Chinese housing: Beauty contest or Ponzi scheme?
Chinese housing isn’t valued based on objective financial metrics. Investors buy what they believe others will find valuable.
Encouraged by the government, the Chinese people support a massive real estate Ponzi scheme. Chinese investors value property subjectively, like a beauty contest, because by any standard metric, Chinese real estate prices justify very little value. The Ponzi scheme inflated far beyond any rational level, and it shows no signs of popping. So how does the government do it? How is an unsustainable bubble sustained?
The government doesn’t provide savers any other viable alternatives for storing their wealth. Bank accounts and housing account for 85% of the investment wealth in China. Chinese concentrate their wealth in real estate because owning carries little cost, the asset is tangible, and the Ponzi scheme enriched so many for so long that few see any reason to diversify.
According to China’s National Bureau of Statistics, 90% of Chinese families own their own home, and roughly 21% of China’s urban households own more than one. While this is clearly an overconcentration in the real estate sector, the mania structurally reinforces the house of cards. The Chinese government encouraged the flow of money into real estate, enriching early investors and fostering a cultural bias that reinforced participation in the Ponzi scheme.
Chinese investors who own multiple properties often neglect renting them out for fear of wear and tear. Since property taxes only exist in a few major cities, owning real estate in China carries almost no cost. In most transactions, investors pay taxes at purchase with little or no ongoing obligation. Chinese investors view condominiums a concrete vaults where the value is in the vault itself. Chinese condos function as the world’s largest safe deposit boxes.
In the United States, we waste fewer resources on the construction of places to store our wealth. The average safe deposit box is perhaps 3″ x 5″ whereas the average Chinese safe deposit box is 1,000 SF. But theoretically people could live in a Chinese safe deposit box — not that any of them do.
Despite obvious signs of a bubble — even to the Chinese that participate in it — Chinese investors faith in their bubble is unshakable. But this faith isn’t due to a belief that the market can’t crash, it’s due to a lack of better options for investment.
China possesses 450,000,000 square meters of unsold housing. Chinese developers occasionally tear down houses that lay fallow for 10 years. While building houses and then tearing them down 10 years later may boost the economy, it isn’t a very efficient use of scarce resources. But like other totalitarian regimes, China’s government worries less about efficiency than it does about maintaining order and power.
So how do the citizens of China react to this situation? They become beauty contest judges.
In an investment environment with little or no cashflow where standard measures of valuation fail, the value of property boils down to whatever someone pays for it. Investors rely on speculation concerning future value, and since value emanates from subjective evaluation rather than objective measures, the entire market is one massive beauty contest. The more savvy speculators realize in such circumstances the way to make money long term is to solve the beauty contest dilemma.
John Maynard Keynes wrote a book called The General Theory of Employment, Interest and Money. In the book he compared stock markets to beauty contests. During the early 1900s, the London newspaper would print 100 photos of beautiful women. Contestants were asked to pick the six women they found the most beautiful, and everyone who picked the most popular woman would win a prize.
If someone really wanted to win the prize, they didn’t seek to pick out the woman they found most attractive. To win, the contestant had to select the woman everyone else thought would be most attractive. To be a true master, one had to go even further. Keynes put it this way:
“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment, Interest and Money, 1936).
By He Qinglian |October 9, 2016
China’s real estate market is akin to a Ponzi scheme with the government acting as the dealer, referee, and big player. The market is entirely propped up by loans.
From a market point of view, Chinese real estate has no investment value. …
Other data, for instance the affordability of housing, as well as rental income from housing, shows that real estate holds hardly any interest as an asset class in China, and is little better than a gamble.
The reason the Chinese government will likely continue to prop up its real estate market is because the bubble is so large, that allowing prices to find a natural equilibrium will lead to a 90% to 95% reduction in home prices — and that’s not an exaggeration.
We built $500,000 houses for a local population making about $40,000 a year in Riverside County, CA. Prices cut in half there despite aggressive government stimulus before an equilibrium was restored. In China, they built $500,000 houses in areas where the local population lives in shanties on $3,180 a year, so take our bubble and multiply the problem by 12. A 90% reduction in prices is necessary just to bring priced down to where they were as inflated as our bubble was during 2006. Cut that in half again, and a 95% decline in Chinese house prices is a very realistic scenario.
Real Estate Dependence Sickness
China’s economy is suffering from real estate dependence sickness, primarily because local governments are financially dependent on land.
China’s local governments all make money on land sales as all land in China is state-owned. Between 2003 and 2015, their land dependence ratio (the ratio of land transfer fees to general budgeted revenues) averaged nearly 50 percent. …
Now, with the depressed real economy, what would the Chinese regime do if real estate collapsed? Therefore, the central bank must be the dealer and keep issuing money and distribute dice to the local governments, real estate developers, and buyers, for them to gamble.
In my opinion, mortgage interest rates in the United States can’t rise much because the impact to home sales would devastate the economy. Realistically, the Chinese government and central bank are so heavily invested in their real estate bubble, they will do whatever it takes to keep it going even if that means printing over the debt problems on a scale never before seen. It will make the $4 trillion we printed look like chump change.
From a market economy point of view, China’s real estate boom will die. In fact, the world has experienced real estate bubbles about a hundred times. In the last 20 years, we watched the collapse in Japan, the world’s second largest GDP, and the United States, the world’s largest GDP. While the bubble in Japan slowly deflated, the United States suffered an instant collapse.
Past experience tells us that China’s real estate bubble will burst sooner or later. The only question is how it will collapse. …
It better be the fabled “soft landing” or the world economy will suffer along with them.
Real estate in China has become the central bank’s currency pool. Supplying the real estate market with credit has become the Chinese government’s way of maintaining economic stability. The worst consequence of this approach is inflation. However, inflation only diminishes social wealth.
The moral hazard of central banking
Central banks like our own federal reserve exist to promote moral hazard. Central banks seek to make recessions less painful by making money cheap and plentiful. If they print enough money, and steal from anyone with stored wealth, they buoy nominal prices of most asset classes and reduce the pain for those who deserve to feel pain the most — stupid speculators.
With each round of economic intervention, the people bailed out avoid the consequences for their wild and irresponsible risk taking. In fact, after a few cycles, everyone realizes that any irresponsible risk taking will be bailed out by the central bank. People respond to incentives, and if people realize they enjoy huge potential rewards for wild risk taking and avoid for downside risk, people speculate wildly. Policies of our central bankers nurture moral hazard and germinate larger and larger financial catastrophes.
If China prints enough money to paper over its bubble, it will flood the world with its currency, and its value will crash. Ultimately, the value of any currency cannot exceed the value of a countries assets and the value of goods and services produced. If China’s real estate is 90% to 95% overvalued as I demonstrated above, the actual value of property based on the income of Chinese workers will force the Great Reset to occur — and it’s not like China can raise everyone’s income by 2000% to support real estate because such high wages would ruin its export base and further destabilize the economy.
Central bankers around the world truly believe they can paper over any problem. Most students of financial manias disagree. Unfortunately, with the central bankers in charge of the world economy, their faith in their printing presses will face an ultimate test, and the laboratory is probably in China.