High Altitude, Low Visibility

The inflation has so far occurred mostly in land and commodities. The land price has increased by over ten times since 2002, thirty times in some hot coastal cities, and over one hundred times in the most speculative areas.  For example, in many villages in Zhejiang Province, the land price has risen above 10 yuan per million mu to 100 times the price a decade ago. Even though the land is rezoned for urban use, the price can't be justified under any circumstance.  It is nearly ten times the average land price in Britain for urban use. Britain's urban land prices are the highest among all major developed economies.  It is reasonable to believe that China's land price is the highest among than all the major economies today, even though China's average wage is one tenth of the developed countries'.

The increasingly inflated land prices have shown up in the nominal GDP through rising property sales to over 14 percent of GDP last year. Moreover, so much investment has occurred due to the collateral value of land. Local governments have borrowed enormous amount of money (probably around 17 percent of total bank lending) to fund or subsidize investment for creating GDP. The loans are secured with land. Without the high land price it is impossible for this source of financing to be possible. As fixed investment is close to half of GDP and driven by government, it is easy to understand how the land bubble has accounted for a big part of the growth in this cycle.

Recent manufacturing investment, for example, is partly due to high land price. Local governments have been competing fiercely for manufacturing investment. Many companies have learnt to exact so much benefit from local governments that they put down no equity capital for investment. They often ask for free land and use the land as collateral for a bank loan. They then lease equipment from the manufacturers that obtain bank loans for the leases. Essentially, the equity capital is from the land donated by the government. This explains why so many companies have always had negative net cash flow but keep expanding. Indeed, expansion is critical to their survival, as they need new investment to bring in cash to sustain themselves.

Profit drives investment that in turn powers employment that then grows consumption. When profit is due to asset appreciation and not sustainable, it can lead to crisis. Large bubbles often occur during prolonged prosperity. People stop paying attention to risk and have excessive demand risk assets. It leads to an asset bubble that prolongs prosperity beyond the normal cycle time length. The more overextended the cycle, the more pain in adjustment after the bubble bursts.

Possibly half of China's bank lending is to the property related businesses or local governments that pledge land as collateral. While the current boom has catapulted China ahead of Japan as the world's second-largest economy, we must remember the excesses in this cycle and the need for an adjustment as soon as possible.  Nothing reveals the vulnerabilities more than the banking system's exposure to unsustainable economic activities that depend on land appreciation. China should proactively bring about the needed economic adjustment.

Andy Xie is a board member of Rosetta Stone Advisors Limited