Is China a Bubble? Two Opposing Views

by: Alpha Author

Interesting cover story this week from The Economist about the Chinese economy (see China’s Economy: Not Just Another Fake). In that article, The Economist questions whether asset prices in China are becoming unsustainable, and if China resembles Japan circa the 1980’s. To be a bit of a spoiler (if you have no interest in reading on), their take-away is NO.

Just as in the late 1980s, when Japan’s economy was tipped to overtake America’s, China’s strong rebound has led many to proclaim that it will become number one sooner than expected. In contrast, a recent flurry of bearish reports warn that China’s economy could soon implode. James Chanos, a hedge-fund investor (and one of the first analysts to spot that Enron’s profits were pure fiction), says that China is “Dubai times 1,000, or worse”...

Scary stuff. However, a close inspection of pessimists’ three main concerns—overvalued asset prices, overinvestment and excessive bank lending—suggests that China’s economy is more robust than they think.

Start with asset markets. Chinese share prices are nowhere near as giddy as Japan’s were in the late 1980s. In 1989 Tokyo’s stockmarket had a price-earnings ratio of almost 70; today’s figure for Shanghai A shares is 28, well below its long-run average of 37.

China’s property market is certainly hot. Prices of new apartments in Beijing and Shanghai leapt by 50-60% during 2009.

Average home prices nationally, however, cannot yet be called a bubble. On January 14th the National Development and Reform Commission reported that average prices in 70 cities had climbed by 8% in the year to December, the fastest pace for 18 months; other measures suggest a bigger rise. But this followed a fall in prices in 2008. By most measures average prices have fallen relative to incomes in the past decade (see chart 1).

The most cited evidence of a bubble—and hence of impending collapse—is the ratio of average home prices to average annual household incomes. This is almost ten in China; in most developed economies it is only four or five. However, Tao Wang, an economist at UBS, argues that this rich-world yardstick is misleading.

Furthermore... One-quarter of Chinese buyers pay cash…China’s property boom is being financed mainly by saving, not bank lending.

Although I agree that there are some important differences between China today and Japan in the 1980’s (see my recent interview in the Effective Executive), I remain skeptical about whether China’s recovery is legit and that it is, in fact, not experiencing another bubble. For the flip side of the argument I point interested readers to the work of Andy Xie (see China has become a Giant Ponzi Scheme or Trapped Inside a Property Bubble):

Many would argue that China isn’t experiencing a bubble. The high asset prices just reflect China’s high growth potential…

I want to make myself perfectly clear on China’s asset markets today. They are a big bubble. Its bursting will bring very bad consequences for the country.

The most basic approach in studying bubbles is to look at valuation. For property the most important measures are price to income ratio and rental yield. China’s average price per square meter nationwide is quite close to the average in the US. The US’s per capita income is seven times China’s urban per capita income. The nationwide average price is about three months of salary per square meter, probably the highest in the world. As far as I can tell, a lot of properties can’t be rented out at all.

The stock market is in a final frenzy again. The most ignorant retail investors are being sucked in by the rising momentum. They again dream of getting rich overnight. As in the past, retail investors usually lose, especially like the ones jumping in now. The final frenzy usually doesn’t last.

from Trapped Inside a Property Bubble:

The biggest risk to China’s economy is the desire to maintain past economic growth rates by maximizing investments in property — an unproductive asset. It supports short-term growth by sacrificing long-term growth as capital’s average productivity declines over time.

Bubbles exaggerate reality but are not formed out of thin air. Cheap money and strong growth are the usual ingredients for bubble-making. Both existed over the past five years. But now, China depends entirely on cheap money to support overvalued assets. Cheap money came from past exports and was warehoused in banks. Cash also came from hot money inflows due to the yuan’s peg to the dollar and weak Fed dollar policy.

Neither money source is sustainable.

So there you have it – two opposing views on China. Funny thing. These arguments sound vaguely familiar to me. They seem to parallel the ongoing debate as to whether the U.S. is experiencing a sustained recovery or whether its asset prices are similarly over-inflated. Nevertheless, when it comes to China, I think that asset prices are currently overheated and will likely experience a near-term correction. But there is no question in my mind that China is on a long-term growth path toward prosperity, …provided it can avoid political calamity.

Disclosure: No positions