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Tuesday, June 8, 2010

A Nervous Eye Toward the (Far) East

Technically Europe is a closer east than Asia is, but I will conform to the conventional parlance on this one. In any case, while the concerns around Europe are well known, I have been more closely tracking the troubling developments in the property markets in both mainland China as well as Hong Kong, and I don't like what I see. 

From this Bloomberg article on Hong Kong: 
"Home prices have risen 41 percent since the end of 2008, prompting the government to tighten down-payment requirements for luxury homes in October to curtail speculation after record- low interest rates fueled the surge. Financial Secretary John Tsang on May 12 pledged to keep boosting land supply."

Home prices up 41% in 16 months? That's worrisome to say the least. Considering that in the long run home prices are a function of incomes, I find that a little odd. I suspect that there are some at the upper ends of the income strata in Hong Kong that have seen even greater than 41% income growth and that is probably what is propelling prices higher at the margins. However, just as in California five years ago, the super rich are never enough to support a large real estate market (and despite being only one city, Hong Kong is a large market). Eventually, California reached a point where 88% of the population could not afford the median house. Yes, that is just as silly as it sounds. Hong Kong is at a similar juncture right now. Prices will have to correct, the question is when.

Then there was this LA Times Article describing the dramatic plunges in May home sales in mainland China as the government has stepped up measures to try to get that runaway market under control. Many have dismissed the idea that China's property market is vulnerable to a collapse similar to what we had here or what Japan has had over the past two decades because they cite the oft-mentioned fact that Chinese banks require much greater down payments for property loans. That's all well and good if you assume that bank oversight is strong or that people might not be using other forms of debt as their money down. It is hard to imagine that the activity by Chinese real estate investors would be possible in a world of so little leverage. Indeed, real estate investment is only highly attractive in a world of heavy amounts of leverage. Paying all cash for a property severely limits your percentage return, particularly since property markets rarely yield the out-sized returns financial markets can. 

I think we will find that Chinese banks have gotten into a good deal more trouble than we have been led to believe. I find it nigh impossible to believe that loan growth was as rapid as it was without poor lending controls and weak due diligence. Now, in China, because it is still essentially a centrally planned economy (policy makers target growth and do whatever they have to in order to get there, it is not the residual output of their policies) banks will not be subject to quite the same pressures they were here from 2007-2009. The government undoubtedly can stretch the process along for a greater length of time. However, that would simply mask the fact that the banks are already dead. 

I do not know when there will be a fierce correction in property values in Hong Kong and China, but I am fairly certain on the "if" portion of the question. The good news is this: the United States has relatively little exposure to China. Our banks have nearly no loan exposure and we only export $70 billion a year there. Even a 50% contraction in Chinese imports of U.S. made goods would barely ding GDP and aggregate corporate profits. However, there is residual spill-over in places like Australia and Brazil if things grind to a screeching halt and it pays to be mindful of that. I still maintain the world would sustain a financial crisis in China fairly well due to China's strangely isolated capital markets. 

Of course, I could be entirely wrong about all of this and I welcome the appropriate criticisms. 

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