How to Spot a Bubble in China

Back in December, I wrote about what appeared to be a growing asset bubble in China, particularly affecting real estate prices. The New York Times has an article today to keep the debate going about whether the developing economy is overheating, or just experiencing incredible growth. After all, it's not a bubble if the increasing values are justified. This speaks to a broader question: how does one spot an asset bubbles to begin with?

I've written about the difficulty bubbles pose before. They may be completely unavoidable. Even if you can manage to spot one, it's pretty hard to prevent their inevitable inflation. In the case of China, government authorities have begun taking measures to try to slow down asset appreciation. But such action is only warranted if you can be reasonably sure that there is a bubble. How do you know?

There are a few ways of doing this. I think the best way is to try to determine the cause for the asset's appreciation. Let's use the U.S.'s recent real estate bubble as an example, since it's so fresh in our minds. What caused housing prices to increase?

Actually, let's back up a little. What are some things that could cause housing prices to increase? One might be a prevailing change in investing philosophy. If some economic shock caused people to abandon the stock market and shift their savings from equity to real estate, then that would cause stock prices to decline, but real estate prices to go up. If that change is permanent, then it would be a legitimate increase, since it's based on cash reallocation. This wasn't the case in the U.S. Although some investors turned increasingly to real estate during the bubble, other asset markets soared as well.

Another potential cause would be legitimate economic growth. For example, if a nation's economy is soaring, then its people will be able to buy more stuff. When demand increases, price follows. In fact, residential real estate's dependence on consumer demand separates it from most other assets. Gold, for example, is not as directly dependent on the health of the average American's wallet.

Going back to the U.S. housing bubble, it's pretty clear that personal income growth couldn't justify the new housing prices. Using data from the Bureau of Economic Analysis, I calculated that from 2001 through 2006 (the peak of the bubble), personal incomes increased by 30%. That's not bad, but it's also no where near the rise we saw in home prices, which increased by 77% over the same period, according to the S&P Case-Shiller Composite-20 Index. If, over that time period, housing prices had increased by around 30%, then that appreciation might have been more justifiable through income growth. That's not what happened.

If people weren't making more money, how were they buying more expensive homes? Credit also lends itself to creating housing bubbles. For example, if home purchases required 100% cash, then inflating a widespread housing bubble would have been a lot more difficult. People just wouldn't have been able to afford to buy more houses beyond their means, even if they wanted to. As a result, more relaxed lending standards are another warning sign that a bubble might be forming.

Moving back to the China question, it's pretty hard to tell for sure if it's in the midst of a dangerous real estate bubble. But if its asset prices are increasing far more than its personal incomes and lending standards have been significantly relaxed, then it could in for some trouble. Of course, the struggle with macroeconomics is that there are so many variables to consider, so just taking a few into account is an overly simplistic approach, but it's a start. Other characteristics of its economy would also need to be taken into consideration to get a more robust aggregate view.