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China's Housing Bubble: Mainly Hot Air, Part 2

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Here, a look at concerns regarding the impact of measures to rein in credit growth on the overall Chinese economy via its effects on the residential real estate market.

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Editor's Note: This is Part 2 of a two-part series. Click here to read Part 1.

In Part 1 of this article, I outlined the most obvious reasons that prove why the popular narrative of a huge bubble in the Chinese residential real estate industry is mainly hype.

In Part 2, I would like to review some less obvious factors that support this same thesis. In addition, I will address concerns regarding the impact of measures to rein in credit growth on the overall Chinese economy via its effects on the residential real estate market.

Deconstructing the China Housing Price Bubble Story

Various statistics have been cited by China bears to promote the notion of a price bubble in China's residential real estate market. Most prominent amongst these are home price to income statistics (PE). Accounts vary, but most bears cite PE ratios of 8-9 on a nationwide basis and over 20 in some major cities such as Beijng. This compares to averages of 3-5 in the US, Australia and Canada and 5-10 in Europe. The reported figures in China are similar to those of other emerging Asian nations.

At first blush, these statistics seem to demonstrate that housing is unaffordable in China. And it probably is, if you take the median income, which is what is used to calculate these statistics. But whether housing is affordable or not to the median Chinese income earner is not the relevant issue at hand. The issue under discussion is whether there is a price and/or quantity bubble in the Chinese residential real estate market – i.e. whether quantity and price outstrip effective demand. These are clearly distinct matters.

The problem is that home price-to-income statistics deceptive because they are not representative of the income of the relevant population cohort. Median statistics do not take into account the fact that Chinese income distribution is fantastically skewed. The folks in the upper middle income ranks described in Part 1 of this article – which constitute the real sources of effective housing demand – are earning vastly above the median income.

Thus, when one strips out the bottom 60% of Chinese households, that are not in the market for housing, one arrives at a PE that is somewhere in the 4-5 range. That is well within a range that has long been proven to be sustainable on an international basis. Such reasonable PEs on a segmented basis hold true true on the national level, as well as with regards to the big cities where median incomes are substantially higher than national averages.

Besides properly identifying the proper population cohort, factors unique to the Chinese market must be considered for the purposes of determining the affordability of housing for the relevant Chinese cohort on an absolute basis or in relative international terms. Let us briefly consider a few of these differentiating factors:

1. It has been estimated that due to tax evasion and other reasons, upper middle income earners in China under-report their income substantially. Estimates vary, but various studies and surveys show that the upper-middle income cohort under-report earnings by between 50% and 100%. Adjusting the housing PE ratio for the lower bound figure of under-reporting, the adjusted PE drops to 3-4. This puts the Chinese PE at the lower end of global comparisons for the relevant population cohort.

2. The effects of taxation on disposable income must be taken into account. Income taxes, property taxes and other taxes are much lower in China that in other countries. Whereas taxes take up 30% or more of the disposable income of homeowners in developed countries, the comparable figure in China is less than 10%. Thus, if a disposable income figure were used rather than a gross income figure, the Chinese relative PE would look even better.

3. Residential PE ratios don't take into account the impact of Purchasing Power Parity (PPP). $1 of income in China purchases more in basic goods such as food and clothing than $1 the developed world. This means that the Chinese have a greater proportion of any given level of income available for housing expense.

4. Extremely high Chinese savings rates imply that the Chinese can afford much higher home PE ratios than their western counterparts. Relative to income, the Chinese on average have more than twice the amount of savings as their developed world counterparts. If we take only the upper middle income cohort into account, Chinese savings are over three times the developed country average. This means that the Chinese are able, more than developed country citizens, to deploy savings to supplement their income in order to afford homes.

5. Low Chinese household debt ratios imply that the Chinese can afford much higher home PE ratios than western counterparts. This point is related to the above issue regarding the savings rate.

6. Higher income growth expectations warrant higher home PEs. Adjusted for the various factors cited above, China's adjusted home price to income ratios for the relevant income cohort are no higher than international averages and are probably actually below average. However, even if they were well above average (which they are not), this would be entirely justified for one simple reason: income growth expectations. Real Chinese personal incomes have been rising at a 12% per annum pace for many years. Even if this rate of income growth were to slow, there is little doubt that real Chinese personal incomes can continue to grow at a rate that is at least 3 or 4 times faster than developed world counterparts for the foreseeable future. Thus, home price to income ratios that are higher than international averages would be entirely justified for the Chinese since an efficient market will discount not only present but future income flows.

Could a Real Estate Slump Become a Drag on Growth?

It should be clear at this point that the supply overhang in the Chinese residential real estate market is not a big deal. Furthermore, home prices in general seem broadly in line with fundamentals. Only in few cities and small sub-segments (e.g. the luxury sector) – altogether representing less than 10% of the market – does it appear that the residential real estate market might be exhibiting signs of froth.

Thus, it can be inferred that left to its own devices, the overall rate of housing price increases that China has experienced in the past few years could continue unabated for many years. In other words, China's current level of real estate oversupply and pricing is not, in and of itself, a reason to expect a cyclical slowdown in the Chinese economy. Nor, contrary to popular belief, can it be expected that the residential real estate sector in China will represent a drag on Chinese growth in the future. To the contrary, pent-up demand for real-estate represents a major potential source of Chinese GDP growth for many years to come.

Only a catalyst from outside the real estate economy could derail the continued organic growth of the Chinese residential real estate market. As it turns out, as I shall explain in my next article, such a catalyst is at hand: Anti-inflation measures including rising interest rates and other policies directed at restricting the rate of credit growth.

What would be the consequences of a real estate slump in China triggered by a tightening of credit conditions? At first blush, the consequences seem daunting. First of all, China's real estate sector represents 6% of GDP, a level comparable to that of the US prior to its housing collapse. Second, the indirect impact on GDP through industries linked to construction is even greater. Third, the impact on employment could be disproportionate to the share of GDP given the labor intensity of the activity. Finally, the financial system could suffer major damage as it is highly exposed to loans to real estate developers.

Having said all of this, the economic effects of credit tightening on the Chinese economy via the residential real estate sector may turn out to be less severe than many have supposed. First, the Chinese government will almost certainly use its considerable balance sheet to socialize any losses in the banking system caused by defaults in the sector. Second, given the severe housing deficit, the Chinese Communist Party is likely to employ extraordinary measures, such as subsidies, to move inventories and make sure that residential real estate construction does not come to a standstill. Third, to the extent that market adjustments temporarily caused rising unemployment in the sector, the Chinese government will likely utilize its considerable balance sheet to initiate massive infrastructure projects building roads, bridges, railways, etc. to deploy these idled workers. Given the frightening levels of traffic congestion in China, unclogging the transportation system could hardly be considered a waste of resources.

All and all, while some speculative shocks are likely to impact the sector, the real estate market is likely to do fine in the medium term. Furthermore, warnings that the Chinese real estate sector could suffer a multi-year slump such as occurred in Japan are misplaced. In a nation with such desperate housing needs, it is quite natural that residential construction will make up a large share of GDP and that it will be a major driver of growth – certainly a larger factor than in developed countries. With effective demand of 70-90 million units through 2015, residential real estate can be expected to command a large share of GDP and to constitute a major driver of Chinese GDP growth in the medium to long term.

Conclusion


Relative to the size of its population, its economic growth rate, and its housing needs, China's oversupply of residential units is not as great as popularly believed. Furthermore, the level of oversupply and pricing is not so great as to constitute, in and of itself, a catalyst for an economic downturn in the Chinese economy. The real estate sector will also not act as a restraint to Chinese growth going forward. To the contrary residential real estate appears to be a sustainable source of long-term growth for the Chinese economy.

Having said that, Chinese culture is somewhat prone to financial speculation and this tendency clearly affects the residential real estate market. There is a widespread perception that there is a residential real estate bubble in China. And since in speculative markets, subjective perceptions matter as much as economic fundamentals, this perception can come to define reality.

As such, I do not doubt that substantial volatility could emerge in the Chinese residential real estate market as credit conditions tighten in China later this year. Given the importance of residential real estate construction to the overall economy, a slowdown in this sector could certainly have a substantial impact on overall growth.

However, as pointed out above, the Chinese government has many tools at its disposal to mitigate what might, under different circumstances, amount to a more substantial blow to the economy.

In sum: 1) The depth of the problems in the Chinese residential real estate sector are not that great; 2) The Chinese government has the wherewithal to effectively deal with these problems and will likely do so.

How can investors make use of this knowledge to make money? I suggest investors dust off this article when prima donna fund managers come on the tube in a few months proclaiming how the then-ongoing economic slowdown in China could finally burst the real estate bubble and therefore devastate the Chinese economy. When, as a result of speculation regarding the "popping of the Chinese real estate bubble," Chinese stocks (FXI, HAO), emerging markets stocks (EEM, VWO, ILF) and commodities stocks (DBC, DBN, MXI, HAP, XLE, XOP, IEO, USO) are getting smashed, this article may help keep things in perspective, and help investors identify opportunities in the midst of excessive pessimism.

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