A couple of research reports released overnight by Deutsche Bank and Bank of America, respectively, come to a sobering conclusion: the fate of the global economy may be in the hands of the Chinese housing bubble. As a reminder, China is a serial bubble inflator courtesy of a closed (capital account) economy, and nearly $30 trillion in bank deposits which slosh from one asset class to another, be it the stock market, bitcoin, commodities, farm animals or – most often – housing.
As all China watchers knows, and as DB confirms, the root cause of this bubble is “excessively loose monetary policy set to achieve growth above its potential.” Furthermore, while the most recent housing bubble, the third in a row, appears to have recently popped as annual home price growth declined in January for the first time after 19 months of continuous acceleration, the question is how hard will Beijing push to prevent the same hard landing that took place in late 2014 when the bursting of the second housing bubble led to substantial slowdown in China, and sent rippled effects around the globe.
So why is it so important for China to periodically and consistently reflate this bubble? The answer is simple: a gargantuan wealth effect, to the tune of 24 trillion yuan, or roughly $3.5 trillion.
As Deutsche’s Zhiewi Zhang writes when discussing the macro and market consequences of the Chinese bubble, it is nothing more (or less) than “a massive wealth effect”:
We estimate that in 2016 the rise of property price boosted household wealth in 37 tier 1 and tier 2 cities by RMB24 trillion, almost twice their total disposable income of RMB12.9 trillion (fig.11).
Such effect even spread to many tier 3 cities (Figure 13).
And, as Deutsche further points out, the (rather fleeting) wealth effect “may be helping to sustain consumption in China despite slowing income growth. A decline of property price would obviously have a large negative impact.” And not just in China, but around the globe, as this incremental $3+ trillion in demand provide a material boost to not only China’s direct trading partners, but set the economic pulse around the globe via various “soft” sentiment surveys, via transposition of the “EM to DM” growth narrative, as well as via direct purchases of offshore assets by capital controls-circumventing Chinese residents.
In fact, as the German bank explicitly states, the “property sector has become the critical pillar for fiscal revenue and the economy.” A sector which as both the Chinese government, and DB, call a bubble.
But why would the government tolerate the bubble – knowing its bursting could have dire consequences on the economy if not contained – instead of seeking to deflate it gradually? There are three reasons:
- The property and construction sectors accounted for 33% and 15% of local government tax revenue growth between 2010 and 2015. They contributed 43% of local government tax revenue in 2015, compared to 11% from manufacturing (Figure C3). Besides taxes, local governments also heavily rely on land sales to finance infrastructure projects.
- Banks, developers, urban property owners, and government all benefited tremendously from the property sector so far. This makes it difficult for the government to tighten monetary policy or roll out straightforward measures such as property tax to contain the bubble. The reluctance to prick the bubble only makes it larger.
- The government may have the confidence that they can avoid a property bubble burst. It does appear that China has a stronger control over property prices than other countries, because it has a closed capital account, high saving rate, low CPI inflation, high level of reserves, a current account surplus, monopolized land supply, and a financial system largely controlled by the government. Some may argue “why can’t Beijing and Shanghai become Hong Kong?”
So the question the is simple: with the fate of the domestic, and therefore global, economy in the hands of China’s housing sector, what happens next. The answer is unclear, however as DB warns, “property bubble bursts in other countries were often preceded by higher interest rates.” And in what direction is the world headed? That’s right: one where gradually every central bank is starting to tighten and raise interest rates. As DB further adds, “the chance of rate hikes in China rises in 2018 as we expect higher inflation in China and six more rate hikes in the US over 2017/18. In the longer term, unfavorable demographic trend and slowdown of urbanization are the ultimate constraints.“
So while it is clearly Beijing’s desire to keep the housing bubble as inflated as possible, it may not have a choice absent further, much looser monetary conditions. The reason for that is as Bank of America’s David Cui writes, “China’s housing market is among the least affordable globally. Although this doesn’t necessarily mean a sharp price correction anytime soon, it leaves the government with less scope than most others in our view to manage housing price, should interest rate jump or income growth slow. In addition, we believe that high asset prices, including housing price, is one of the main drivers of capital outflow.“
Some further thoughts on what may be the world’s least affordable housing market:
Many use the housing-value to GDP ratio to gauge whether a country’s housing market is reasonably priced. We believe that the ratio of housing value over household income is more telling – after all, households spend their income buying houses, not businesses nor the government. Based on this ratio, China’s is the second most expensive market among the countries that we track, all with a reputation of excessive housing price at various times (Chart 1). Other than the high housing price (relative to income), another major contributor to China’s high ratio is a low share of household income in GDP (which, by the way, goes to the heart of China’s imbalanced growth problem in our view).
Does this unprecedented unaffordability mean that a crash is imminent? According to Cui, China’s high ratio currently doesn’t necessarily mean that housing price will drop sharply anytime soon – Japan’s and Ireland’s had reached far higher levels before theirs corrected while Australia’s, Korea’s, and indeed, China’s have stayed at high levels for years without any major price correction so far. However, a few factors could make housing price in China over the next few years more vulnerable than most, including financial system risk posed by a rapid rise of leverage economy-wide, and a lack of exchange rate flexibility.
A far more immediate problem as a result of China’s housing bubble may be the acceleration of Yuan outflows. According to Cui, a major driver of China’s capital outflow is high asset prices.
In another word, the local rich may prefer NY condos to Shanghai apartments for better value, for example. From this perspective, for the outflow pressure to ease, either housing price in Rmb terms has to decline or Rmb devalues. This assumes that the government cannot control capital outflow effectively in the long run, a reasonable assumption in our view given how open the Chinese economy is.
How will the government react? BofA predicts that “if it comes down to it, we expect the government to choose Rmb devaluation over asset price deflation” aka a housing hard landing. ” Arguably the biggest driver behind high asset prices in China is leverage in our opinion. As a result, any major asset price decline may quickly trigger a debt deflation spiral and financial system instability.”
The take home summary: keep a close eye on how Beijing manages to deflate the existing bubble: if it fails to be aggressive enough, home prices will once again spike, leading to an even more precarious bubble. If it is too aggressive, a hard landing is in store, coupled with what a crash in the country’s financial system, where the bulk of the banks’ $35 trillion in assets is collateralized by housing values. While such a crash may not necessarily lead to a catastrophe for China, where the government ultimately backstops all the banks, the deflationary wave spread around the globe from a housing crash would be dire.
Which is why those who are looking for key inflection points to determine the future trajectory of the global economy, in addition to the global (read Chinese) credit impulse…
… we suggest keeping a close eye on what happens with Chinese housing, which has become a – if not the – top variable for the fate of the both the great inflation-deflation debate, as well as the overall fate of the world economy.