Real estate weakness drives China rebalancing

April 25, 2014

April 25 (Reuters) – China’s economy is rebalancing.
Unfortunately it is changing a lot like the U.S.’s did in 2006
and 2007, with a sudden slowdown in real estate.

That was perhaps inevitable, but raises some familiar risks
- a chain reaction of real estate losses, debt defaults and a
sudden slowdown in growth.

The costs for the rest of the world could be high,
particularly in places like Brazil and Australia which have
prospered by feeding China’s formerly insatiable appetite for
raw materials.

China’s GDP is expected to slow to growth of 7.3 percent
this year, down from last year and the smallest expansion in 24
years, according to a new Reuters poll.

On the surface, that’s in line with a government goal of
transitioning from an economy dependent on investment, to one
more like that of more developed countries with a higher
consumption share.

But while consumption is growing as a share of China’s
economy, it is doing so in significant part because investment,
particularly in real estate, is falling in importance. Property
investment fell in the first quarter to 12 percent of GDP, down
from 15 percent last year. That compares to about 5.0 percent in
the U.S.

The value of new homes sold fell 7.7 percent in the and new
home starts fell by more than 25 percent.

That in turn very likely was driven by a tightening of
financing conditions, with overall the widest measure of lending
down more than 9.0 percent compared to a year ago.

And overall debt in China is very high, with some evidence
that absent a continued flow of new borrowing bad debts will
have to be faced.

“Burgeoning debt was not an unlucky accident,” according to
Michael Pettis, a finance professor at Peking University.

“It is fundamental to the way the growth model works, and we
have arrived at the stage, probably described most imaginatively
by Hyman Minsky in his work on balance sheets, in which the
system requires an acceleration in credit growth simply to
maintain existing levels of economic activity.”

Pettis argues that China’s debt problems have become so
large than they can’t be “managed” by imposing discipline on
borrowers or reforming banking.

“Without a massive transfer of wealth from the state sector
to the household sector it will be impossible, I would argue,
for GDP growth rates of anything above 3-4% – and perhaps even
less – to occur without an unsustainable increase in debt,
whether that occurs inside or outside the formal banking system
and whether or not discipline has been imposed on borrowers,” he
wrote.

MINSKY MOMENT?

A Minsky moment, the sudden collapse of asset values when
debt fueled speculation comes to a sudden halt, would be, like
everything else, different in China.

China’s economy has pulled off an economic miracle, but done
so by relying heavily on investment, and with an increasing
proportion of that investment funded by debt. So far, so Minsky.

While it is true that the quality of investment has fallen,
theoretically reducing borrowers’ ability to repay debt, the
story is not as simple as it would be in the U.S.

In China, not only is everything a political question, the
state’s apparatus has far more power to manage how political
questions, i.e. everything, are resolved.

So while the government has a stake in a transition away
from low-quality investment, many bet that they won’t allow
credit to tighten so badly that real estate crashes.

As individual borrowers tend to be less leveraged than in
the U.S., that makes the job of managing a credit slowdown a bit
easier.

It doesn’t make a real estate crash impossible however.
Animal spirits works the same way in China they do in Orlando,
and with about ten years of overbuilding to work through, it’s
not hard to see the possibility of a cascade of weakness through
the economy.

Ultimately, bad debts in China will need to be recognized
and absorbed by some sector. Pressing them on to households goes
against the goal of increasing consumption, while company
balance sheets seem unlikely to be able to handle the sheer
size.

That leaves the government, which may be China bulls’ best
hope.

It won’t end at China’s borders. Managed or out of control,
the transition to lower investment is at hand, and for those
who’ve done well out of it – think resource-heavy countries -
the most they can hope for is enough time to absorb the blow.

(At the time of publication James Saft did not own any
direct investments in any securities mentioned in this article.
He may be an owner indirectly as an investor in a fund. You can
email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

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