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.

This is exactly what happened in Hong Kong, South Korea and Southeast Asia a decade ago. Their banks were quite dependent on hot money to support lending growth. When the shock came and foreign liquidity was pulled, most banks collapsed. Hong Kong's banks remained afloat due to strong capital bases. Still, interest rates had to be raised forcefully to maintain liquid positions. These high interest rates, in turn, popped Hong Kong's property bubble.

China's household debt level is getting close to the danger level. Even if the growth trend moderates, debt is likely to surpass 15 trillion yuan in 2011, equivalent to about 100 percent of urban labor income. More importantly, China's household debt is a new phenomenon. For it to rise so fast to such heights rings alarm bells. Experiences from other countries show that whenever household debt rises at such a rapid pace and to such high levels, delinquency rates are likely to go up – a lot.

Buy Now

A combination of fear and greed are driving changes in Chinese household behavior. Inflation expectations seem high and rising. Considering how low interest rates are, it is understandable that people don't want to increase deposits. They would rather borrow to buy something else. This is just a matter of price. When a product's price is low, people want to buy more and sell less. When real interest rates are low, people want to decrease deposits and increase borrowing.

Fears that property may become unaffordable in the future are factoring into the latest frenzy as well. Many in China's middle class have been accumulating bank deposits to upgrade their housing in the future. They've watched prices rise faster than their deposits. So now, fears that they may never catch up has pushed them to borrow as much as possible. The idea is that they will have a stationary target-debt for their catching up rather than a moving target, such as property prices.

In addition to rational concerns about interest rates and the inflation outlook, a case of financial mania – or perhaps we can say an animal spirit – is affecting China's property market on an unprecedented scale. Property speculation is no longer a game for rich people or sharp cookies in Wenzhou. Now, people from all walks of life are talking about property inflation, speaking as if they lost money by not being in, or even deeply in, the market. People who make 30,000 yuan per annum are trying to buy property worth 3 million yuan while trying to borrow as much as possible from relatives, friends and, of course, banks.

One could never identify a 100 percent, open and closed case of financial mania. But it's a pretty clear case when so many are trying to buy something that costs 50 to 100 times their annual income and only think about upsides, not downsides. I am quite sure China's property market is one of the biggest financial manias in modern history.

When a government faces financial mania, does it have a responsibility to act? Former Federal Reserve chief Alan Greenspan said "no" when a debate about the U.S. property bubble began. He argued there was not a nationwide bubble and, if there were one, the Fed could only deal with the consequences after a burst, not contain a bubble through policy measures. His decision not to act was the main reason for the financial crisis.

Greenspan now acknowledges regulatory supervision was faulty but denies loose monetary policy was a factor. He is dead wrong. Faulty regulation can contribute to a bubble when the environment is right, at a time when there is plenty of liquidity. A bubble can be as big as the money supply, regardless of regulatory loopholes. So the most important policy action after a bubble is identified is to decrease the money supply.

Rate Action

In this context, China must raise interest rates quickly. Each increase should be 27 bps. Anything less would be an insufficient response to the inflation outlook and deny the strength of the animal spirit. In my view, China's inflation is likely to average 5 percent or more in the coming decade, so current interest rates are possibly 5 percentage points too low. Whenever rates are this far below equilibrium, an economy is subject to bubble sectors. And it's never stable.

A perception of instability makes many analysts argue against raising interest rates. But leaving rates low prolongs the bubble and increases long-term instability. It creates a false sense of security through short-term stability. Such a short-term mentality only leads to more pain, more instability, and even crises.

Obviously, there is political resistance to raising interest rates. It is equivalent to redistributing wealth to depositors from borrowers, which are mainly local governments and state-owned enterprises. On the other side of the equation are household deposits totaling more than 27 trillion yuan. If rates are raised 5 percentage points, the government sector would have to pay 1.4 trillion yuan, or 4 percent of last year's GDP, in interest.

Should the extra burden faced by the state sector prevent interest rate increases? I think not. This would not be an extra burden. Instead, current low interest rates are subsidizing the state sector, which leads to inefficiency and waste. I think enough money could be saved by simply eliminating waste in state sector procurement practices.

Cooling a property market through administrative measures has backfired before, and may do so again. Such measures seem to have only a psychological impact, since technical barriers can be circumvented. For example, a rule setting different credit terms for second and third homes could be circumvented by dividing ownership among family members, since ownership on behalf of someone else is common in China.

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