Wednesday, April 11, 2012

Chinese Housing Market: More than "Tail Risk"

The story of the Chinese housing market has been a nerve wracking one.  Property prices have been soaring, and with all property price growth, there is fear that it could pop in a bubble.  This problem is especially prominent in the public consciousness in light of the U.S. real estate bubble, which seemed to show that no matter what governments may say about soft landings, housing bubbles can usually accumulate into larger macroeconomic crises.  While, yes, I am aware that housing crashed two years before the sharp drop in NGDP, the lack of Chuck Norris-esque monetary declaration in China to maintain steady NGDP growth seems to suggest that a banking crisis, which is essentially an aggregate supply issue, can accelerate into broader macroeconomic troubles.

Some recent news out of the housing market has been simultaneously comforting as well as concerning.  Housing prices have fallen five days in a row, yet the stock market is still rallying behind the bonds of several major Chinese property companies.  This has been interpreted as a prediction for a soft landing, as firms are still willing to invest in housing.  The CNBC article also outlines some other reasons for optimism:

In a report issued last month, Standard Chartered also pointed out that there were signs of hope after the drumbeat of negative news last year. "Apartment sales have improved since the Lunar New Year break," Lan Shen and Stephen Green wrote. "Developers are a little more confident about apartment sales, and price cuts of 10-20 percent are apparently helping to nurture demand."
On Friday, China's largest property developer Vanke seemed to confirm a rebound, reporting a 24 percent increase in sales in March over the previous year. It was the second consecutive month Vanke had reported a year-on-year sales increase.
Scott Sumner is also very optimistic, framing recent concerns as just another false alarm from a long row of pundits.
The price system works surprisingly well in China, despite the half-communist nature of their economy.  Chinese buyers actually use their own money to buy homes, so in a sense the US housing market circa 2005 was much more “communist” than the Chinese market.
China boosters like Robert Fogel claim that China will soon grow to be twice as rich as France the EU.  Others pundits claim it will get stuck in the middle income trap.  Both the boosters and pessimists are wrong.  Like Japan, like Britain, like France, indeed like almost all developed countries, it will grow to be about 75% as rich as the US, and then level off.  It won’t get there unless it does lots more reforms.  But the Chinese are extremely pragmatic, so they will do lots more reforms.
China is currently a very poor country, so the Chinese model has nothing to teach the West.  If we want to learn from the Chinese culture, learn from Singapore(or Hong Kong), which is how idealistic Chinese technocrats would prefer to manage an economy; indeed it’s how China itself would be managed if selfish rent-seeking special interest groups didn’t get in the way.  But they do get in the way—hence China won’t ever be as rich as Singapore; it will join the ranks of Japan, Korea, Taiwan, and the other moderately successful East Asian countries.
This isn’t any sort of “miracle.”  Go visit China and look at the airports, roads, subways, office buildings, shopping malls, etc, that they are building.   Look at educational levels in the cities (to which they are rapidly moving.)  It would be a miracle if a country that could do those things got stuck at the middle income level.  I’ve visited both Mexico and China quite often.  Mexico is a middle income country that is currently richer than China.  But any tourist who visits both places (with eyes wide open) can quickly see who will be much richer in 30 years.  There’s no stable equilibrium where the coastal Han Chinese get fully developed and the interior Han Chinese stay middle income.  And the coastal Chinese are closing in on developed status very rapidly.
While the long run predictions seem accurate (convergence seems quite reasonable for China), the concern is in the short run when the storm is still here. Interestingly enough, the first CNBC article trumpeting the resiliency of stock markets seems to be internally contradictory.  I don't buy the "price cuts of 10-20 percent are apparently helping to nurture demand" argument.  If there is so much demand, why should there be a need to lower the prices to "nurture demand"?  Even the argument about equities rallying because of confidence in the housing market is also specious.  Why should the relationship between the housing market and the housing companies' bonds be linear? Markets are opaque: how do we know the rallying is from perceptions of a short term price spike with a medium term collapse, or will the forecasts just not match reality?  Fundamentally, we just don't know why the movements in prices are happening.  Quoting Taleb in The Black Swan:
History is opaque. You see what comes out, not the script that produces events, the generator of history. There is a fundamental incompleteness in your grasp of such events, since you do not see what's inside the box, how the mechanisms work. What I call the generator of historical events is different from the events themselves, much as the minds of the gods cannot be read just by witnessing their deeds. You are very likely to be fooled about their intentions (8). 
If we really don't know the causes, optimism is unfounded.  Scott's confidence that the housing market will keep on going up also ignores the dual nature of the price movement.  The continual upward climb can both be evidence of stable growth, or the indicator that a crash is coming.  Past performance does not guarantee future results.  Taleb, again:
Let us go one step further and consider induction's most worrisome aspect: learning backward. Consider that the turkey's experience may have, rather than no value, a negative value. It learned from observation, as we are all advised to do (hey, after all, this is what is believed to be the scientific method). Its confidence increased as the number of friendly feedings grew, and it felt increasingly safe even though the slaughter was more and more imminent. Consider that the feeling of safety reached its maximum when the risk was at the highest! But the problem is even more general than that; it strikes at the nature of empirical knowledge itself. Something has worked in the past, until—well, it unexpectedly no longer does, and what we have learned from the past turns out to be at best irrelevant or false, at worst viciously misleading (41). 
Back to the CNBC article, it continues with analyses of severe risks among the housing companies:
Some credit analysts are also warning that the sector faces judgement day as builders struggle to pay back debt. On Thursday, Standard and Poor's cut the credit rating on Hopson Development and Glorious Property. 
"We have to remember, ratings agencies are not the leading indicators, ratings agencies follow the market," says SJ Seymour's Yadav. 
According to her, the best thing for investors to do is to choose the bigger names, which have exposure to mass-market housing and projects outside the large tier-1 cities. She recommends the corporate bonds of Evergrande. 
"We reckon the bigger players, simply because of the bigger number of projects, the diversification, will assist them. The smaller players can come under pressure very quickly," says Yadav. 
Meanwhile, analysts expect further consolidation among the smaller developers. Donald Han, Senior Advisor, HSR Property Group said his firm was advising some of these smaller companies. 
"A lot of these companies by in large have a fairly strong asset bases in terms of balance sheet but the difficulty is trying to move sales and converting that into stronger liquidity," Han told CNBC. "Some of the smaller companies may go through consolidation. The result of the consolidation exercise would turn some of the new entities into a bigger more stable companies."
I see multiple red flags here.  The fact that rating agencies are no longer comfortable with the levels of debt seems to hint at problems bubbling up from underneath.  The fact that they follow the market is not very comforting; it merely suggests that the economy is already moving towards that negative direction.  Additionally, while the analyst recommends investing in large firms to get stability, one has to be aware of how this consolidation of firms, in reality, merely masks tail risk with stability.  Quoting Taleb:
Just as there is a fallacy of aggregation, I believe in the fallacy of scale (because of concavities). Properties change with scale.
It is as if the firms are locking arms to face the wind.  While for small winds they are more stable, a large gust can pull them all away.

The last line about "fairly strong asset bases" but lack of "stronger liquidity" is especially concerning.  It suggests that the market is very prone to panics and shocks; there's no buffer of liquidity to assuage the fears of depositors.  This is all assuming that the asset bases are priced correctly and are actually strong.  Yet even a few minor errors here can propagate systemic risk through the markets incredibly quickly.

Some anecdotal evidence that I saw during my last trip to China also gave me shivers.  We were looking at houses near Shanghai, and found houses relatively far from the city center that were in the 5m RMB range, or about 830,000 USD.  And these relatively "new" houses were not very well constructed either: the walls often had relatively large cracks and the windows were not properly sealed.  Given the apparent high depreciation rate of housing capital: what could justify the high cost?

Of course, that can only pull on my gut feelings; perhaps there is some benefit of having a home at distances that make the city center at least accessible.  But when we were in the cab after looking in houses, I remember the driver talking about how housing prices would never fall, and that there was nothing to worry about.  Worst case scenario, there's a soft landing, but there should be no large scale concerns about housing prices.  This terrified me.  When one can buy 2 RMB newspapers about the housing market from street vendors, and then hear people saying housing price collapses are impossible, it's time to consider the "impossible": a hard landing for housing prices.

Now some may critique this argument, saying that the same arguments about opacity apply to my narrative as well.  The whole problem with low probability high impact events is that the events are fundamentally unpredictable.  We've never observed the probability before: how would we know?  The fact that it's anecdotal evidence is even more specious; I could just be telling a story and not listing the facts.  But the argument I here is not that the housing market will crash by 30% in 6 months and 16 days, but rather that we can't just wave our hands and hide the risks in China.  The problem is more than tail risk.  It's asymmetric tail risk.

If China continues on its current path, it's not going to magically get substantially higher growth.  Even if all the loans go off without a hitch, and all the banks stay liquid and solvent, the Chinese economy cannot grow much faster than 12%.  But if, for some reason, a systemic crisis befalls China, the negative payoff has a very fat tail.  Borrowing and collateral chains would collapse worldwide, and longtime trade partners would suffer through great turbulence to adapt to the new international trade.  Especially with the crisis in Europe, even a small credit shock in China could have massive global effects.  History does not crawl; it leaps.  My fears now are that while we crawl forward with housing construction, we may find ourselves in a "Great Leap Backwards", destroying many of the gains of the past decade.

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