The Chinese Bubble's Slow Leak

Western observers anxious for some schadenfreude will be disappointed. China's housing boom won't bust.

The Chinese phrase for real-estate bubble is Fáng dìchǎn pàomò. For my students in Beijing, it’s not a concept I need to spend much time explaining. As any Chinese citizen could tell you, property values have been exploding throughout the country for more than a decade. Central areas in first-tier cities like Beijing, Shanghai and Guangzhou now rival their Western counterparts in both opulence and expense.

But while an ever-growing housing bubble in Communist China may be cause for glee among Western observers anxious for some cathartic schadenfreude, anyone betting on a Western-style housing collapse-cum-recession will be sorely disappointed. Yes, stratospheric real-estate values are already starting to come back to earth, but the nature of the Chinese bubble and numerous other factors will preclude anything but a soft landing.

Warning Signs

For most of the 2000s, the global economy hummed along on the current of U.S. spending and Chinese saving. This cycle, combined with rising home prices, concealed ominously increasing levels of private debt being amassed throughout the United States.

In 2006, at the height of the bubble, the U.S. savings rate pushed the outer limits of leverage and fell into negative territory. America’s pervasive culture of consumerism, debt and spending was the principal catalyst for all that followed—the first domino. Had Americans had more savings and more home equity during the downturn, more loans could have been serviced and fewer homes foreclosed. Fewer foreclosures would have preserved the integrity of the collateralized mortgage obligations, essentially large pools of home loans, which would have further stemmed the avalanche of credit-default swap payments to investors betting against mortgage holders.

The situation in China over the last decade has been almost comically reversed. Throughout the 2000s, the Chinese savings rate increased, topping out at 38 percent in 2010, one of the highest in the world. Those subprime NINJA (No Income, No Job, No Assets) loans that were all too common in the United States during the boom years would be unthinkable in China, where buyers are required to pay as much as 50 percent of the asking price up front. When the chickens come home to roost, the blow will not be mortal because the Chinese will be equipped with enough personal equity to weather the downturn, and the banks will not be overextended.

In 2003, Warren Buffett declared the increasingly ascendant derivatives market to be the work of “madmen” and “financial weapons of mass destruction.” And in the end, the Oracle of Omaha was right. Overleveraged CMO’s and the wildly unregulated credit-default swaps turned out to be particularly devastating. Billionaire investors like John Paulson may have made a killing betting against them, but for the vast majority, they spelled disaster.

The Chinese Advantage

At the time of the U.S. economic crisis, credit derivatives were illegal in China. Today, the People’s Republic has begun to take steps towards developing a highly controlled credit-derivatives market. With America’s spectacular bust as a guide, the Chinese have banned – among other things—naked credit-default swaps in which the buyer does not own the underlying asset. These transactions, analogous to buying fire insurance on your neighbor’s house, made up as much as 80 percent of the precrisis CDS market and were directly responsible for the collapse of AIG and its subsequent bailout. As of this writing, naked credit-default swaps remain legal in the United States.

Public debt also stands to dramatically differentiate the bubbles. In February 2012, United States Public Debt was over $15 trillion. By contrast, China, Washington’s largest foreign creditor, holds approximately $1.5 trillion, mostly in the form of United States Treasury bills. This is part of a larger overall foreign-exchange reserve with an estimated value of over $3 trillion.

While many of the details are state secrets, it is clear from the circumstantial evidence that China is capable of spending its way out of any slump. In 2008, without batting an eye, China embarked on a nearly $600 billion stimulus plan. While the U.S. stimulus was attenuated by special interests and political jockeying, the Chinese faced no similar difficulties. The U.S. stimulus was blunted because it was too small and its recipients too often used the money to pay down outstanding debt, but the Chinese could compel their state companies to spend and maintain overall system liquidity. As 2012 increasingly points to signs of a housing plateau, a further Chinese stimulus is almost certainly inevitable and will prevent the free fall that the United States saw in 2008.

Consider the root causes. The American bubble was propelled primarily by private development, whereas the Chinese bubble has been driven primarily by public development. A considerable amount of China’s GDP is the result of state construction. Party secretaries and provincial governors are given essentially arbitrary GDP targets for their jurisdictions, and large construction projects are an easy way to artificially boost output.