by Roy C. Smith
The Wall Street Journal recently reported that “China’s housing
market has defied gravity and government regulations for two years, floating on
a tide of bank loans and speculation. Until now.”
Housing prices in Beijing and Shanghai, having shot up 30%
to 40%, respectively, since 2015, have fallen sharply as a result of government
controls imposed last year, and are now dropping below their 2015 levels. From
the government’s point of view, the good news is that its firm hand can deflate
bubbles and cause markets to behave as it wants. The bad news is that heavy-handed
controls can have adverse consequences of their own, and market forces can make
them worse.
Despite
its authoritarian controls, China is not exempt from such market-driven crises.
Indeed, in 2014, after a year of monetary easing and government pressure to
grow the economy and encourage stock prices so companies could refinance loans,
a major effort was made to increase margin loans which grew, in aggregate, to
as much as $2 trillion. So, China’s second stock market bubble in a decade suddenly began
to form - the Shanghai Composite Index of stock prices rose 150% from November
2014 to a cyclical high of 5,166 in June 2015, before the bubble burst,
dropping prices by 43% in a matter of a few weeks. The government intervened
forcefully – requiring government controlled investors to buy stocks, and
encouraging further margin buying – and the rout was halted, but the market has
not fully recovered since then. Investors, fearing the unpredictability of
government intervention, chose to invest in residential real estate and other
assets instead, moving the speculative destination to other sectors.
Indeed,
China’s 250 million “middle class,” aided by continued easy money, piled in
again to residential real estate. There
have been other bubbles in real estate over the past several years, but the
so-called middle class, which includes China’s growing millionaire class as
well, is much larger now than before. There are now approximately $4 trillion
residential mortgages outstanding. Since the stock market crash in 2015, these
folks have upgraded their residences and bought additional homes as
investments. According to the WSJ, “mortgages made up as much as three-quarters
of all new loans in 2017.” According to Moody’s Investor Services, the housing
sector generates about a third of China’s economic growth.
But
the sudden price downturn has affected the resale values of all housing and the
value of collateral held by banks. As we know from our own experience after
house prices unexpectedly started to decline in late 2006, an avalanche of
mortgage problems hit the US housing market and resulted in a major crisis.
Underwater mortgages tend to be abandoned, property developers fail, and banks
have little choice but to write them off. As a crisis develops, all forms of marketable
credit instruments are questioned, and investors run to safer ground. Too much
of this and banks get into trouble and may then either fail or have to be bailed
out by the government.
If
the government has to intervene to forestall a crisis (there is no indication
that this is the case in China as yet), then it may have to direct investors to
purchase mortgages and other debt instruments, whether they want to or not. It will
also have to change mortgage availability and other policies back to what they
were before. This, or course, weakens China’s efforts to improve the role of
market pricing in its economy, something most analysts agree is necessary for
the country to transition to developed status. Doing so also covers up the
weakness of many assets on the books of Chinese financial institutions and
kicks the can of having to deal with them into the future, where the problem non-performing
and risky debts will only be much larger.
Indeed,
China already has a large amount of questionable loans on the books of its
banks ($30 trillion in assets), shadow banks ($9 trillion) and in the high-yield
investment portfolios of middle class investors. Fudging over the mortgage
sector could add a considerable sum to this dangerous accumulation of toxic
assets. From such accumulations, financial crises arise.
Market-driven
crises may be triggered by well-meaning government controls in a
fully-self-confident, authoritarian system with little regard for markets. China’s
marketable financial assets are about $30 trillion today, but markets are
dependent on retail and speculative investors more than institutional ones. Government
intervention is the solution to crises, but such periodic intervention can destroy
market integrity, which weakens the economic system.
Just
as the announcement of housing price declines surfaced, China announced that
its annual growth rate for 2017 was 6.9%, up from 6.7% for the prior year. The
news was met with considerable skepticism by international observers who considered
the results to be managed. The government wants to convey a picture that it is
on top of things and all is well, others see an economy that continues to be in
slow decline despite many efforts by the government to prop things up.
Growth
continues to be essential to the Chinese government. Only with growth can it
hope to meet the expectations of its billion or so people who have not yet
entered the middle class, and provide the resources required to deal with its
aging population and to support its overseas and military agenda. For China,
growth means continuous intervention.
Ironically,
such intervention promotes price volatility in financial assets that periodically
passes capital losses on to the middle class. It is this group that the government must
depend on to be the engine of consumption as the country transitions from an
export-led economy to one that is more consumer-led. It is difficult to achieve
such long-term objectives, however, when the government has to intervene in the
short-term to prop up (and maintain) the weaker elements of the system.
