble and how destabilizing it is socially for land to continue be so unaffordable as to slow the growth of the middle class. An interesting takeaway is that the bubble may continue to build, and that it will be very difficult to predict the timing of the collapse.  "The bubble can still continue because China's banking system has plenty of liquidity – thanks partly to hot money and because local governments have many levers to channel bank liquidity into the market. But the longer the bubble lasts, the more damage it will do to the economy."

Collateral Damage

It is hard to imagine how a country can avoid financial collapse when it has incurred so much debt for so many unproductive assets.  In fact, China has been over-investing in fixed assets of all kinds, including industrial capacity, for some time and not just housing property.  The problem is that many firms in the US and other developed countries are involved in sectors throughout the Chinese economy, which makes one wonder:  Which firms will suffer the most, and how far will the damage go?

Cyclical Upturn within a Structural Decline

There is an interesting presentation from the Economic Cycle Research Institute (ECRI) indicating that the US economy has been recovering from the Great Recession and suggesting that the recovery may continue for a while.

They suggest that, from a cyclical perspective, we are about to see higher inflation, more employment, and higher levels of economic activity.  This does not sound good for bonds in the near future.

There is an interesting divergence between this good news about the immediate future of the economy and implications for the longer term.  The presentation includes several decades of economic data series indicating that the magnitude of US economic recoveries has been declining for a number of decades, and that economic volatility is declining (less difference between peaks and troughs).  This means that the US economy is spending a greater proportion of the time in a state of economic contraction or at very low levels of economic activity.

ECRI suggests that unemployment may have peaked for this cycle, but the news on employment is not totally happy.  The shortening of the expansion phase of the cycle has some sobering implications, including: Job growth during this expansion, if it continues, is unlikely to compensate for the jobs lost during the recession.  ECRI's indicators also suggest that inflation is increasing, which would  not bode well for bonds.

Changing topics to the stock market,  the stock market looks expensive now, and the prospects for very mild growth do not bode well for improved valuations.  For a good source of information on that topic, John Hussman's weekly commentaries contain useful perspectives, as well as references to other sources of information on stock market valuation.