What China Could Be Building

Scott recently expressed his optimism in the Chinese growth story, and sees no reason why the recent trouble with housing markets should jeopardize its growth. As a fellow traveler in China, I have to express reservations about his outlook.

One of Scott's central arguments is that Chinese people want housing. No doubt, people want somewhere to live, and recent waves of urbanization have moved more and more of demand to the cities. However, I'm not sure why this translates into an argument that the current housing situation can't be a bubble. Just because there's a need for housing does not mean that there is enough quantity demanded at current prices. There's no physical overstock, but there's a massive market overhang at current levels. If I were a homeless person who just got a job making thousands of dollars, my first priority would certainly not be moving into a sleek urban apartment whose rent would take up almost the entirety of my income. There are other, cheaper options that are not the drivers behind the current real estate rally.

This is likely because the price of houses represents more than the discounted stream of housing services, it rather represents expectations of future growth. Financial repression and low bank deposit rates force wealthy Chinese to try to grow their wealth by investing into assets such as gold, jade, or housing. Shanghai families view housing as critical to "preserving value" in a household, and the purchase of a house may reflect excessive optimism about the future price path due to other people's purchasing, instead of expectations of the value of future housing services. Printing money wouldn't solve the issue because the real cost of those items are too high, so monetary expansion would only worsen the balance sheets of the savers with bank deposits and strengthen those who had the resources to invest in housing.

The crux of the matter is inequality. Who is buying all those consumption goods you see on TV? Who is buying houses to preserve value? Yogi Berra's quote "nobody goes there, it's too crowded" does not fully apply. Nobody goes there because it's too expensive to live for the "millions of of Chinese living in tiny ramshackle homes." But the houses give just enough return for wealthy Chinese investors, who represent a small, but incredibly influential minority.

The real risk is not that the housing won't be used, but that the crash would have secondary effects. Local governments are dependent upon land sales for revenues, meaning a housing crash could have serious implications for government. In Guangdong province, some local governments are actually tearing down mountains to make new land in the ocean, all to sell the land. This, along with the recent reversal of capital flows and possible insolvency of private wealth management firms, represents a serious liquidity risk that can have disastrous consequences.

In terms of sources, I would recommend looking at Patrick Chovanec's articles on the Chinese housing market and financial system. I don't have much time to provide the direct link for each of my claims, but if there seems like something that doesn't jive right I would be happy to explain further.

So let's answer Scott's fundamental question:

So here’s my question for all of you China skeptics that insist they are building way too much housing, infrastructure, heavy industry, etc.  What precisely do you want them to build more of?  And what are the 100s of millions of Chinese living in tiny ramshackle homes to do?  Sit tight for a few more decades while resources pour into nice urban services for the pampered elite?

I want them to start building leaf blowers, so we don't have so many Chinese people in the low productivity position of sweeping streets. I want them to start building farm equipment, so we don't have so many Chinese farmers tending the fields. I want them to build more laundry machines, to free the rural Chinese from scrubbing clothes on washboards. I want them to build electric stoves, so my Grandpa can put away the coal fired outside oven. I want them to build computers that can deliver cheaper education to the masses.

Instead of just focusing on "building," I want them to invest in human capital, so productivity can be at a level that we don't need "make work" jobs. I want them to build more schools and hire better teachers, so classes aren't as large and you're not damned if you can't make it in a top elementary school. I want productivity to be high enough that high end stores don't need more clerks than actual customers.

I want these things among many others that will only be more obvious in a freer market.

That Scott can get a haircut for $4 or an ice cream cone for 50 cents shows how low productivity and wages are in China. Yet they will not grow any faster with more housing or more state directed investments. Cheap subway rides are nice, but are they not just another sign that transportation infrastructure has been built too quickly? I'm not saying China is hitting a ceiling for growth, or that vast swaths of China are condemned to poverty. But what I am saying is that we need to worry about the systemic fragility that underpins the Chinese system, and be very, very concerned about the unknown magnitude of the downside risk.

Chinese Economic Slowdown: A Reminder of How Little We Know

For an economy of such complexity and opacity, how could one not be afraid?

With most of the developed world stuck in economic doldrums and the Eurozone quickly falling apart, developing countries like China have been a key source of economic growth. However, with recent developments in China, there's a substantial fear that Chinese growth could suffer a hard landing and go through the worse period of the crisis-inducing lower rate of less than 7%.

I won't offer any predictions on how this will evolve, but rather I find that this is another instance of how fragility and uncertainty are incredibly important to the evaluation of a macroeconomics. Much like my analysis on Chinese housing, the real concern is how far the left tail can go and how little we know about it. In addition to what we think we know, we need to be very aware of possible domains that contain unknown unknowns. One key area is the extent of the feedback mechanisms that link the economy together. Once we know about them, they seem obvious. The problem is trying to figure them out.

Housing is rapidly unwinding, inventories are overflowing, and government is unlikely to respond due to credibility issues. The slowdown in housing and shipbuilding is disrupting steel production. Internationally, steel production may cause Australia to slow down substantially. Domestically, the drop in steel production reduces electricity demand. Lower electricity demand causes defaults on coal contracts. Weakening export production means problems in providing Yuan liquidity as capital takes its flight to quality away from China. And on top of these interactions, shadow financial firms are folding as a result of the unsustainability of their ponzi schemes. The shadow banking internal link is particularly fearsome because there's a risk of a major systemic crisis. From Chovanec:

The concern in China is that — like that tornado — a drop in the local property market, or a decline in exports, could hit all borrowers at once, overwhelming the local credit guarantee company and leaving the banks high and dry. The risk is exacerbated by the fact that many credit guarantee companies were capitalized with loans from the same banks whose other loans they are guaranteeing. In effect, banks are insuring themselves, or each other, and would still end up holding the bag on loan losses that are supposedly insured. (It would be interesting to know how such “guaranteed” loans are treated when regulators perform their much-vaunted stress tests on Chinese banks. I suspect these loans are considered loss-proof, because they are “insured.”)

None of these connections are meant to be predictive; rather they are meant to show the limited capacity of prediction. These linkages were not publicized in earlier articles; now that they are uncovered they can leave the domain of unknown unknowns into that of known unknowns. The quote also hints at how common regulatory approaches such as stress tests fail spectacularly in these unclear, systemic conditions. How much risk is captured in these loans, when the webs connecting the official and shadow banks are so complex? Moreover, even if one knew about these connections, shoddy paperwork would prevent understanding of the magnitude of these connections. The holes in the data also should lead one to weight the possibility of a crisis more as the risk of substantially worse data is asymmetric. There's only a slight risk that the data overstates the crisis, whereas the magnitude of an understatement is unknown and can be extremely high.

This opacity in the Chinese economy leaves me unconvinced of arguments that the strength of the government is enough to prevent any crisis from spreading. To reverse the extent of the slowdown, there would need to be a massive reform in banking, corporate governance, and the structure of government in the society. For as much as the Chinese are a pragmatic lot that are willing to pursue institutional reform, the short-term does not look good. Investment has fallen too much, and consumption spending has fallen as well. Attempts at unwinding commodity bubbles such as those in copper may result in large unknown impacts as a result of copper's role in financing deals. Monetary policy also seems very uncertain given the complex network of repo/RRR cuts/interest rate controls/loan to deposit ratio requirements that severely distort what one would consider regular open market operations for easing. Capital flows look to be partially reversing on count of lower exports and higher demand for oil. Local currency loans grew nearly 300% from 2008 to 2009, adding massively to fragility. And fuhghedabout optimal hedging; how do we even know the probabilities? The way housing is unwinding rapidly is also concerning for the possibility of government intervention as land transactions have been an important source of revenue for governments. The Telegraph UK article has an important warning against the thought that government firewalls could stop a crisis:

The property correction is deemed benign because it is planned. Premier Wen Jiabao wishes to forces down prices as a social welfare policy. Yet did the Fed not slam on the brakes in 1928 to choke an asset boom? Did the Bank of Japan not do likewise in 1990, only to find that boom-bust deflation has its own fiendish momentum? Once you let credit rise by 100pc of GDP in five years – as China has, more than in those US or Japanese episodes – you are at the mercy of powerful forces.
Something odd is now happening. The People's Bank said new loans fell from $160bn (£99.5bn) in March to $108bn in April. Non-conventional lending seized up altogether. Trust lending fell by 96pc, bankers' acceptance bills by 90pc. This is astonishing data.
It may not be as easy for Beijing to turn the tap back on again. Loan demand has been falling for months. Banks are offering credit. Companies are refusing to take it. This is the old Japanese story of pushing on a string, or the European story today.

Given the precarious financial system, it's not unthinkable that there can be self-fulfilling prophecies that can overwhelm any kind of government stopgap. Once government measures start to fail, confidence in subsequent policies evaporates, the music stops and market participants scramble for chairs. Beware manufactured stability. Just because it's coming from a developing country doesn't make the warning any less true.

P.S. This gloominess hides an asymmetry in my personal bets on Chinese growth. In any given month, China is likely to grow at a moderate risk with a non-negligible chance of a catastrophic decline.  There isn't some convex set of possibilities: either it's medium good or really bad.  With all the possible feedback loops, a small  but critical perturbation is likely to cause much larger impacts.