Animal Instinct on China's Real Estate Range

When the Chinese government announces administrative measures, the market takes a step back to ascertain the government's intentions. The key question is, "Does the government want prices to fall?" If the answer is no, speculative demand can return again and push prices up another notch. More government measures may follow. But this is a vicious cycle, and the bubble keeps getting bigger.

Current property prices are bubble prices: They will either go down or up; stability is impossible. This is where the policy dilemma arises. If the government doesn't want prices to fall, they will rise regardless of technical measures introduced by the government. Indeed, the government's interventions do nothing more than introduce more volatility to the bubble's development. And the end result is unlikely to change: The bubble will burst when the money runs out.

If the Chinese government wants to contain the bubble, it must raise interest rates to remove negative real interest rates. And the government must be prepared to let prices fall to normal levels. Unless the government is prepared for a major correction in property prices, tightening measures can only be half-hearted and ineffective.

Day of Reckoning

Nevertheless, regardless of the ineffectiveness of government measures, the property bubble's days are numbered. As household sector debt rises faster than deposits, the increasingly vulnerable banking system is becoming more dependent on hot money. But global monetary tightening has begun, which means normal interest rates will likely be restored in 2012. That's when China's property bubble is likely to burst.

Since the consequences could be catastrophic for China's banks, the government must act now to prepare for this day of reckoning.

When the last property bubble burst in the mid-1990s, China's banking system was saddled with 40 percent non-performing loans (NPLs). Bank supervision is certainly much better now. But it is impossible for banks to prudently manage against macroeconomic risk. When the current property bubble bursts, everyone will have a lot of bad debt, as events in the United States have well illustrated.

The property sector may directly account for one-third of total loans in the Chinese banking system and collateralize much of the rest. A major percentage of bank borrowers are local governments, operating through fund-raising vehicles, and their loans are usually backed up with land.

Land prices have increased more than 10 times nationwide and 30 times in some cities over the past seven years. When the bubble bursts, a 70 percent decline for land prices won't be surprising. That would still leave land prices very high relative to the levels seen seven years ago. But this kind of normalization would prove catastrophic for banks, perhaps pushing NPL ratios to 20 percent.

The next NPL recovery ratio is likely to be 0.5 or less after a property bubble burst. With a loan book of 40 trillion yuan, China's banking system could suffer 4 trillion yuan in losses.

To prepare, China's banks are raising an estimated 500 billion yuan through the stock market. This is a good step. Indeed, the banks should raise as much as possible while the market can handle it because their current capital levels are far from adequate.

After banks have raised equity capital, they should be discouraged from lending again. This can be done by raising capital requirements. Liquidity is not a likely problem: If banks raise 500 billion yuan in equity capital, their lending capacity would rise by 10 trillion yuan. And a strong expectation for yuan appreciation is pushing hot money into the system. So in response, the government should raise the equity capital requirement to 8 percent within three years.

Another factor to remember is that some government officials consider the property bubble a tool for development because it raises funds for projects. This attitude may be as important a factor in the bubble's growth as negative real interest rates and animal spirit. And it's dangerous for China's future. It is similar to what Wall Street did before leveraging up to produce speculative gains: They are borrowing against the future on a vast, unsustainable scale.

What's needed now is political will. Many vested interests favor continuing the property bubble. They often benefit from the bubble process and are not personally liable for the consequences. They also have a disproportionate influence on policy debates. To contain the bubble's consequences, the government must be prepared to accept pain from the deflating bubble.

In addition, China needs a national property policy. Hong Kong provides public housing to about half its population, even while private market prices are high. Hong Kong's policy is to raise revenue from property buyers and give low-income households a way out.

Singapore subsidizes housing for more than 80 percent of its population. Hence, the private market is virtually irrelevant to the welfare of the people. Indeed, Singapore's government raises a lot of revenue from a property market dominated by foreign buyers.

Affordable property ownership is the most important factor for a modern economy's stability. It's an economic bedrock that encourages middle class expansion. If the middle class can't afford property, an economy is likely lose balance with a small, speculative and rich upper class at one end, a vast and property-less lower class at the other, and a small, burdened middle class in between. China should avoid this kind of unhealthy, unstable development route.

1 yuan = 14 U.S. cents

Andy Xie is a board member of Rosetta Stone Advisors Limited