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Friday, July 9, 2010

On Bad Analysis and the Chinese Real Estate Market

It's amazing how some lines of logic will never die. I saw this article from Bloomberg about the likelihood of a collapse in real estate prices in China. In it was this absolutely awful line of reasoning from Stephen Roach:

"Rogoff’s view clashes with that of Stephen Roach, chairman of Morgan Stanley Asia Ltd., who said last month the property boom isn’t a bubble. While portions of the market such as high- end apartments are overheating, residential demand will remain robust as rural Chinese migrate to cities, he said in a radio interview in Hong Kong with Tom Keene on Bloomberg Surveillance."

Well, this actually sounds familiar. I seem to recall discussions about how the U.S. faced "pockets" of overvalued real estate, though when you added up the pockets they amounted to half the entire real estate market. Also, there were discussions about the growing demographic demand for real estate as well as the fact that inventories were temporarily lean. While not discussed much in this article, the same logic has been used to defend Chinese property prices.

At the end of the day, however, the problem is that average and median sales prices here far outstripped incomes, whatever temporary supply bottlenecks existed to support prices for an instant. In China, many central city areas, from what I have read, are priced at 14x median incomes. California, at the peak, was about 8-10x before declining approximately 40%. It may still decline further. Housing prices must necessarily be a function of incomes in the long run, whatever short term trends may distort them. This is similar to how stock prices must conform to earnings eventually as they are supposed to represent the value of a company. Asset prices cannot remain entirely detached from their underlying determinants for long ("long" meaning more than several years). 

Sometimes, I think analysts forget that asset prices cannot rise independent of their determinants in the long run. This is why they fall victim to bubbles so frequently. This is part of the reason that asset managers do not truly "create" wealth. In the end, it works out to be closer to a wealth transfer. In the case of China, incomes are rising, people are moving toward the cities, and financing has been plentiful. Against the backdrop of squeezed supplies, yes, prices can rise exponentially in the short run. However, the high prices will bring more supply onto the market and they will also sap demand. In time, financing too will ease as overlending will lead to higher default rates. At that juncture, prices will drop to a level more supported by the fundamentals. 

It is odd that a man generally as bearish as Stephen Roach is would fall victim to the sort of arguments that the National Association of Realtors used back in 2005. It could be that he is talking the book of Morgan Stanley in China, but I don't want to make that accusation without evidence. In any case, this bears watching.

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