We believe the time to be worried about bubbles bursting is when (i) excess investment leads to deflation (China has close to record deflation), (ii) house prices fall (they are currently down by a record amount), (iii) we see FX outflows (which are now close to record highs), (iv) deposit growth slows down sharply (they are close to a record low), and (v) the labour market shows signs of full capacity (the job offer to application ratio is at an all-time time high). Furthermore, nominal GDP growth has fallen to 5.8%, only a third of average levels.
However, there are some signs of near-term improvement: (i) house prices have stabilised (temporarily, we think), (ii) the current account has improved (which creates more monetary flexibility), (iii) there are signs of policy proactivity (as shown last week with the government’s moves to stabilise the equity market), and (iv) the Credit Suisse Premier Li indicator is ticking up.
Nevertheless, we believe that if house prices fall 15% or deposit growth falls to zero, China’s real GDP growth will slow to sub-3%.
Finally, we think that there is a clear cut housing bubble.
Almost by the nature of a bubble, the participants are reluctant to acknowledge that it is one. But three factors indicate that it is a bubble:
■ The size of real estate as a share of GDP: This is now triple that of the US at its peak and similar to peak levels in Spain and Ireland (Moody’s claim that real estate is around 23% of GDP, directly and indirectly);
■ Overbuild: Housing starts are 12% above housing sales, and vacancy rates, according to the SHFO are 15% to 23%. Inventories in third and fourth-tier cities are now equivalent to 5 years’ worth of demand, and 18% of completed homes have become vacant.
■ Overvaluation: It is hard to get clear cut data, but house price to wage ratios appear excessive by any standard (even central London) and this is assuming three income earners per household. The rental yield is very low (officially it is 2.4% but in many instances it is a lot lower) compared to mortgage rates of 5.1% and the Yu’e Bao money market fund rate of 4.2% (with 14 day SHIBOR running at 3%).
Of course, the debate is over the leverage in real estate, but in our opinion, if there has been a credit bubble at the same time as a housing bubble, then it is highly likely that leverage has found itself into housing. For example, housing developer Evergrande announced on April 16th it would allow buyers to get a full refund any time before the delivery of housing units (which is usually 6-12 months after pre-sales). Our concern is that a triple bubble in housing, credit and investment comes with the significant risk of a hard landing. The question is when?
If house prices fall by 15% or more, then we think that we are likely to get a hard landing and the authorities risk running out of fiscal firepower. We suspect that if house prices fell by that much, then the LTV threshold would be absorbed. Moreover, with housing contributing to a third of local government revenue, 56% of banks’ collateral and around a fifth of GDP, the knock-on impacts could be immense.
Twice in the past, NPLs have risen above 20%. If this were to happen again, on the current credit-to-GDP ratio, the cost of recapitalising the banks could easily be 50% of GDP, not to mention the deterioration in the fiscal position on account of the loss of fiscal revenue. At that point, most of fiscal flexibility would be used up; however, the authorities would still have the ability to expand monetary policy, cut rates and RRR.
The second catalyst we see for a hard landing would be if deposit growth at banks stopped [now the lowest on record at just 6% with external liquidity in the form of FX flows drying up], as this would essentially limit the ability of banks to roll over loans to SOEs, in our opinion.
The MB view is that this is all inevitable. The only question is timing, whether is takes one year or five years. Given the Chinese Communist Party’s proclivity for growth (still), the base case is the longer term outcome. But even that is pretty fast and does not change the implications for Australia nor what it should be doing to prepare (same goes for investors).
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
