It has been about a year since Jim Chanos labeled the Chinese real estate market a giant bubble. Other analysts and traders like Hugh Hendry joined in, in agreement. And there are now special funds popping up in the hedge fund ecosystem specifically for this purpose. However, the Chinese real estate bubble has just gotten bigger in the meantime.
Edward Chancellor, a member of the asset allocation team at GMO, wrote in the Financial Times over the weekend:
The value of the housing stock is set to exceed 350 per cent of GDP this year, the same level as Japan at the height of its real estate bubble.
Shen Minggao of Citigroup said in an interview:
China’s property market is entering into a bubble stage. It’s evident that property prices are no longer sustainable once the residential investments achieve above 8% of nominal GDP, and China may not be an exception.
According to Shen, Chinese investment in residential property accounted for 6.1% of GDP in 2010 – the same relative level that we saw in 2005 for the US, before its real estate crisis. And it is only 2% points away from reaching the level that marked the top for the Japanese real estate market bubble.
If the above doesn’t scare you witless… I don’t know what will.
The Chinese government is aware of the danger. A government think-tank (Chinese Academy of Social Sciences) issued a recent warning that out of 35 major cities, real estate prices in 11 cities were overvalued by between 30-50%. Last year they implemented several new rules to cool things down. First time home buyers had to have a 30% downpayment and second and third time buyers need 60%. And just recently they instituted a property tax of 0.4-1.2% for homes in Shanghai and Chongqing. But the hotly debated tax only applies to large houses and only those that will be purchase recently (after March 27th 2011).
The problem is that on a local level, the municipal governments have a vested interest in the real estate bubble continuing. This is because land sales account for a large percent of their budgets and they simply can’t go without it. And while these new property taxes may alleviate a small portion of any potential reduction in land sales foregone, the developers will simply add it to the final bill and the buyers will pay for it. In effect, the Chinese government has actually helped to increase house price inflation. Needless to say there is also a large amount of fraud and corruption fueling the mania.
In January China’s property prices increased for the 20th consecutive month by 1%. This in addition to a 0.9% increase in December 2010. Obviously the curbs are not working.
The Chinese stock market has been a lousy place to have been an investor last year. The last time I mentioned it was in May 2010 when I noted that it had broken down below its 200 day moving average and was listless, especially relative to the US equity market. The Shanghai Composite ended 2010 down 15%. And remember, the Chinese stock market does not allow short selling. My concern continues to be that the bubble growing there threatens everyone else.
The shockwaves of a “hard landing” for China’s real estate market will reverberate throughout the global financial system. Especially hard hit will be commodity markets which have been driven by a seemingly insatiable appetite for raw materials. China’s economy has been an inverse cornucopia, sucking up all of the earth’s raw materials as fast as it can so it can grow and grow.
Based on Shen’s calculations, a 10% drop in Chiese property investment will lop off 1% China’s nominal GDP. If we take into account peripheral investments indirectly related to the real estate industry, then nominal GDP will decline between 2% -2.5% points. And based on a report from the ratings agency Fitch, if China’s growth declines to 5% from the estimated 10%, then global commodity prices could fall as much as 20%.
The nature of bubbles is that when they correct, they usually overshoot on the downside. So my own estimate is that if we are looking at this scenario, then the commodity markets will see some irrational shocks that might take some individual raw material prices down 40-50%. That in turn will translate into losses in the equity markets as the shares of the companies involved in the affected industry see their equity fall.
tradersnarrative 
One excellent thread, Babak!
Now that the Chinese Central Bank has raised a key rate for the third time, without an intervening cut, I wonder if this centrally-controlled economy/market will exhibit Edson Gould’s classic “Three Steps & a Stumble” effect. Will this indicator concerning restrictive Fed actions work in a non-Western country?” (To whatever effect it has worked in ours…)
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Thanks for another well written, well reasoned, thought-provoking article. I can’t help thinking that China could be replaying the 2006 scenario in the US when the bank regulators issued the “Interagency Guidance on Non-Traditional Mortgages” (signed September 26, 2006, virtually the day the housing market peaked) that not only guaranteed a sub-prime ARM crisis and prohibited virtualy all potential sub-prime ARM mortgage borrowers, which accounted for 26% of all mortgages in 2006, but also disqualified a huge portion of prime borrowers by eliminating stated income, no ratio and no doc loans and jacking up the qualifying payments for all prime ARMs (fully-amortizing payment at the fully-indexed rate, then about 7.5%, regardless of the note rate and regardless of interest-only payment terms). Now we have the Chinese government jacking up down payments, property taxes, and interest rates to “cool” the housing market. As we found out when a bubble “cools” it can cool very fast and a lot with dire consequences for mortgage investors and borrowers alike. I’ve been mentioning the Guidance in blogs for years, but not even one other commentator I’ve found has pointed to these ill-timed overly restrictive regulations as a major culprit in causing such a severe downturn. In my mind they’re eerily analagous to the drastic change in stock margins after the 1929 crash which only fueled stock selling and preventing any quick recovery. In my testimony during the comment period prior to the Guidance being issued I flatly predicted a financial tusnami and economic crisis rivaling the Great Depression if the regulations were issued. Perhaps the actions of the Chinese government will spark similar consequences to housing values in PRC, but I’m not sure how that would affect other economies or the world financial system.
President Obama is fond of saying that the federal government pulled the economy back from the brink of a depression, but unfortunately it only provided significant relief for investment banks, a temporary reprieve for the bankrupt second mortgage lenders and stock market investors, but almost no effective relief for mortgage or credit card borrowers. As un/underemployed borrowers default on their mortgages and credit cards and inflation soars while wages don’t, and politicians do nothing to stop the consumer bleeding, in fact make it worse with spending cuts, there will be continued massive bankrupties and foreclosures for quite a while. There are millions of homeowners stuck in mortgages ARMs that cannot be refinanced, and if interest rates rise persistently, that will be another blow to housing. There are millions more in mortgages that are upside down, about 30%, and they can’t sell or buy another property without ruining their credit or paying off a huge amount of negative equity, which most cannot do. I don’t see how this can end except with continued economic malaise and financial chaos until homeownership is down to 50% as in the Great Depression, or less.
I thought the rise of raw material was mainly caused by US dollar depreciation and they were seemingly in the same pace.
Also, i believed that the increase of key rate and property tax imposed were in response to current crucial inflation problem about which government far more concered than this real estate bubble.
Why is it that we cannot reinvent our own economy and stop sending our business to the Asian continent? Why can’t we too make it possible for China to play on a level playing field. We have been giving China the store for decades starting with the Bush clan and then the Clinton era. Why can’t we see that we have passed the torch to a communist country. Will they eventually rule the free world and therefore dictating our every move?