Animal Instinct on China's Real Estate Range

The State Council recently issued new policy measures designed to limit property market speculation. These steps restrict financing options for property owners seeking to buy a third home, increase mandatory down payments to 50 percent from 40 percent, and abolish interest rate benefits for second-property purchases.

Although these measures have changed market sentiment, such psychological effects may wear off quickly and the property bubble expand yet again unless interest rates are raised soon and significantly. Administrative measures can play nothing more than a secondary role in China's great property game, which I fear may have morphed into animalistic mania.

At the root of the property bubble are negative real interest rates. China's bank deposit rates are extremely low: 0.36 percent for demand deposits and 2.25 percent for one-year deposits. These rates are set against a backdrop of rising inflation fueled by a tight labor market and skyrocketing prices for government-owned land.
                                  Inflation Looms 

Source: Merrill Lynch Research

China's consumer price index generally offers a benign picture of inflation. Yet the GDP deflator, the broadest inflation gauge, has been quite high. Between 2004 and '08, the deflator averaged 6.7 percent, reflecting a rising trend. The financial crisis pushed the indicator down to minus 1.9 percent in 2009, but it rebounded to 5.4 percent in the first quarter this year. Of course, we don't know how accurate these data are. But chances are that the inflation rate is already quite high and rising.

When real interest rates remain in negative territory for a sustained period of time, the motivation to increase bank deposits falls and borrowing increases. China's household debt rose 43.3 percent to 8.2 trillion yuan in 2009. In January, it rose another 7.9 percent. In terms of total value, household debt rose to 2.7 times household deposits in January.

The latest government measures may slow household debt growth, but the total is likely to top 12 trillion yuan this year. Chances are household debt has already reached 10 trillion yuan.

This will be the first year in a long while that household debt rises more quickly than household deposits. In other words, China's household sector will reduce rather than increase its liquidity in banks. That makes the banking system more dependent on hot money for liquidity and the system vulnerable to shock.