Finally an Economist who understands China

Patrick Chovanec at Tsinghua has put together some excellent research on the current property bubble in China.

In China, however, “flipping” is not the problem. Some people may be engaged in short-term ”flipping,” but as I’ve described in my FEER article “China’s Real Estate Riddle,” a lot more are buying residences — in many cases multiple units — and holding them vacant indefinitely as an unproductive ”store of value,” like gold. As I mentioned in my article, the Financial Times estimates that there are 587 million meters of apartment space that buyers have purchased over the past five years only to leave lying empty (for a concrete notion of what this statistic means, take a look at Al Jazeera’s report on Ordos). This puzzling phenomenon is due to the fact that Chinese citizens have relatively few investment options, and China’s real estate sector (unlike its stock market) has never experienced a sustained downturn since the country converted to private home ownership in the mid-1990s. The fact that China has no annual holding tax on property means there is little penalty for letting property lie idle, in the hope that it will appreciate or at least retain its value. The result is an inflated market where the demand for property as a pure investment vehicle far outstrips the demand for affordable, usable space.

The way I read these figures is that an immense amount of new housing is being purchased and accumulated (in a vacant condition) off-market. Nobody has any idea what it is actually worth because there is little urgency to offer it, to end users, on the secondary market and actually see it priced based on their demand. If investors were at least trying to “flip,” we might find out, but they’re not, and so prices for new residences (especially on the high-priced luxury end) continue to rise without anything to bring them back down to earth.

If China’s real estate sector were experiencing a typical bubble, where assets are being rapidly flipped higher and higher until the music suddenly stops, China’s new property sales tax would make eminent sense. But this new policy misdiagnoses the problem, which is that property is being accumulated and left idle, indefinitely, as a store of value. As long as that property remains off-market, and is not compelled to be priced based on actual demand for affordable usable space, the asset price illusion will continue and the bubble will grow. If China wants to bring it real estate market back to earth — and that’s a big “if” — it should be offering investors a reason to use, rent, or sell. An annual property holding tax does this. A higher property sales tax, while well intentioned, only makes things worse.

Read the full article.

Chovanec also had an article in the June ’09 issue of the Far Eastern Economic Review called “China’s Real Estate Riddle“.

A modest annual tax may not be the only factor shaping these behaviors, but it’s emblematic of an important difference in outlook. There’s an old story reported by an American journalist in Shanghai after the end of World War II. Ravaged by hyperinflation, locals had turned to using tins of sardines as an alternative currency. One recent arrival opened his “proceeds” from a sale only to find the sardines inside were spoiled. He complained to the other trader, who cried, “You opened them? My God, man! Those sardines aren’t for eating, they’re for buying and selling.” Apartments in China aren’t for living in, they’re for investing. That is the real source of demand.

One problem is that using luxury condos as currency is immensely wasteful, compared to sardine tins or tiny amounts of gold. Construction of all these useless high-end units consumes huge quantities of labor and materials that could go into creating, rather than merely representing, useable wealth. And without adequate maintenance (recall the need to minimize holding costs), any practical utility these units might have had as residences will deteriorate rapidly.

The other challenge is psychological. A useless asset like gold or vacant apartments can only serve as a store of value so long as people have collective confidence it will continue to perform that function and thus retain its value. China’s property market may well crash. The point is that if it does, it won’t be because the supply of apartments outstrips the practical need for affordable living space, as it has for many years now. It will be because the Chinese lost faith in real estate as a form of tangible savings, or found a better alternative.

And last up, an article concerning China’s “Quality” of GDP

My concern is how even true-blue GDP figures can sometimes paint a misleading picture of the real health of an economy.

When smart analysts look at companies, they don’t just look at the announced profit figure and accept it at face value. Even if they have no reason to doubt the accounting, they try to apply a concept called “quality of earnings” to get a better sense of how the company is really doing.

Back in March, I was asked on Chinese TV whether I thought China could achieve its target of 8% GDP growth for 2008. I said I didn’t see any reason why it couldn’t. All the government had to do was take all the laid off migrant workers and hire them to dig a hole in the ground one day and fill it up the next. Since the total would be added to National Income, the government could simply pay them enough to hit whatever GDP target it had in mind. The more important question, I said, is whether China is preparing itself for the next phase of economic growth. Focusing exclusively on GDP, as a number, is a distraction.

The example I gave may have been a little bit extreme, but it gets at an interesting and important point. GDP tells you how much the economy is producing; it doesn’t tell you whether that production is actually creating real value or not. In a free market, where people are making voluntary exchanges based on supply and demand, presumably it is, otherwise they would behave differently (unless, of course, there are major externalities that market prices aren’t taking into account, see Stiglitz, below). But when the State is either directing economic activity without regard to prices, or when it is artificially influencing the conditions of supply and demand in a way that distorts prices, the conclusion doesn’t necessarily follow. Production may actually consume more value than it creates, destroying wealth, or divert resources from more productive pursuits, yet in the short term, still count positively towards GDP.

The “resilience” of the Chinese economy right now is based, at least in part, on several factors that I find cause for concern:

construction of large-scale luxury condo developments that go entirely unoccupied and serve merely as investment vehicles, on the expectation of future appreciation;
easy state-provided credit that has kept businesses — many of them poorly run and financed — from exiting sectors (such as steel) that have chronic excess capacity;
a massive shift in resources towards the State Owned sector and away from private enterprise (including the acquisition by the State of controlling stakes in successful private companies);
misdirection of business loans into stock market and real estate speculation, fueling bubbles in both markets;
direct investment by government ministries in order to speculate in — and thereby prop up – the real estate market, on the misconception that a rising real estate market is a “driver” of growth (rather than a result of real demand for more and better usable space driven by business expansion and rising living standards);
the possibility of “channel stuffing,” where wholesalers and retailers are forced to build up unsold inventories to keep factories (particularly state-owned factories) running. Ironically, this shows up in China’s official statistics as “retail sales” because in China, retail sales are counted when the manufacturer ships, not when the products is sold to a consumer.

Developing a vibrant service sector, improving quality and safety in manufacturing, building recognized and well-respected brands, developing more efficient and transparent capital markets, providing a social safety net that lubricates labor markets and liberates savings, moving towards full convertibility of the Renminbi, learning how to manage and grow businesses in political and social environments beyond China’s borders — these are the challenges China must master to take its economy to the next level. But I don’t see anything in the “8% growth” story that is moving China in that direction.


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