China’s growth is fueled by a bubble in real estate and seems destined to pop sometime in the next decade. While consensus is growing around this sentiment, two New York Times articles stand out as part of a growing body of evidence that China’s rise may be a bubble waiting to pop.The first is an article about the housing market in Amsterdam over the last four hundred years. Dutch economist Piet Eichholtz conducted research which led to a shocking conclusion: Over the last 350 years real estate prices did not rise very much at all when adjusted for inflation:
“Between 1628 and 1973 (the period of Eichholtz’s original study), real property values on the Herengracht — adjusted for inflation — went up a mere 0.2 percent per year, worse than the stingiest bank savings account. As Shiller wrote in his analysis of the Herengracht index, “Real home prices did roughly double, but took nearly 350 years to do so.”
China is in a situation now where real estate prices are rising FAR faster than inflation.
The second article is about the rising debt load in China’s cities. Fixed asset investment is now 70 percent of the economy in China. This is a ratio never before reached in any modern country. This expansion is being financed by off the books loans taken out by individual cities themselves, not Beijing. The collateral used to secure these loans is land owned by the cities. The value of this land is very likely overinflated. If there is any decrease in the value of land, the loans will become un-payable. In fact, some of these loans are already un-payable, and the cities are merely taking out more loans to pay for the loans they already have. While China’s substantial cash reserves may serve as a buffer to a crash, some analysts predict that the amount of unsecured off the books loans help by municipal governments is roughly equivalent to Beijing’s war chest. Bejing realizes that the municipal governments are out of control and is trying to rein them in, but there are many obstacles– the primary one being that Chinese officials are still essentially only evaluated on their ability to promote very short term economic growth.
If the bubble pops in China, let’s consider what might happen. The government will be forced to spend its substantial cash reserves to bail out municipal governments. Sure, the Chinese and their massive economy are here to stay; it would be foolish not to accept that fact. A bubble would, however, vastly slow their explosive growth. It will also have extremely deleterious effects on the global financial system as a whole. If the Chinese stop buying US government debt it is hard to see who would step in to play that role. It has the potential for triggering a crisis on the level of the Great Depression, or possibly worse.
The investments that China is making in infrastructure may pay off enough to fuel real economic growth. If this is combined with sustained inflated real estate prices the crisis may be averted. This is a reality that is rather unconvincing. When one reflects upon the funding of the transcontinental railroad in the United States in the late 19th century, they were built substantially ahead of demand, just as the investments in China are now. The only thing that made the railroad possible was collusion between the railroad developers and corrupt politicians who gave companies loans on extremely favorable terms, which also has echoes in the current situation in the People’s Republic. These loans were essentially never repaid. I fear that this will happen again, and that it will have a ripple effect with massive consequences for the global economy. It may be naïve to think that things will be different this time.