Chinese Housing Dwarfs The Past Booms In The U.S. And Japan

by: Robert Wagner

The Federal Reserve has an essay titled "The Great Chinese Housing Boom," and in it are some pretty shocking statistics. One of the statistics that made me do a double-take was that housing prices in China are 11 to 23x annual income. I immediately thought to myself, "how does someone pay off a 30 year mortgage on a house worth 23x your annual income?" Clearly there must me huge income differentials within China, not only between people but between locations, but still the statistic is pretty eye opening. On a historical perspective, the housing price to annual income ratio was 5 to 6x in the US and 15x in Japan at the peaks of their "bubbles."

Current housing prices are roughly 11 times annual income; in large cities such as Beijing and Shanghai the price-to-income ratio is as high as 23 to 1.1 By comparison, Tokyo house prices were 15 times income and U.S. house prices 5 to 6 times income when the Japanese and U.S. housing bubbles, respectively, burst in 1990 and 2006.

There is a huge difference between the Chinese boom and other booms however. The Chinese boom seems to be driven by investment and rental properties, not the drive for individual home ownership. The Chinese real estate boom has the feel more like what happened in the US during the early industrial age when the expansion in housing was to house workers for the newly built factories. Housing back then had a far more utilitarian and economic basis, than the luxury that it represents in the US today.

The U.S. housing boom reflects overconsumption and overborrowing, whereas the Chinese housing boom reveals large investment in construction and apartment holdings. Most of the "vacant" Chinese homes have been sold to private owners but are being held as investments alongside multiple other homes.

The one metric on the above chart that stands out is the vacancy rate. China has 10x the amount of vacancy as the US did at its peak. Clearly China is building for the future, and isn't building to fulfill current market demand. In my opinion this is the benefit and danger of a centrally planned economy. The benefit is that China can artificially expand investment in an area well beyond where market forces would with relative ease. The danger is that the "central" plan never materializes...which almost always happens. The track records of central planners is legendary for their failures. China should know this well considering the classic examples of "The Great Leap Forward" and "Cultural Revolution" are homegrown disasters. China must be thinking three time's a charm, but I doubt it.

The most frightening part of the article is the logic being used to justify the continued expansion of vacant properties. Believe it or not, the properties are being purchased as a "store of value" without consideration to it being used to house people. Ah, central planning at its best. By the way, you can see the "store of value" theory unfold right now in the gold, silver and precious metals markets. I would imagine that real estate investors will soon awaken to the fact that spending a fortune of something that really has little or no use isn't a great idea. Gold at least can be easily be converted to US dollars, unlike Chinese real estate.

Store-of-value demand is speculative in nature because it hinges on the expectation that housing prices cannot fall or the rate of return to empty apartments can consistently dominate that of cash. But nowhere in the world is this guaranteed-housing prices do fall sometimes, as they did in the United States in 2007. Thus, speculative demand generates bubbles because, more so than fundamental demand, it is fickle and prone to sharp reversals.

In the article there is an interesting discussion on policy, but considering that China's main monetary policy is to peg their currency to the US Dollar at a highly competitive rate, and then deny that they are manipulating their currency, makes it pretty much moot. China's monetary policy will be to maintain a dollar to yuan ratio that keeps dollars flowing to China and goods flowing to the US. I doubt real estate valuations will ever enter into the conversation. That is another benefit and danger of a centrally planned economy. You can ignore market based signals...often/mostly to your detriment.

Given the evidence for significant speculative demand, how should authorities, including monetary policymakers, react? There are generally two views on this question: (NYSE:I) Intervention is not necessary because the bubble is not highly leveraged and will not significantly impair the financial system. And (ii) the bubble requires appropriate policy action because regardless of financing, it promotes inefficient resource allocation. Mishkin (2009) captures the first view; he argues that responding to "a pure irrational exuberance bubble" (i.e., a bubble that is inflated through investors' own savings) risks doing more harm than good. Chen and Wen (2013) argue for policies under which housing can maintain its role as a store of value but mitigate related inefficiencies.

Already the signs of this flawed central plan are becoming evident. Resources that could be used for productive uses like building factories, manufacturing goods, providing services, creating jobs and a higher standard of living are being used to build vacant apartments so some rich person can store their wealth. All this is happening while the poor in China are effectively barred from buying real estate. Ah the joys of central planning, I can smell the brewing revolution already.

Housing is not an ideal store of value. Building houses consumes productive resources, and those who need housing as a basic necessity must compete for its acquisition with those who want it to preserve wealth. Chen and Wen (2013) demonstrate that private investment in fixed capital in China is negatively correlated with housing price growth. In addition, more low-income households are excluded from purchasing homes because their income growth falls behind housing price growth.5

The only thing worst than a flawed central plan, is a flawed policy to fix the problems created by the flawed central plan. If Chen and Wen get their way, China's real estate problems will likely get worse not better. I always find it amazing how these central planners never simply decide to let the market set the price, and determine supply and demand? I guess letting the market decide is bad for the employment prospects of central planners, so they choose to keep repeating mistakes and creating problems that need more central planners to fix the problems the other central planners created. Personally I think Adam Smith's invisible had will do far more for China than any number of central planners could ever dream of accomplishing. Unfortunately the one thing constant about communism is that they have short memories and are fond of repeating the mistakes of the past. Repeated failure is no deterrent to a communist, history proves that.

In order to alleviate inefficiencies, Chen and Wen (2013) advocate government policies to ensure that the growth rate of home prices equals or is slightly above the rate of return on bank deposits but does not exceed the average growth rate of household income, (ii) provide government-subsidized housing units to low-income households, and (NASDAQ:III) facilitate the development of rental markets so that empty apartments can be used more efficiently. This approach allows housing to still serve as a store of value (for middle- or upper-middle-income households), but its rate of return is not high enough to distort firms' investment incentives and low-income families are not pushed out of the home market. Middle-income Chinese households demand a good store of value, and a policy of bursting the bubble would likely generate substantial negative wealth effects and hinder China's urbanization process.

The final paragraph of the essay provided the most important information to investors. Bubbles, when they will burst and how severe the damages will be are difficult to predict. It is one thing to recognize that you are in a bubble, it is a whole other thing to manage it effectively. Gold had 12 up years in a row, bubbles can last a long time. The dotcom bubble harmed the economy, but nothing like the damage done by the real estate bubble and the resulting financial crisis of 2008. Each bubble is unique, and they are always difficult to predict and manage. If they weren't we wouldn't call them bubbles.

The Chinese housing boom has generated global attention because of fears that it is not sustainable and its collapse would intensify the current world slump and significantly prolong the worldwide recession. Because of its speculative nature, significant store-of-value demand for housing suggests a bubble that could burst, especially when both the household income growth rate and the savings rate start to decline and capital controls in China start to relax. But how soon and how fast these events will happen-and if, when, and how investors might lose faith in housing as a store of value-are naturally difficult, if not impossible, to predict.

In conclusion, the Fed essay is a good wake-up call for investors in China, and countries that are heavily dependent upon future Chinese growth. If there is a real estate bubble in China, and if it does burst, the consequences are likely to be different from what happened in the US. While the risks of a financial crisis appear less likely than what happened in the US, the excess capacity, social inequality and underinvestment in productive assets will likely create a unique set of problems. While it is always difficult to identify the peak of a bubble, investors in China and related countries should be aware of what is happening and develop a strategy if things begin to deteriorate. Selling their Chinese and Pacific/Asian holdings would be a first step, or even buying a short china fund would be another. The impact on the US Economy should also be analyzed. If China falls into crisis, it will likely have a deflationary impact on the US, as they try to export their way out of it. China would also likely sell some of their gold holdings, as well as some of their US Treasuries. The later would have a mixed impact on US rates because as China exports more to the US to stimulate their economy, they would also be forced to buy more US Treasuries to maintain their currency peg. So China would be selling US bonds with one hand and buying them with the other. The deflationary affect would also help keep US interest rates low even if China were to dump their US bond holdings.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

ETFs of Interest:

iShares FTSE China 25 Index Fund (NYSEARCA:FXI)
iShares MSCI China Index Fund (NYSEARCA:MCHI)
Guggenhiem China Small Cap ETF (NYSEARCA:HAO)
Global X China Consumer ETF (NYSEARCA:CHIQ)
PowerShares Golden Dragon Halter USX China Portfolio (NASDAQ:PGJ)
ProShares UltraShort FTSE China 25 (NYSEARCA:FXP)
Direxion Daily China Bull 3x ETF (NYSEARCA:YINN)
PowerShares Chinese Yuan Dim Sum Bond Portfolio (NYSEARCA:DSUM)
Guggenhiem China All-Cap Fund (NYSEARCA:YAO)
Guggenhiem China Real Estate ETF (NYSEARCA:TAO)
ProShares Ultra FTSE China 25 (NYSEARCA:XPP)
Market Vectors China A-Shares ETF (NYSEARCA:PEK)
WisdomTree China Dividend ex-Financials Fund (CHXF)
iShares MSCI China Small Cap Index Fund (NYSEARCA:ECNS)
iShares FTSE China Index Fund (NASDAQ:FCHI)
Guggenheim China Technology ETF (NYSEARCA:CQQQ)
EGShares China Infrastructure (NYSEARCA:CHXX)
First Trust China AlphaDEX Fund (NASDAQ:FCA)
Direxion Daily China Bear 3X ETF (NYSEARCA:YANG)
Global X China Financials ETF (NYSEARCA:CHIX)
ProShares Short FTSE China 25 (NYSEARCA:YXI)
Market Vectors Renminbi Bond ETF (NYSEARCA:CHLC)
Global X China Industrials ETF (NYSEARCA:CHII)
Global X China Energy Fund (NYSEARCA:CHIE)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.