As I have said many times before, I suspect we will see a lot of discontinuity in policymaking this year – amid lots of panicking – and recent events show just how. In the past few months Beijing seems to have become so worried about signs of overheating that, after trying unsuccessfully many times to pare growth carefully, it has given up the scalpel and has brought out the sledgehammer.
Although the history of financial cycles is thousands of years old, it has only been in roughly the past 200 years that we have begun to think of the ups and the subsequent downs as involving the same process, rather than emerging as the consequences of exogenous shocks, like war or famine. In fact I would argue that the process that creates the expansion, especially the credit process, is itself what inexorably causes the contraction.
The contraction, in other words, is often simply the process of resolving the distortions that goosed the boom. As an aside, one of the earliest recorded acknowledgements that credit cycles are endemic to the economy may have been the entry on “Credit” in the 1838 edition of the Encyclopedia Americana: “The history of every industrious and commercial community, under a stable government, will present successive alternate periods of credit and distrust, following each other with a good deal of regularity.”
Will it ever. This is not exactly what the authors meant, of course, but it looks like we are watching China experience its own alternate periods of credit and distrust, with Beijing once again changing the pedal on which it is stomping. Given the bad global environment, China’s huge domestic imbalances, and its out-of-control monetary condition, there are precious few tools Beijing has for fine-tuning growth. Instead policymakers are going to switch back and forth throughout the year between stomping on the accelerator and stomping on the brakes.
For now, it’s the brakes on which they seem to be stomping, and the market is scared. Stocks took a big beating this past week, with the SSE Composite down 6.3% (although the whole year has been pretty bad overall) partly on fears that Beijing is very serious about overheating and may overreact (and Greece didn’t help). Real estate has also been affected. According to one report, after surging in early April, property prices in Beijing dropped a shocking 31% in the past month. I don’t know whether this is believable – I am always nervous about taking any of these numbers too seriously given the amount of manipulation that occurs – but clearly there is nervousness in the Beijing market:
The average transaction price of commercial residential properties in Beijing for the week ended May 9 fell 1,790 yuan per square meter or 9.6 percent week-on-week to 16,898 yuan per square meter, reports The Beijing News, citing statistics released by Beijing Real Estate Information Network.
Compared with the week ended April 11, the average transaction price of commercial residential properties in Beijing plunged 31.43 percent to 7,744 yuan per square meter. In the last weeks of April, the transaction volume of commercial residential properties in Beijing decreased by 10.34 percent, 11.39 percent and 30.82 percent respectively. Average transaction price was flat at between 22,000 yuan to 23,000 yuan per square meter.
But although I suspect that Beijing has no choice but to overreact, I expect that as soon as its cooling-down policies gain traction, the slowdown will alarm policymakers enough to get them stomping again on the accelerator. Managing the economy smoothly isn’t going to be very easy.
In the past several months two issues seem to have dominated worries within Beijing’s economic and monetary policy-making spheres. One is the burgeoning debt, particularly bank debt, supporting investment projects about which there is increasing evidence of economic non-viability. The other is the rising concern over real estate prices and real estate development projects.
Repressed interest disguises the cost of investment
Take the first issue. Debt levels are soaring and, if correctly counted, direct and contingent net liabilities of the government are probably over 70% of GDP, and may be significantly higher. Matters weren’t helped by the announcement Tuesday that new lending in April was RMB 774 billion – far more than RMB 600-700 billion most analysts expected, although last week I was already hearing rumors that it would easily exceed RMB 700 billion.
This compares to RMB 464 billion and RMB 591 billion in April of 2008 and 2009, respectively, and brings the total for the first four months of the year to RMB 3,375 billion, or 45% of the total quota for 2010 (in 2008 and 2009 the first four months of the year accounted for 37% and 54% of the totals for their respective years). These are big numbers, and given the frenzy for lending, it is hard for me to believe that there won’t be a big jump in net contingent liabilities.
By net contingent liabilities I mean the excess of debt over the value of the investment it supports. For example, if RMB 100 is borrowed to build a railroad, the debt is sustainable if the railroad creates net economic value to China of RMB 100 or more. If it doesn’t, the difference must be considered net debt that one way or another must be paid for by Chinese households. This will of course reduce their future consumption along with the economic growth associated with satisfying that consumption.
Note that net economic value does not mean the total profits of the railroad generated by ticket revenues less operating costs. We could begin with that number, but the value of the railroad would be increased by associated externalities – i.e. building the railroad might lower transportation costs for a number of businesses, allowing them to grow and to add economic value indirectly. It would be reduced by certain opportunity costs, for example the alternative use of the land if it had a better use, or the negative impact it might have on the existing highway and airline infrastructure.
But most importantly it would be reduced by distortions in the financing cost. For example, if the railroad were to be fully financed by 10-year bonds with interest rates 3 percentage points below the “natural” borrowing cost (a very low estimate), the economic value of the railroad would have to be reduced by RMB 19.
This amount is simply equal to the net present value of the hidden transfer from the lender to the borrower. The fact that the borrower can obtain subsidized funds at an artificially low cost must represent a transfer of wealth from the providers of the funding, and this subsidy is a loss for the rest of the economy equal to the additional value for the entity being subsidized (another way of saying that there is no free lunch*). By the way if the cost of funding is repressed by 6 percentage points, a perfectly plausible number, the net present value of the hidden subsidy is RMB 34. These are not small numbers.
Real estate frenzy
The second issue creating headaches in economic policy-making circles is, of course, the real estate market. Prices have soared in all the major cities. According to an article the People’s Daily, “China’s home prices in 70 large and medium-sized cities rose by 12.8 percent from a year earlier in April, the National Bureau of Statistics said in a statement on Tuesday
Although clearly Beijing, Shanghai, Guangzhou and the other primary cities are at the center of the frenzy, it isn’t just the primary cities driving this. Price fever is spreading to secondary cities. David Pierson of the Los Angeles Time had a very interesting article last week which starts out:
Hundreds of miles inland from the booming real estate markets of Beijing and Shanghai, an unlikely property fever is gripping this middling industrial outpost. Rows of half-completed apartment buildings rise over former farmland, each crowned with yellow construction cranes that seem to outnumber trees in parts of this dusty city of 5 million residents.
Taxi drivers boast of owning multiple flats for investment. Billboards hawk developments with names such as Villa Glorious and Rich Country. Frenzied crowds pack sales events with bags of cash, buying units that exist only on blueprints. Average home values in Hefei soared 50% last year.
China’s real estate rush, once confined to a handful of leading cities, has spilled into the hinterlands with a ferocity reminiscent of American expansion into exurbs like the Inland Empire. In a country that economists say is treading dangerously close to a full-blown property bubble, Hefei represents more evidence of China’s headlong embrace of housing to power economic growth.
“The situation in Hefei is a symbol of the craziness in China’s real estate market,” said Cao Jianhai, a professor of economics at the Chinese Academy of Social Sciences, a government think tank. “Prices in second- and third-tier cities are increasing more dramatically than in the first tier. It’s very dangerous, and it puts local banks at risk.”
The two worries, of course, are inextricably linked. Real estate speculation is funded primarily by bank loans, and if the assets go bad, the loans almost certainly become contingent liabilities of the government.
The government’s response to the real estate bubble is to attempt to target speculative, as opposed to real, purchases of apartments and tighten lending conditions. They have used a number of tools, ranging from regulatory, interest rate, and lending margins, and backed them up last week with the third hike in the minimum reserve requirement this year. For example in an article today the People’s Daily lists some Shanghai property curbs:
The Shanghai municipal government may release detailed regulations for the property sector in two weeks, in line with central government policies, to curb housing speculation and soaring prices in the local market, an industry insider said on Wednesday. “A meeting will be held by the Shanghai municipal housing support and building administration bureau on Friday, and the main topic for discussion would be detailed regulations for the property sector,” said Sun Lijian, a professor with Fudan University and an adviser to the local government.
On April 16, the State Council rolled out a series of measures to curb the domestic housing market amid concerns over asset bubbles. These measures include a 30 percent down payment for first time buyers for houses larger than 90 square meters, 50 percent down payment and lifting mortgage interest rate for second home buyers. The government has also imposed a temporary ban on mortgage applications for third or above home buys and cross-city purchases. Shanghai will be the third region after Beijing and Shenzhen to have rules governing property buys, said Sun.
Will all this work? I am not sure – I guess it depends on what you think the underlying problem is. If you believe that the real estate bubble is caused by easy loan regulations for speculators, then all these measures will almost certainly end speculation. If you believe as I do, however, that China’s real estate bubble, and asset bubbles generally, is caused by excess liquidity, credit surges, and suppressed financing costs, then the various measures are mostly cosmetic. By targeting specific forms of speculation, Beijing might be able to shift the speculative frenzy around, from one asset to another, but it won’t end it. It will simply move on.
What really matters if we want to stop the speculative frenzy is to find ways of raising interest rates and removing domestic liquidity. But both of these are tough to do. Raising lending rates, if it is done enough to suppress real estate speculation, will put unbearable pressure on Chinese borrowers – many of who can only manage the debt because it is virtually free – and will make it impossible to revalue the currency in any serious way. The fact that it would prevent currency revaluation shouldn’t matter because, as I have pointed out many times, low interest rates may have as much or more to do with China’s trade surplus as the undervalued RMB, but unfortunately the RMB has become so politicized that a failure to move will simply fan foreign anger at China and lead to increasing trade tensions – and China is terribly vulnerable to trade war.
But putting pressure on borrowers is a real problem. After so many years of being able to invest with almost no concern for the return on investment, raising funding costs will force real financial distress onto borrowers. Either they ignore it, and government debt levels rise serenely ever higher (and remember, as I discussed in a previous post, government debt must be paid for by reducing future household consumption), or they respond by cutting borrowing. Less borrowing means that investment slows dramatically, and in an economy so dependent on increased investment for its growth, anything that slows investment slows growth.
It is even tougher to contract domestic liquidity. As long as China maintains the currency regime it is hard to control the domestic money supply, and the one powerful tool Beijing does have – too powerful to be wielded smoothly – is the lending quota. The problem here of course, to repeat, is that Chinese growth is so heavily dependent on additional investment, which is itself heavily dependent on new lending, that Beijing can’t really force down loan growth without seeing GDP growth drop sharply.
So I think we are stuck. For now, the focus is on attacking economic exuberance, but in such a manic-depressive economy the alternative to exuberance will be deep, deep gloom, and as soon as that happens it’s back to inducing ecstasy once again.
My guess? After a few weeks of official posturing, with the concomitant fear and market contraction, the markets will stabilize for a while, and then take off again. If Beijing is really successful in halting real estate speculation in the primary cities, expect the secondary cities to take off. Also after a period of stability we will probably see great action in the stock market as liquidity pours back in. Last Friday the SSE Composite closed at 2688. I bet it is much higher by the end of the summer.
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