Another Real Estate Bubble -- In China?

The entire world just got finished watching the kind of havoc a real estate bubble can create as the U.S. economy went down the tubes last year. So you'd think that other countries wouldn't want to repeat the same mistakes. Yet, it appears that China might be doing just that. A dangerous real estate bubble may be forming in the growing economic power. Could its bubble lead to a similar fate?

Bloomberg has an article today detailing some of the madness. Here are a few choice excerpts:

Gloria Gu paid $483,000 for an apartment near Shanghai's financial district so her 3-year-old son could attend one of the city's best kindergartens. Six months later, a similar place in her building sold for $615,000.

Average new apartment prices in Pudong gained 57 percent this year to a record $4,061 per square meter, while overall prices for China's richest city rose 26 percent to a record $2,434, according to Shanghai Uwin, which tracks prices.

New home mortgages in the first nine months of this year totaled about $139.5 billion, quadruple the amount offered a year earlier, the central bank said.

That all sounds vaguely familiar, doesn't it? You could probably change Pudong to Miami or Las Vegas and suddenly be transported back to 2005 in the U.S. But actually, these increases might be even more irrational -- I'm pretty sure that new home mortgages didn't quite quadruple year-over-year in the states.

Now some of this is genuine growth. China is experiencing much more economic expansion than the U.S. But I don't think its nation's growth rate is so high that the kind of real estate appreciation that this article talks about is sustainable.

The government is taking some measures to try to calm things down. It recently reinstated a tax on flipping houses. But according to Bloomberg's sources, the government isn't doing nearly enough:

China's leaders won't make major policy changes because they are preoccupied with economic growth and social stability, overriding concerns that rising property prices are forming a bubble, said Clement Luk, an analyst at Centaline Property Agency Ltd. in Shanghai.

"The government is clearly in a dilemma," Luk said. "It wants to address the surging property prices and concerns on bubble-bursting, yet it dares not take drastic measures for fear of hitting the market too hard."

Does China's bubble have the potential to be as catastrophic as the U.S.'s? Well, China's real estate bubble has different origins than the one in the U.S. Here, government sponsored mortgage companies and securitization helped to fuel a great deal of lending. As home prices increased, banks and finance companies relaxed their underwriting standards. Eventually, bad things happened.

Our resident China expert, James Fallows, explained to me what caused the real estate expansion in China. There, banks were sitting on heaps of deposits. So when its economy slowed, the government urged banks to start lending that cash. Like in the U.S., loan quality has likely declined.

But there is an argument out there that China's real estate boom actually isn't a bubble. The theory purports that increased urban migration has caused real estate prices to rise, and that's rational. Yet, those are some pretty darn large price increases. One expert, Professor Michael Pettis, who writes the "China Financial Markets" blog (which I need to start reading regularly), doesn't put much weight into this theory. He thinks there's a real estate bubble, but he isn't much concerned. In a post earlier this week, he writes:

Last week (sorry, but I lost the article) I read that the head of one of Beijing's and China's largest real estate developers (Vance, I think I remember) publicly warned that we are in the midst of a property bubble, making it the second time in the past month that the CEO of one of China's biggest real estate developers has made the claim. He may be right, and of course the muted warnings by the PBoC that we are in the midst of a stock market bubble may also be correct, but to me the wealth effect of collapses in the two markets are not large enough really to matter. The wealth effect isn't likely to be big enough to affect consumption. Not only are these markets relatively small as a share of Chinese savings, but ownership is heavily concentrated among the relatively richer.

The main way a fall in real estate prices would hurt China, in my opinion, is if it causes a sharp drop in real estate development and, with it, a sharp drop in employment and the business activities of industries that feed the real estate sector. I suspect however that if we were to see a drop in real estate prices, the decline in activity would be much less than expected because banks and the government would continue actively supporting real estate development projects as long as they had the credibility to do so. This is not an economy where price signals always decide business strategy.

That's an interesting perspective. According to Pettis, China's economy isn't nearly as dependent on real estate as the U.S. economy was. A much smaller portion of the nation's population would be affected by a real estate collapse. Price changes would also be more muted, given the government's involvement in its market.

China's financial markets won't take as painful a hit either. That's partly because China has a far less robust securitization market than the U.S. Its banks, consequently, don't contain nearly as much hidden leverage as ours did. So even if loans started failing, there wouldn't be as much uncertainty in the market. Investors could understand loan loss exposures, re-price things accordingly, and move on. As Pettis says, the real fear would be if employment was significantly affected, but he doesn't anticipate that would happen.

So might China be in a real estate bubble? Yes. If they are, should they worry about ending up like the U.S. did in 2008? Probably not. Clearly, whenever a bubble pops it causes harm to an economy. But few bubbles have the sort of destructive force as the housing bubble did in the U.S. It doesn't appear that a similar perfect storm would occur when China's housing bubble bursts.