This column originally appeared in CNBC
"Hear that sound?" said Andy Xie while cupping his ear. "That’s the sound of China's real estate bubble bursting.”
Xie, a former Morgan Stanley star economist and one of the more vocal China bears, was telling me that Armageddon had arrived. Housing prices were going to drop 50 percent, maybe even 90 percent. Xie and I were debating on CNBC last September in a China "Bull vs. Bear" showdown hosted by Bernie Lo. You can see the three segments here: Bull vs Bear: China property debate 1, Will China's property bubble burst? and China's growth story.
Xie dismissed my argument that moves to limit leverage – home buyers needed to put down 30 percent for their first home, 50 percent for their 2nd – made it unlikely that prices were going to drop anytime soon. He pointed to vacant units as proof that a hard landing was imminent for China, and that it would come from its real estate sector.
What has happened in the 8 months since the debate? Housing prices have risen 30 percent while sales volumes have dropped 70 percent. In other words, people buying homes can afford them. There is no panic selling like in the US or Dubai because rules in place for years have prevented the kind of speculation that was rampant in America, where people bought multiple homes with zero down.
Restrictions have actually gotten stricter and have kept buyers on the sidelines. In Shanghai, third home purchases are no longer allowed, and non-Beijing residents cannot easily buy homes in the capital now. There are reports of an annual property tax being implemented throughout the country.
Even if prices drop 20 percent (as they might) that won't cause the panic that hit the US because mortgages won’t be underwater. Loans were not sliced up and packaged to be sold off as CDOs in a massive exercise in leveraging.
During our debate and in subsequent media appearances, Xie surprisingly made the mistake of equating empty units with a bubble. Instead, empty units indicate a misallocation of resources, not a bubble. There are far too many empty units being held by wealthy folks as investments while far too many live in abominable housing conditions.
The lack of affordable housing could cause social instability. Even the 10 million units of affordable units the government has pledged that will hit the market this year are not enough, as incomes for the majority are not rising as fast as the cost of decent homes. As the country urbanizes, the demand for housing will continue to spike.
Moreover, on the commercial side, there have been too many poorly conceived retail centers. Too many developers don't seem to understand the market can only sustain so many luxury complexes housing Louis Vuitton and Gucci boutiques. Expect to see more wasteful commercial projects launched as more developers switch from residential to commercial because of laxer controls in that area. This is an area where the government will need to step in to absorb excess liquidity.
Still, even a steep drop in commercial is not going to seriously threaten China’s overall economy; analysts estimate that commercial accounts for just 20 percent of total real estate construction there. And the government can force state-owned banks to roll over loans rather than answer to quarterly calls and mark to market accounting like Citigroup and Bank of America have to.
In the short term, inflation is a far larger threat to China’s overall economy than the risk of a hard landing in real estate. Prices on food products like eggs and milk have risen 10 percent over the last few months. In response, the government has increased produce stocks, implemented price controls and pushed consumer product companies like Unilever and P&G not to raise prices.
Last week truckers in Shanghai shut down ports for three days as they protested soaring oil prices. Low-income families and retirees have been hoarding out of fear of rising prices.
Price caps are not an effective long-term strategy, however, as we saw during the Soviet era. To stave of inflation, the government needs to move less through administrative means like price controls and more towards currency reform. Although it will be painful in the short term, the yuan needs to appreciate 3-5 percent in a one-off event to offset rising commodity prices.
Doing so might cause some pain ahead, notably for low-end manufacturers, but it must be done for the broader economy. The reality is that inflation is here to stay. This is due mainly to two main reasons: The first is rising labor costs as the government increases the minimum wage to push a shift away from exports to consumption. The second is global investors’ dislike of US Federal Reserve Chief Ben Bernanke’s monetary policies which are causing them to abandon the US dollar for commodities like oil and gold.
China is not immune from a hard landing, but if one comes it won’t be because of a supposed housing bubble, as economists like Xie have argued. Inflation imported from the US is the bigger danger, and China will need to adjust its currency to deal with it.