Aug 09, 2013 06:35 PM

Do the Property Dance Once More?

The market is speculating that the central government is about to loosen up financing for the property sector. What this really means is that the banks may increase lending to developers for land purchases. Property developers are beholden to local governments. If they get loans, they will buy land to boost local government revenues. Essentially, bank loans would turn into local government revenue. When the local governments spend the money, it becomes a form of fiscal stimulus.

When the economy was growing rapidly, the property bubble was justified on reflecting high future income through extrapolation. As the economy slows, the justification is that the property bubble is needed to support the economy. Neither is meaningful unless monetary and/or credit policies are affected. The latter argument was undoubtedly a force in influencing the 2008 policy to massively boost credit growth. Even though this policy is the reason for most economic difficulties today, the same argument is being used again. If China tries the same policy, it will not produce the same results and may trigger a financial crisis quickly.

In 2008, the Federal Reserve was just beginning its unprecedented quantitative easing policy. The bearish sentiment towards the U.S. dollar allowed emerging economies to boost money supplies without worrying about devaluation. Further, China's credit policy then was looked upon positively by the international community as contributing to stabilizing the global economy.

If China were to pursue the same policy now, the opposite would be true on both fronts. The Fed is about to begin its tightening policy. And the U.S. has a strong stock market and recovering property market to attract global capital. Emerging economies have to tighten monetary and credit policies to maintain their economic stability. A repeat of 2008 policy would immediately lead to capital flight and currency devaluation. The resulting inflation could totally destabilize the economy.

Further, there is consensus in the global financial market that China's property market is a bubble. If some policy is introduced to prolong it, the negative segment would worsen, triggering massive short selling of the yuan. The resulting devaluation pressure would be self-fulfilling, leading to a financial crisis similar to Asia's in 1997.

The Ponzi Scheme

The National Bureau of Statistics (NBS) says that in the first half of 2013 property investment, mainly spending by developers, rose by 20.3 percent, the volume of property under construction by 16.5 percent and property completion by 8.7 percent. These numbers are probably not accurate. But the pattern of land purchases growing faster than property construction, and construction growing faster than completion seems to fit anecdotal evidence. China's property market has become a vast land game on small and declining final sales. It is like a listed company with a small proportion of floating shares. The share price could be pumped up very high through manipulation, a bank would take the illiquid shares for collateral at the so-called market price and the borrowed money is pumped back into the liquid shares.

The bounce in the property market that began in the last quarter of 2012 ran out of steam in the second quarter of the current year. But in some cities the land market is heating up again. This is partly due to the cash inflow from the sales before. But ramping up price expectations could be the goal. Some of the land sales may involve little cash payment. The odds are that the buyers could return the land with little penalty. Hence, the so-called land kings are just tools to scare people into buying now out of fear for higher prices later.

The NBS also says that nearly 20 trillion yuan has been poured into property development in the past three years. As the development cycle is about that long, the cost of the properties under development should be that much plus interest accruals on the loans. Plus taxes on sales and the net margin to developers, the sales value needs to be above 30 trillion yuan to sustain the market, or 60 percent of the last year's GDP. The country's total household debt is 18 trillion yuan. Massive credit expansion would be needed to clear the inventory. In the current global environment such credit expansion would likely lead to maxi currency devaluation and economic chaos.

The Bigger Bubble

While the residential bubble is well known, the commercial side has quickly become a bigger bubble. Most cities have commercial space per capita higher than in developed countries. Yet they are building much more. Purchase limits have been imposed on residential properties in recent years. Much of the speculative excesses have been diverted to the commercial side. This is why the building of commercial properties exceeds that of residential properties.

The hotel market is a good example. The overbuilding is apparent. The occupancy rate for hotels is low. Most are not making money. Yet so many more are being built. Banks will suffer a huge amount of bad loans in this market.

Individual investors have been speculating in retail properties. The average yield in this market has fallen to the same level as in the residential market. With so much more under construction, the rents will only fall further. Widespread bankruptcies in this market are quite likely in the coming years.

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