China Bubble: Now the Locals are Worried

Alarm over China’s bubble economy continues to grow.

First, Western commentators, led by Jim Chanos and Vitaliy Katsenelson, warned that China’s economy is over-dependent on fixed asset investment – i.e. building infrastructure, real estate and manufacturing plants. This over-investment in fixed assets, which now comprises a whopping 60% of China’s annual GDP, has caused China to build far too many things (apartments, factories, etc) that are not needed, resulting in significant over-capacity and malinvestment that will ultimately lead to a pile of non-performingloans and destruction of wealth. One only has to view footage of China’s empty cities to understand the extent of this fixed asset malinvestment.

Then, as reported last week, Yu Yongding – a prominent economist from within the Chinese establishment – published a scathing attack on China’s economic model in the state-run China Daily. This article supported the concerns voiced by external commentators over the Chinese economy.

Now the Shanghai Daily has published an explosive article entitled: It’s only a matter of time before China’s housing bubble bursts. Here is an extract of the best parts:

…Property developers everywhere are competing to break records for the highest land-bidding prices, hence, we see a series of “kings of the land,” referring to lots acquired at the highest bid.

What’s more, the fever for land acquisition is spreading from the major cities, mostly coastal ones, to medium and small cities.

…Frustrated people are even beginning to doubt that authorities have silver bullets, and scrambling to buy before prices rise further. This is a vicious cycle, making it more difficult to control prices.

The People’s Daily has been bashing tudi caizheng, or “land revenue,” meaning taxes and fees local governments levy on developers and other land users.

Almost everyone knows that tudi caizheng is at least partly responsible for the ever-inflating bubble.

National data shows, during 2001-2003, the total land-sales revenue was over 0.91 trillion yuan (US$137 billion), accounting for 35 per cent of total fiscal revenue. The figure for 2009 rose to 1.5 trillion yuan, equivalent to 46 per cent of the total.

This year’s figure is expected to surpass 2 trillion yuan, an astronomical one.

In the breakdown, the combined land revenues for Beijing, Tianjin and Shanghai – whose housing prices are among the nation’s highest – are expected to hit 400 billion yuan, 20 percent of the expected national total of 2 trillion yuan. In contrast, the combined GDP of these three cities accounts for only 11 percent of the national total.

Many other cash-strapped cities and counties are virtually running on land sales.

…The adoption of the “revenue-sharing-scheme” in 1994 gave governments great incentive to sell as much land as possible at top prices.

While the ingenious model did spur economic development, it sowed seeds of risks.

With farm land disappearing around cities, vegetables and other food are more expensive; conflicts – many bloody and even deadly – are escalating between demolition teams and home owners.

…Despite wide concern over rising risks, few seriously think the bubble is likely to burst here, as it did in Japan, Ireland and now in Spain.

The latest buzzword is “rigid demand” for homes, meaning demand is endless considering the huge population and booming economy.

There seems to be a “China Myth.” Is that true?

A study of the Japanese property bubble may be helpful.

In the heyday of Japanese prosperity, the land value of Tokyo alone exceeded that of the entire US. Japanese tycoons were considering buying up America. What happened later is history.

Wandering around newly completed residential areas near my home in Shenzhen – stacked with gleaming apartments, I find 80 per cent of the units are still unoccupied one year after completion. The same is true in Beijing.

Prices have made ownership impossible for most buyers. So, it’s a matter of time before the bubble bursts…

This article illustrates just how much of a bind China’s Government is in. Although it wants to reign-in the property market, it has to keep the bubble going in order to preserve local government finances. But by perpetuating the bubble, the Government is on a collision course with ordinary Chinese who are being squeezed by rising costs of living. Not only have housing costs gone through the roof, but food prices are rising due in part because farm land is disappearing to make way for new development.

And although the Chinese believe they are different, the fact remains that China’s housing bubble is approaching Japanese proportions. Whereas Japan’s residential housing values reached a stratospheric 3.8 times GDP at the peak of its bubble, China’s housing values were 3.5 times GDP as at February 2010 (see below chart from my Battle of the Bubbles article).

Implications for Australia:

I won’t rehash previous analysis on the importance of continued strong Chinese growth to the health of the Australian economy, since you can read these for yourself herehere and here.

Instead, I will point you to an excellent article by fellow blogger, Financial Follies, entitled Australia’s unhealthy dependence on China. It’s a brilliant discussion of the devastating impact that a China slowdown could have on the Australian economy. I highly recommend that you read the entire article. Here is a sample:

…Like it or not, our economic future is now inextricably linked to that of China. China now accounts for an astounding two-thirds of world iron ore demand, around one-third of aluminium ore demand and more than 45% of global demand for coal.

…Michael Pettis of Peking University has been arguing for some time that China is running up against the limits of it’s investment and export-led growth model, and that the days of double digit growth rates will soon be a thing of the past….”It seems to me that consumption growth of 8-9% will be very hard to maintain, so I would argue that we should be prepared for even lower average growth numbers, perhaps in the 3-5% range… Non-food commodity exporters will be badly hurt”.

…What would the implications be of such a drop in China’s growth rate? Fitch Ratings recently performed a “stress test” of what would happen if Chinese growth slowed to 5% in 2011…Fitch expects that such a growth slowdown would cause a major crash in Asian stockmarkets, and a 20% fall in commodities prices.

…Fitch identifies iron ore exporters as amongst the biggest potential losers…But perhaps the most interesting section of the report is Fitch’s expectations of what would happen to banking systems and financial markets in the event of a sharp slowdown in Chinese growth….

…Fitch anticipates that a material slowdown in the Chinese economy would have a negative effect on the willingness of global banking systems to continue providing credit… Those countries with the heaviest reliance on China as a destination for exports (Hong Kong SAR, Taiwan, Japan, Korea, Singapore, Malaysia, Australia, Brazil, Chile, Peru and Russia) could potentially see a retrenchment of their banking systems, with credit availability reducing…

This impact could be exacerbated by negative developments in the real estate markets of those countries with strong trade links to China, particularly those where property prices have risen strongly over the past 12–18 months, such as Singapore, Hong Kong, Taiwan and Australia.

…So let’s summarize the implications for Australia of a sharp growth slowdown in China. Firstly, our miners will be heavily hit as Chinese demand contracts and commodity prices drop significantly. The Australian dollar will probably fall sharply. International investors will become risk averse, and may be unwilling to refinance the massive external liabilities of Australian banks without demanding a large risk premium. As credit dries up, Australian property prices will inevitably fall. This is an ugly scenario all round.

The risks articulated by Financial Follies are similar to the doomsday scenario described in my 6 December post. That is, where China’s economy slows considerably causing: (1) Australia’s Terms-of-trade to crash; (2) increased unemployment; (3) severe worsening of the Budget bottom-line; (4) credit rationing and severe bank stress; and (5) a house price crash.

Batten down the hatches, Australia. Things could get ugly.

Cheers Leith

Leith van Onselen

Leith van Onselen is Chief Economist at the MB Fund and MB Super. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.


  1. Leith,

    Will the new MBS and Covered Bonds be sufficient to replace the Australian banks' off-shore wholesale borrowings for real estate?

    This is what it is all about, not "competition", in my opinion….and taxpayer guaranteed!

    Incidentally, the informal finance for property in China – the "sharks" ponzi scheme – will be interesting when it unravels. Only then will it be apparent how widespread it is. Just the same, in the above referenced M Pettis article he does not see a China property crash…he thinks they will manage it down over many years…which, he believes will ultimately be worse.

  2. I've been following the development in China for some time and your blog during the last cople of weeks and I absolutely beleive this will blow up in the coming year.

    I have a friend who visited China about a year ago (working as a construction-consultant for a chemical-plant) and his stories are really horrific to hear. According to him the Chinese authorities basically go into the countryside and "fetch" poor peasants and force them into factories – where they have no clue what to do and they're basically treated as cattle… and according to my friend they're absolutely incompetent to do anything and because of this efficiency is extremely low.

    I live in Sweden and I have the same worries as Australians have – Sweden has a very large dependence on iron-ore, steel and industrial equipment exports for its well-being.

  3. Financial Follies

    Leith — Thanks for the link. The China story is certainly starting to get interesting!

  4. Great post again Leith. The final paragraph in the FF link states "Now, even Fitch says it doesn't expect it's "stress case" of 5% growth in China to eventuate in 2011. China's economy is still in the relatively early stages of industrialisation and it's obvious that there is still a lot of growth to come."

    Pundits are always early in predicting collapse, ala Alan Greenspan's 1996 "irrational exuberance". The Chinese slave labour camp will probably continue for longer than most predict.

    So rather than predict when China will stumble investors may be better served by focusing on what indicators to watch for evidence of a stumble and how to profit. I think you cover most of that in your posts, but not front and centre.

  5. Australia's estimated nominal GDP for 2009 was 994.246 billion (or $45,285 per capita). Depending on which source you use, it is generally agreed that Australia's total residential housing value is between $3 trillion to $4 trillion. Base on this range, Australia's total housing value to GDP ratio sits somewhere between 3.02 to 4.02 (with an average value of 3.52). Looks like after all this explosive growth in residential property prices in China over the last decade it has finally caught up to Australian levels.

  6. Leith van Onselen

    Thanks LBS. Great video. It basically backs-up everything Chanos and Vitaliy have been saying.

  7. Whenever I think about bubbles the first question I ask is how is it being financed. In the US housing bubble, the financing came from the near unlimited demand for AAA securities combined with the perceived alchemy of securitization. In other words, junk was turned into apparently risk-free debt, which allowed housing to be financed in near unlimited quantities until the bubble collapsed under its own weight.

    I had been struggling to put my finger on how exactly China had been able to consistently finance mal-investment on such a gargantuan scale in recent years. I think the answer is land sales. Land sales are funding much of the over-expansion of commercial and residential real estate as well as many local industrial projects. Land sales are the linchpin in my opinion.

    Based on my historical readings, it seems that bubbles go into late-stage terminal growth in which they "blow-off"–i.e., grow at such spectacular rates that the amount of new credit required to sustain the bubble is impossible to achieve mathematically. In the US, late-stage growth in securitizations was literally trillions of dollars a year; continued growth became close to impossible, though attempts were made through the extension of very dubious credits. But those bad credits ultimately doomed the bubble.

    My question is where is China on this continuum? I do think that the 2008 stimulus began the process of late stage blow-off excess. In order for the bubble to collapse in China (if I am correct about land sales being the financing mechanism), it would seem that the ability of local governments to use land sales to fund new projects at an increasing rate would need to become impaired. What makes China difficult to analyze is that the demand side of the equation bears little resemblance to western markets (and has been unbalanced for a while). So I am stuck analyzing the financing mechanism alone. What would make the land sale gravy train become unable to sustain the current bubble?

  8. and my question is "where is brad setser" – one of the best china watchers around. sucked in Obama admin vortex by an offer he couldn't refuse i guess – he was too good to be out there blogging publicly on the machinations of chimerica. too close to the truth!

    even the archives are still a good read.

  9. "What would make the land sale gravy train become unable to sustain the current bubble?"

    An inability to source cheap, high grade coking coal and other fuel?

    "China is about to have its steel mills shut down due to a lack of available high BTU coal. This has always been the weak link in the Chinese export model. A reliance on imported raw commodities.
    China is about to have its electrical grid under perform during the peak winter months as it uses Australian high-grade coal to “sweeten” local Chinese sourced low-grade low BTU coal for their power plants. While these plants will work using the local coal, they will not produce the same Megawatt load they did.
    China will have to import emergency supplies of Diesel to help the local factories to continue to run on their own independently powered generators.
    China will end up paying at least 100% increase in high-grade coal prices, year over year. This will have to be pushed into their cost structure, it is too large to absorb."

  10. Do you know the story of Cassandra?

    While Cassandra foresaw the destruction of Troy (she warned the Trojans about the Trojan Horse, the death of Agamemnon, and her own demise), she was unable to do anything to forestall these tragedies since no one believed her.

    Actually that's how I feel these days. Everybody over here (Germany) is telling me that I am wrong about China. There is no China bubble, China gets it, China is the next Superpower and so on. And I hope that we are all wrong. This would hurt our economy bad.

    In another forum someone mentioned that the Security level in China was raised and wasn't that high since 1989 (Source: CNBC)

    This article is also very interesting. About the rising inflation:

    Combine that with the blog article about rising coal price due to the Australia Flood and the low Baltic Dry Index, rising food price.

  11. China is very hard to get your head around but even the most bullish Sinophile can see its going to get ugly if measures arent taking.

    I do know that the real estate is geared v differently to the West insofar as deposits for first homes are 30% and for subsequent homes are 50% (depending on the city).

    It does represent a very different dynamic to the US but no one would ever think that the appreciation of the last 3-4 years is sustainable.

    To make it even more interesting the government is also the bank and has a vested interested in not pissing off its “customers” while trying to let steam out of the pressure cooker.

    Either way its going to be interesting.