China’s economic strength grows apace and despite fears of an asset bubble, bulls outnumber the bears and argue that property prices have already peaked and will fall slowly - with no apocalyptic consequences for the economy Anthony Beachey reports.

Even Andy Xie, a former chief Asia-Pacific economist at Morgan Stanley, who was another prominent bear, no longer argues that the property market is about to implode.

Xie recently told Bloomberg that while he had previously thought that the property bubble, “fuelled by rapid monetary expansion and expectations of a stronger yuan [renminbi] since the beginning of 2007…would pop with a big bang in the second half of 2011 or in 2012”, recent events had caused him to change his mind.

Xie said that the government was not relaxing the restrictions it had introduced to quell speculation, as he had expected it would; hence, property prices have already peaked and, rather than collapsing as the bubble bursts, they will “trend down gradually for the rest of the year”. Xie further argued that the “market will deflate faster when expectations of a yuan revaluation reverse and capital outflows ensue, probably in 2012”.

However, the independent economist also remained downbeat regarding the longer-term outlook, saying that, “China has entered a property bear market that will last for five years. The average prices in larger cities are likely to decline by half or more. Land values will fall by much more. In the biggest and craziest bubble in Zhejiang Province, prices may drop 80% or more.”

He based this prediction on the idea that “when a bubble deflates, the price must fall to where incomes and returns can support each other. In the case of China’s property market, it means that rental yields – less than 3% – must rise to 5% or more, and the price per square metre should be no more than two months’ average salary.”
Like Xie, Ma is also less bearish than he was a few months ago on the immediate prospects for China’s property market. Ma says he sees no comparison between rising property prices in China and the real estate bubble that developed in America, and which led to the subprime debt crisis.

”Demand remains very strong, as secular forces are clearly at work”

“We do not believe we will see a situation where many households face large negative equity or bankruptcy, and where the banks are left holding the keys of many households,” he says.

“However, we anticipate that property prices in China will experience some sort of adjustment, and that this could vary from between 5% and 10% on average, probably in the first half of 2011.” Yet in April 2010, after the government had first introduced measures to curb property speculation (mainly by reducing credit availability and raising its cost, as well as significantly increasing housing supply, especially at the lower end of the market), BNP Paribas had forecast falls of about 20% in 2010.

Ma says that prices have not fallen so far this year, even though the authorities have introduced further measures since April – hence BNP Paribas’s less bearish short-term outlook.

The evidence from previous cycles in the real estate market influenced BNP Paribas’s forecast of a 20% fall. Ma says: “In 2007, China experienced similar trends in the property market, with buoyant demand and prices, and the authorities rolled out a series of measures that were less severe than those implemented in April of this year. Prices corrected by more than 20%.”

The build-up of wealth may explain why demand and prices are more resilient this time around, says Ma. “But the fact remains that property prices haven’t fallen and demand remains strong, as secular forces are at work, hence our downward revision of the likely decline in prices.”

Increased supply could cause drama in 2011. That is not to say that the government’s actions have had no effect. “The pace at which house prices are rising has fallen considerably, and supply is accelerating, while the number of transactions has also declined significantly,” according to Ma, who adds that ebbing activity normally precedes a turning point in house price trends. Prices rose by about 9.3% in August, the slowest pace in eight months, while the value of sales fell by 19.3% from a year earlier in July. (Transactions rose again in August and the government has introduced a new wave of measures to dampen the market).

”Most Chinese consumers can’t afford highly-priced units and just want a basic home”

Ma says that the authorities will continue to bear down on prices, including boosting the supply of social housing. In addition, Thomas Au, the head of research at Invesco Real Estate Asia, says that there are rumours that the government may introduce a property tax. Not only would this dampen the real estate market, but it would also provide Beijing with a stable source of revenue.

Like Ma, Charlie Awdry, the manager of Gartmore’s China Opportunties fund, also says that a greater volume of housing for sale will be a key factor in helping to limit price rises: “New supply is likely to come onto the market in 2011 and will help to soak up demand.” He points out that, “developers have focused on supplying high-quality, expensive properties, where profits are at their highest. But most Chinese consumers can’t afford highly-priced units and just want a basic home.” Awdry further anticipates that the government will introduce measures to boost the supply of reasonably-priced properties, or social housing.

Michelle Kwok, a property analyst at HSBC in Hong Kong, echoes Awdry’s views: “We see supply jumping 64% year-on-year in 2011, posing a real test for demand.” Kwok adds that slow take-up rates between April and July of this year – following the announcement of the government’s austerity measures, “implies that inventory has been piling up and is likely to be brought forward for sale in the final quarter of 2010, exacerbating the potential for over-supply in the market”.

Whether or not that market can absorb this abundant supply remains to be seen, according to HSBC, and depends on how economic growth develops in the next two years. “Fundamentally, underlying residential property demand will be underpinned by urbanisation in the years to come; hence the physical market will be supported by a certain level of pent-up demand, with buyers looking to purchase so long as the policy environment remains accommodative and favourable,” says Kwok. But a “worst-case scenario” could unfold if the government were to announce more stringent measures before year-end, with the follow-on effects filtering into the system next year. Hence, a property downturn would coincide with massive supply coming on-stream in 2011.

Government concerns over fast-rising prices are not simply economic – housing affordability for first-time home buyers in major eastern cities has become a leading social and political problem. Indeed, it is a source of potentially destabilising public discontent, even if the property bubble can be controlled, according to a report published by the Carnegie Endowment for International Peace in July 2010*.

Yet what led to the explosion in house prices? The Carnegie report blames excessive domestic credit expansion in 2009, when the authorities were seeking to offset the impact in China of the global economic slowdown. The report adds that significant inflows of “hot money” from abroad, low (government-mandated) bank deposit rates, widespread property speculation mania, corruption, and incentives for local governments to drive up land prices to augment local fiscal revenues, also played their part.

This resulted in a property price boom in major cities such as Beijing, Shanghai and Guangzhou, according to Thomas Au. Speaking from Hong Kong, he said that prices in the capital, for example, had risen by 50% over the past 18 months.

Awdry, meanwhile, points to another fact propelling house prices higher – the huge volume of savings in China: “Due to capital controls, there is little that the Chinese can invest in other than property, the stockmarket or a bank deposit, where they will get a negative real return.” Awdry does not argue there is a bubble, but he warns that one could develop if the Chinese decided to shift an even greater proportion of their savings into housing.

The effect on the economy of any fall in house prices will depend on the scale of the adjustment, says Ma. “If house prices fall by between 5% and 10%, or even by 20%, I don’t think there will be a major impact on the overall consumption within the country.” This is because there is not much leverage, with most people buying property with their own cash or putting up large deposits, which will also contain the effect on the financial sector. Banks do have exposure to property developers, says Ma, but not on the scale seen during the subprime debt crisis in America.

Awdry agrees that many properties are bought with cash. “You often hear stories of so-called ’coal barons’, from Shanxi Province, China’s coal capital, who have earned fortunes selling the fuel. They arrive in Shanghai with bag-loads of cash to pay for apartments.” However, he adds that the mortgage market is relatively well developed and there are plenty of mortgages in major cities such as Beijing, Shanghai and Guangzhou. Indeed, it is “one of the main avenues for the growth of bank lending in the country, and a relatively safe way [given the high level of deposits] for financial institutions to gain exposure to consumers”.

Kokkie Kooyman of Sanlam Investment Management also says that banks’ limited exposure to property buyers will cushion the impact of any house price falls on the economy. However, he points out that it will have a psychological effect. “If house owners feel less wealthy, they may well save more and cut back on spending,” Kooyman, who manages Sanlam’s Global Financial fund, says.

Those commentators who say that property prices are not that stretched argue that the population’s fast-rising incomes should be taken into account. But Ma points out that there is no single property market in China.

Hence, while wage increases can support property values in inland cities, where real estate inflation has been relatively subdued, this is not the case in Beijing and booming coastal cities such as Shanghai and Guangzhou, whose already high prices have rocketed, outstripping the ability of many people to buy homes.

”Banks are largely state owned, so even if property prices were to fall by 60%, the government can simply recapitalise the financial sector”

“The wave of strikes we’ve seen in recent months also suggests that Chinese consumers are beginning to feel under pressure,” says Kooyman, responding to those who argue that income growth will support high prices.

Overall, says Awdry, Gartmore is comfortable with the outlook for the property market but will remain vigilant. “It does pose a potential threat to the stability of the economy, but on current trends, we do not believe we have reached the stage where the real estate sector will cause a dramatic economic slowdown.” But he adds that Gartmore is selective about how it is exposed to housing. “Our biggest property position is in a company called China Vanke, which has much greater focus on the mass market than many other developers, who are targeting the high end.”

Carl Astorri, the global head of economics and asset strategy at Coutts in London, is also sanguine about the Chinese property sector, and about the economy in general. He says that “the trend of decelerating economic activity that began in late 2009 is continuing, with property price inflation slowing”. Moreover, says Astorri, retail sales, “typically the last sector to turn in the economic cycle, have also begun to show the same slowing trend as property prices and car sales. Indeed, we expect the retail sales deceleration to intensify into early 2011.”

Coutts thus expects to see a “slowing in the Chinese economy extending into late 2010 and early 2011, which will allow policymakers to follow the pause in tightening with a shift towards a more accommodative policy stance early next year”, a development that should support demand just as new supply threatens to flood the market.

Meanwhile, Kooyman says that even if a real estate price correction were to occur, it would not have a significant effect on the economy. “Banks are largely state owned, so even if property prices were to fall by 60%, for example, the government can simply recapitalise the financial sector. It has certainly taken bad loans off bank books in the past. Of course, government bond yields would soar, but since Beijing has no external debt it would not care.”

However, Kooyman does have some concerns regarding the Chinese economy. Echoing Chanos’s remarks about the government being on a “treadmill to hell”, Kooyman argues that Beijing has overspent and overinvested for the past 10 years just to maintain economic growth, and it now has a lot of excess capacity.

“The lesson from around the world is that eventually you need a shake-out, precipitated, for example, by a recession, to get rid of that spare capacity. How that restructuring process will unfold in China remains unclear, if only because the government is so powerful and has so much capital at its disposal.”

Yet no government is immune from economic forces, as the Soviets and the once all-conquering Japanese found to their cost. The longer China’s boom continues, the more painful the correction will be. So perhaps we should be asking whether in the long run, it will be the economy that brings down the housing market, rather than the other way round. Given that a sharp Chinese economic slowdown would reverberate around the world, that question may be academic.


* Beijing’s New Challenge: China’s Post-Crisis Housing Bubble, by Pieter Bottelier, published by the Carnegie Endowment for International Peace.