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Is China in a housing bubble?

pc_006_small3.jpgPatrick Chovanec is an associate professor at Tsinghua University’s School of Economics and Management in Beijing, China. Prior to that, he worked for several private equity funds focused on China, and continues to serve as a fund adviser. He's also got a blog. An edited transcript of our conversation about China's economy follows. This is part one of a two-part interview.

EK: When I was in China last week, there seemed to be widespread fears of a real-estate bubble. There was clearly an enormous amount of construction going on, but plenty of unlit office buildings and empty malls. What's your take?

PC: Until November or December of last year, when high housing prices started to be a focus of popular anger, the Chinese government was really touting construction and real estate as key drivers of the economy. That made sense: Construction employs a lot of labor, and particularly unskilled labor. But in the process, a situation took hold where you have people building projects and prices are going higher but you've also got slumping rents and high vacancy. You have entire office buildings and malls and luxury residences with no lights on. They're completely unoccupied.

There are different dynamics in the commercial sector and the residential sector. The commercial sector is a classic leveraged bubble: Loans went out through state-owned banks, many of them to state-owned enterprises, and people built these projects. A lot of those loans are probably not good. The collateral beneath them is probably not good. And it's not just Beijing and Shanghai. In some ways, places like b Beijing and Shanghai can absorb it more because they'll have future growth. But the smaller cities are much more vulnerable to bubbles.

Residential real estate is a more complex story. You have the continuation of a trend that's been around for a while. People are paying mostly cash to buy multiple residential units, mainly high-end, that they leave empty as a form of savings. It's not a productive asset. It's a place to stash your cash. They do that because, first, most Chinese citizens don't have many investment options. They can put money in a bank, or government bonds, or the stock market, but the stock market is perceived as risky.

EK: How could China have a housing bubble so soon after the United States did? Aren't there lessons learned from our experience?

PC: Real estate is a relatively new market. China only came to private home ownership in the 1990s. So the market has never seen a sustained downturn. Very often when you have a bubble, it's because there's a new asset class, like Internet stocks or mortgage-backed securities, where people overestimate the upside and have no experience with the downside. And then the other factor is there's no property holding tax in China. So it's just treated like gold.

But as long as this persists, this demand for housing as a pure investment vehicle competes with housing as a human need. It bids up the price for housing for people who actually want to live in it. You have empty complexes while people can't afford a place to live. It also skews the development market: Do you want to build affordable housing for people to live in or luxury condos for people to buy and hold? So there's a mismatch between what people need and what's coming onto the market.

EK: Is there a case for optimism on China's real-estate market?

PC: When people who're bullish about the property market in China, they point to rising incomes and rising urbanization. And both are correct. But what's actually being demanded is incrementally better housing. You come from the countryside and you want indoor plumbing, or you come from a walk-up and you want a place with an elevator. That doesn't mean you want a luxury condo or a villa.

And we've mainly talked about the problems that occur while the boom persists. When it ends, there are different problems. Real estate isn't gold. If you had to take all those empty units that are being held off the market and not priced and you had to put occupants in them, the market clearing price will be way below what it is today.

EK: Does this interact with the banking sector in the way it did in America? For one thing, it's less leveraged, right?

PC: The banks are very exposed in the commercial sector. People holding commercial property are generally leveraged up. The situation is different in the residential sector. Go back four years and almost every residential purchase was in cash. Last year, it was more half and half. And now I've heard we've neared to two-thirds mortgage.

But even if the mortgage market is small, a lot of the country's loans are made on the basis of collateral. They don't loan based on earnings projections like they do in the U.S. They're trying to move in that direction, but much like Japan and like developing countries, they lend on collateral. And the prize asset they look for is land. When a factory wants a loan, they go to a bank and the bank asks for collateral and they say we own the land underneath the factory and they just built luxury condos down the street and that's what our land is worth. So if the bubble bursts and you need to take these empty units and get people to live in them, all those loans will be called into question. The government says that property prices could drop by 30 percent without causing a spike in non-performing loans. I don't know whether that's accurate or not. But it tells me that they know there's a lot of property exposure, and that's why they're running these stress tests.

EK: A lot of the big Chinese banks have private investors. Some of them are listed on public exchanges. So why are these interests standing by while the banks to make these loans? Is the theory that Chinese banks are simply too big to fail?

PC: Yes, if you look up "too big to fail" in the dictionary, there'll be a picture of a Chinese bank. These are state-owned banks and everyone assumes they cant go under because the government will have to bail them out. And I think that's accurate. But that doesn't mean there's no risk.

When these banks listed on the stock exchange, the idea was they were reforming themselves to become commercial enterprise that made good loans and made money off of those loans. And they were making great strides in those directions. And then the banks, last year, were turned into the main conduit for stimulus spending. They essentially became a slush fund for propping the economy up. And that did huge damage to the corporate culture they were trying to establish. I think that Chinese officials, if they could go back, would do this differently. Maybe set up a special policy bank that was insulated from the commercial banking sector they'd been trying to reform. But this had a cost.

And then there's another downside, which is dilution. All these banks are all going out looking for capital to recapitalize their balance sheets. The regulators say this is just precautionary. But the point here is that the institution gets more money and the existing shareholders end up owning less of the bank. So the shareholders may not get bailed out.

So we may be seeing something similar, but not precisely like, a replay of America's experience.

We always expect this bubble to look like the last bubble. And in China, there's no securitization, no flipping, none of that. So some say there's no bubble. But that's why bubbles keep happening. They don't look like the last bubble, and that's why we don't see them happening.

By Ezra Klein  |  June 9, 2010; 10:42 AM ET
Categories:  China , Interviews  
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