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Friday, September 3, 2010

What if China's Real Estate Market Does Pop: U.S. Outlook

On the heels of Alex's post on his on-the-street view of the Chinese real estate market, I wanted to provide a good sense of what the actual risks are. As you may have seen earlier, I don't buy into the double-dip recession hypothesis except if there is a large unforeseen shock. Now, as soon as I wrote that, a reader might have gone "AHHHHH!!!! They've said this all before!" Indeed it does sound awfully familiar. Indeed, some friends of mine may know that I thought the 2008 recession, which I admittedly called in 2007, would be shallow and long in the absence of a total freeze in credit markets. In truth, even short of Lehman, it appears that it would have been deep in any case. So, I guess to try to be better prepared it might help to examine what are the potential channels of a relapse.

The first one we might want to examine, because its effects set in the quickest, is on the banking side. I drew up this little table that showed bank risks by country as of Q1 2010. I am quite sure these haven't changed much since then.

In relation to the risks that our banks took in the real estate sector, the risk to China is small potatoes. Even in the event of a total calamity, maybe 30% of that would be written off. Spread among the various banks that lend to China, it's not a particularly big deal. Now, I put in Japan and Korea because it's possible that some of the large financial institutions there have also been providing credit to China. I can't find data on that because: 1. The relevant websites are in their native languages most often and 2. Disclosure in most other countries isn't as good as it is here. It's actually one of the reasons the U.S. has commanded lower risk premiums over the years, recent experiences notwithstanding.

A second channel some might point to is the U.S. Treasury market where China might sell off assets and repatriate money in the event of a major financial crisis. There is actually historical precedence for that where in World War I France and the UK repatriated assets from the U.S. and helped contribute to a rather nasty decline in equity markets here. The fear is that China would cause interest rates to spike prematurely, raising borrowing costs for corporations and governments alike and that the interest rate shock could completely unsettle financial markets. However, this is only really a problem on a short term rather than a long term basis as what can happen is that the Federal Reserve could step in and soak up the sales and slowly work that off over several months in order to keep markets orderly. There is no guarantee that the Fed would do this, but they could do this.

The third major channel is of course through exports. Now, U.S. exports to China are running at about an $80 billion annual rate or so. This is about .7% of GDP. Even a huge hit to these exports of, say, 40%, would not be enough to drive the U.S. into recession, even in our presently weakened state. I have said as much before. However, I did some more thinking on this and of course there are other spill overs. Other trading partners including Brazil and Australia buy decently large amounts of capital equipment including mining machines from the U.S. in order to extract raw materials to sell to China. Add up the $36 billion at an annual rate we sell to Brazil and the $14 billion at an annual rate we sell to Australia along with maybe another $30 billion to other large natural resource extractors and you get, well, around another China's worth of secondary effects. I haven't looked closely enough at the trade data with each of those countries to know how much of what we export is actually economically cyclical, but the odds are that it is quite a bit.

Even with all of this, it would not be a calamity, but it could be enough to grind growth to a complete halt for a time given how modest growth is right now at maybe 2% annualized in the third quarter. Luckily, China seems to be dragging this real estate cycle out long enough that a crisis might not occur until our growth is a little more self-sustaining. As for some other economies, anything Australian-related worries me. They have this potential pitfall as well as their own housing bubble. Brazil would suffer badly if China suddenly stopped importing so much iron ore among other things. The same holds for Peru and Chile and whatever commodity-export countries you might think of.

Now, the Chinese real estate market should give plenty of warning signs before a collapse in both residential and non-residential investment might occur. The first would be stagnation in prices followed by a pullback of some sort. As prices drop, expectations about future returns drop leading to cancellations of building projects and a slow down in new projects. This in turn leads to a drop in the imports of raw materials and machinery. All of that actually takes some time to manifest and you can spot it in advance if you are looking for it.

1 comment:

  1. I would add that I think China's govt will try very hard to stop a sharp decline. So the more creative policies we see, the closer it is getting to the crash.