China's Astonishingly Bizarre Land Development Finance System

One thing casual observers of China's real estate markets always try to say is that there is comparatively little leverage in the system, which means that any decline in prices is borne principally by the holders of the property and there are not ripple effects through the rest of the system. This is similar to how declines in stock prices tend to have very little collateral damage since they are very nearly entirely bought without leverage. Sure there is up to 2% of stock bought on margin in periods of excess, but compared to real estate markets, it's modest. That's why the stock market could shed $7 trillion in value during the 2000-2002 bear market and the broader economy felt very few ill effects from it. However, a similar decline in the value of residential real estate nearly destroyed the global financial system.

In China, however, it is simply not true that all real estate transactions are financed with equity. Indeed, a great deal of development is done by local governments, who engage in a program not entirely dissimilar from Tax Incremental Financing (TIF) in this country, where they borrow to develop certain properties and hope that they eventually pay for themselves (that's a very quick and dirty version of it). However, their practices are far sloppier than TIF districts in this country, and that's disheartening since a good number of TIF districts have run into trouble as well. Needless to say, in both cases, if the development stops, these financing deals run into serious serious trouble.

However, unlike TIF, properties are not valued according to fair market value, but in many cases in appears that local governments can just simply say what they're worth and use those amounts as collateral. This would be similar to if a financially troubled TIF district could hire an assessor to say that a $5 million hotel was really worth $57 million and collect the corresponding taxes on it. Fortunately, we have many safeguards in our system of property assessment and property taxation that prevent that from happening, including appeals and state oversight of local governments. China does not have much of a system of property taxation (though that is starting to change), and hence no good comprehensive system of property assessment.

Here are a couple of stories to chew on:

http://www.reuters.com/article/2011/07/14/markets-ratings-china-idUSL3E7IE0F520110714

http://www.bloomberg.com/news/2011-06-27/china-audit-office-warns-of-risk-on-1-7-trillion-of-local-government-debt.html

At least they had the good sense to try to head it off

So, there's this story on Bloomberg about Asian real estate markets coming in due to policy tightenings. At least they don't wait for the overshoot to be too large before trying to correct it. We could learn a thing or two about it. Sadly, they will probably blame these policies for any resulting problems and not the runaway speculation. Sigh.

Has Commercial Real Estate Reached Bottom?

Link here: http://web.mit.edu/cre/research/credl/rca.html

Take the relative stability in prices along with the fact that the Fed's Senior Loan Officer Survey shows that banks, on net, have ceased to tighten lending standards and are beginning to see demand increase and there might be a good case to be made that we are nearing the end of this long nightmare. We've even seen strong evidence that delinquencies and charge-offs are on the downturn.

However, it is still likely that with fairly high vacancy rates that new construction will still be a while off.

Hong Kong Property Prices

We have previously discussed the property price bubble in mainland China as well as a similar bubble in Australia. Hong Kong, too, not surprisingly has been a center of quite a lot of speculative activity. There's a good post here about it: http://www.favstocks.com/hong-kong-bubble-hong-kong-residential-property-prices-july-2010/2024975/

I read a Bloomberg article today discussing whether or not it will be as bad as 1997. I really rather doubt that because while prices are approaching similar levels, incomes have grown notably in Hong Kong since then. However, there is little doubt that even with that income growth prices have still outstripped people's ability to afford them. This is all despite admirable attempts by the government to stop the bubble from building. 

On a related topic, the mainland Chinese government is rumored to be introducing a property tax in the fall. http://www.bloomberg.com/news/2010-09-21/china-may-unveil-property-tax-in-october-to-reign-home-prices-report-says.html A property tax similar to that in the U.S. does serve as a buffering mechanism to restrain house price bubbles for two reasons. One is that it adds a significant annual carrying cost so that you are dissuaded from sitting on property waiting for the right price. The other is that it cuts down on your expected rate of return and the tax is immediately capitalized into the house price. 

I will point out that states with high property taxes generally were spared from the housing bubble in this country, at least the most direct effects of it anyway. California and its peculiar property tax system actually encourage bubbles because house values are capped for property tax purposes at artificially low rates until they are sold. Depending on the rates China introduces, this will have a major effect on the housing market in China. Those sitting on investment properties that presently have no tenants will find the costs too great and be forced to sell while prices generally will take a hit. I think this is an interesting experiment on China's part to try to rein in a bubble before it reaches unmanageable proportions. However, it may be too late.

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.