The world’s investors seem to have changed their collective mind. Recent panic selling implied an implosion in China and recession elsewhere. The sudden turn to recovery and moderation indicates something much less pessimistic if not absolutely upbeat. Since markets, as always, remain vulnerable to future emotional outbursts of this kind, it might help to take this moment of relative calm and examine some of the issues that contributed to the recent panic and might contribute to a future panic. One of particular importance is China’s by now long-standing real estate crisis.
Though the evidence, as always, is muddled, statistics nonetheless yield a picture that should at once sober optimists and embarrass pessimists. On the side of bad news, there is no denying that China faces a significant real estate bubble. The adjustment to it will take a considerable time and will inevitably have negative economic and financial implications. On the side of good news, it is clear that the adjustment has already begun and is proceeding in an orderly fashion that promises to avoid the kind of financial collapse many fear.
The Bubble’s Extent
The evidence of excess and all that goes with it is clear. Between 2012 and 2014, China engaged in significant overbuilding. By early last year spending on residential construction had reached an unsustainable 10.4 percent of the country’s gross domestic product (GDP). That is the second highest figure on record for any country. Only Spain’s 2006 bubble, which took such spending to 12.5 percent of GDP, surpassed it. China’s rate tops Japan’s 1973 bubble peak at 8.7 percent of GDP and certainly this country’s 2005 peak at 6.5 percent of GDP. China’s breakneck pace of residential construction was at its 2013 peak increasing floor space at a clearly unsustainable 50 percent annual rate. It had increased the per capital available floor space in China 20 percent to some 30 square meters, far above any other emerging economy and even some developed economies. Spain, for instance, has only some 27 square meters of living space per capita and Japan has only some 22 square meters. Only the rich nations of Europe, the United States, Canada, and Australia offer their populations more. This construction so far exceeded sales that unsold inventories reached astronomical levels of over two year purchases.
Debt problems have inevitably accompanied this kind of overbuilding. Though government debt in China is still a relatively low 25 percent of GDP, real estate-related debt in recent years has exploded to more than twice that figure. At last measure, almost half of all outstanding credit in China was somehow related to real estate. The excesses promise to force a significant portion of this debt into default, with some estimates indicating that a fifth of all the real estate debt will fail in one way or another. Since that figure amounts to nearly one-tenth of the country’s GDP, the legacy of this overbuilding cannot help but strain Chinese financial institutions, investors, financial markets generally, and consequently overall economic growth prospects. The need for construction cutbacks will further impair growth prospects, not the least because residential building has until recently accounted for so much of China’s economic activity.
Still, It is Not the End of the World
As strained as all this looks, and is, much suggests that China can avoid the implosion many have from time to time feared. After all, the evidence suggests that the adjustment has already begun and, far from a crash, is proceeding in an orderly way. Residential construction had begun its declines late last year. In December 2014, new construction was already reported down 26 percent from the previous year. No doubt these cutbacks contributed to the slowing of China’s overall pace of growth, but the fact that overall growth continued despite them argues against the earlier concern that the inevitable construction cut backs would precipitate a recession. Even in this relatively short time, the cutbacks have begun to address the overhang of unsold space. Inventories remain high, to be sure, but by the middle of 2014, they had already stabilized and had begun to ease by the turn to the new year. Little data exists so far for 2015, but all signs point to still more relief in recent months.
Meanwhile, declines in real estate prices will help relieve the inventory overhang further by bringing new buyers to the market. The price picture certainly has changed radically from the 2013 peak. Back then, home prices in China’s 100 city average were rising at annual rates approaching 15 percent. By late 2014, that pace of advance had slowed to 5 percent and is little different from zero so far this year. Since household income in China has continued to grow, this price slowdown has made Chinese real estate more affordable. The percent of average annual income needed to purchase 100 square meters of living space has fallen almost 20 percent from where it stood in 2010 before the bubble began to inflate. There are already signs that this affordability improvement has moderated the pace of sales declines. In contrast to early 2014, when purchases were dropping at a 10 percent annual rate, official sources recorded only a 3 percent rate of decline in early 2015. And recently the Shanghai Daily reported an almost 17 percent jump in purchases during the first seven months of 2015. That figure may exaggerate reality, but its direction certainly points to another source of relief for China’s huge unsold inventory.
In a major study released this past spring, the International Monetary Fund (IMF) estimated a year-end 2014 excess housing inventory of some 20 percent in China. No doubt some of the developments outlined above have reduced that excess marginally in 2015. Still, it is clear from the IMF estimates that China has a long way to go yet. A “scenario analysis” in this IMF report suggests that a complete adjustment will take another three or more years. Given the extent of the earlier bubble, that projection seems entirely credible. For investors, however, the adjustment’s timing is less important than that it has already begun; that it is proceeding, not as some fear from time to time with an implosion, but rather along a gradual, orderly glide path; and that despite it, the overall economy has continued to grow, if less rapidly than in the past.