China talk is confusing. The Shanghai stock market is at its lowest level in eight months, with the real estate sector especially hard-hit. Yet the media is focused on a property bubble that triggered another baby step by the government to rein in bank credit to head off speculation.
Meanwhile, others fret that a big bust is about to follow the boom induced by a 32 percent rise in lending last year, which drove first quarter growth in gross domestic product this year to a bubbly 11.9 percent. Even the usually bullish consensus on China seems to be shifting in favor of bears who predict crashes ahead. They note in particular the quiet but spectacular build-up of borrowing by companies controlled by local governments and used as conduits for projects of dubious commercial value.
Is there a plausible middle ground between these positions? Yes, there is on a short-term view, but the longer term is more problematic.
There undoubtedly has been a property bubble, particularly in the major cities, with prices driven by speculative investment, as the few who have money — often ill-gotten — buy more property. Prices have soared 40 percent in 18 months, according to independent analysts. They are now almost 20 times average earnings in the top tier cities and at least 10 times in many lesser ones — far beyond the reach of most salary-earners, even in a society where interest rates are below the rate of inflation, stock markets are erratic and thus property is seen as the only dependable security.
There is a reasonable prospect that this bubble will deflate gradually, thanks to additional housing supply and the government’s administrative measures to restrict credit. A 20 percent fall in peak prices could occur, but this should not hurt the banks because few purchases are made with less than a 20 percent down payment.
On a medium term view, prices should also be held down by the government, which is moving back into the business of housing for lower income people by setting aside urban land. In the future, 25 percent to 30 percent of new urban construction may be for this sector and will probably have a knock-on effect by improving affordability for middle income earners. Slowing urbanization may also reduce housing price pressure.
But a more balanced housing market could reveal a bigger problem: the true state of local government finances. City and county administrations have become extremely dependent for revenue on land sales. Local governments have a vested interest in speculation and high land prices to fund the grandiose infrastructure and show projects that enhance their reputations and drive local growth.
Fast-rising land prices have lifted local government revenues, so officials have a vested interest in keeping prices inflated. But even without central government efforts to rein in prices, local land revenues could well stall soon.
China’s dirty secret is the amounts borrowed by corporate entities created by local administrations as fronts for grandiose projects. While central government finances remain very conservative, the situation elsewhere is at best opaque. The separation of state and corporate sectors is still fuzzy. Government-related companies have been receiving most of the new credit, often spending with scant regard for the rate of return on the investment. The genuinely private sector has less political clout to get loans, and is rightly viewed as riskier than a state sector that can get bailouts or has land that it can sell to pay debts.
Given minimal household debt levels and low direct bank exposure to property, China can afford some housing bubbles and busts, just as other East Asian countries did in decades past. But what it cannot afford, particularly now that its workforce is no longer growing, and urbanization is slowing, is inefficient use of capital. That danger is being exacerbated by low interest rates and bank bias toward state-sector lending.
China’s very high savings rate is a cushion, but it holds back consumption and, if poorly invested, it ultimately will result in bailouts and black holes for banks. Ask Thailand or South Korea about the roots of their crisis of 1997.