April 25, 2014 / 4:01 PM / 4 years ago

COLUMN-Real estate weakness drives China rebalancing

(The opinions expressed here are those of the author, a columnist for Reuters.)

By James Saft

April 25 (Reuters) - China’s economy is rebalancing. Unfortunately it is changing a lot like the U.S.’s did in 2006 and 2007, with a sudden slowdown in real estate.

That was perhaps inevitable, but raises some familiar risks - a chain reaction of real estate losses, debt defaults and a sudden slowdown in growth.

The costs for the rest of the world could be high, particularly in places like Brazil and Australia which have prospered by feeding China’s formerly insatiable appetite for raw materials.

China’s GDP is expected to slow to growth of 7.3 percent this year, down from last year and the smallest expansion in 24 years, according to a new Reuters poll.

On the surface, that’s in line with a government goal of transitioning from an economy dependent on investment, to one more like that of more developed countries with a higher consumption share.

But while consumption is growing as a share of China’s economy, it is doing so in significant part because investment, particularly in real estate, is falling in importance. Property investment fell in the first quarter to 12 percent of GDP, down from 15 percent last year. That compares to about 5.0 percent in the U.S.

The value of new homes sold fell 7.7 percent in the and new home starts fell by more than 25 percent.

That in turn very likely was driven by a tightening of financing conditions, with overall the widest measure of lending down more than 9.0 percent compared to a year ago.

And overall debt in China is very high, with some evidence that absent a continued flow of new borrowing bad debts will have to be faced.

“Burgeoning debt was not an unlucky accident,” according to Michael Pettis, a finance professor at Peking University.

“It is fundamental to the way the growth model works, and we have arrived at the stage, probably described most imaginatively by Hyman Minsky in his work on balance sheets, in which the system requires an acceleration in credit growth simply to maintain existing levels of economic activity.”

Pettis argues that China’s debt problems have become so large than they can’t be “managed” by imposing discipline on borrowers or reforming banking.

“Without a massive transfer of wealth from the state sector to the household sector it will be impossible, I would argue, for GDP growth rates of anything above 3-4% - and perhaps even less - to occur without an unsustainable increase in debt, whether that occurs inside or outside the formal banking system and whether or not discipline has been imposed on borrowers,” he wrote.


A Minsky moment, the sudden collapse of asset values when debt fueled speculation comes to a sudden halt, would be, like everything else, different in China.

China’s economy has pulled off an economic miracle, but done so by relying heavily on investment, and with an increasing proportion of that investment funded by debt. So far, so Minsky.

While it is true that the quality of investment has fallen, theoretically reducing borrowers’ ability to repay debt, the story is not as simple as it would be in the U.S.

In China, not only is everything a political question, the state’s apparatus has far more power to manage how political questions, i.e. everything, are resolved.

So while the government has a stake in a transition away from low-quality investment, many bet that they won’t allow credit to tighten so badly that real estate crashes.

As individual borrowers tend to be less leveraged than in the U.S., that makes the job of managing a credit slowdown a bit easier.

It doesn’t make a real estate crash impossible however. Animal spirits works the same way in China they do in Orlando, and with about ten years of overbuilding to work through, it’s not hard to see the possibility of a cascade of weakness through the economy.

Ultimately, bad debts in China will need to be recognized and absorbed by some sector. Pressing them on to households goes against the goal of increasing consumption, while company balance sheets seem unlikely to be able to handle the sheer size.

That leaves the government, which may be China bulls’ best hope.

It won’t end at China’s borders. Managed or out of control, the transition to lower investment is at hand, and for those who’ve done well out of it - think resource-heavy countries - the most they can hope for is enough time to absorb the blow.

At the time of publication James Saft did not own any direct investments in any securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft

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