November 17, 2021
Co-Founder and Head of Risk
As a risk manager, I am used to pointing out risks and scenarios that end up not being realized. I know how it feels to see risks and vulnerabilities remain unresolved -- for years. At this point, however, with China we might see the tipping over the edge, and a yawning gap on the way down.
Here is a chart of property prices in various versus household income. The chart is no secret, and its importance as a metric is likewise well known.
There is no surprise that valuations are not sustainable for Chinese real estate. It is not like we have no experience to lean on. The U.S. ratio of median home price to income was redlining before 2008. On a scale of 1 to 10, Japan was at 11 before their real estate bubble burst, and decades of equity growth were lost thereafter.
The risk for China begins with juggling unsustainable growth, high savings, and driving investment that is sufficient to feed that growth and use the savings. But because of the high savings, do this absent the demand for the output. It ends with pushing housing to absurd levels, which is creating a housing bubble. I hesitate to use that term, because to say “bubble” suggests a prognosis of a bursting, and I am focused on the risk of things happening, not on predictions of their realization.
This chart puts the real estate stresses stark terms.
It shows the share of GDP coming from real estate investments less the cost of land. Since 1997, China has moved from under 10% to nearly 30%. All the other countries in the chart are stable, in the 15% to 20% range from 1997 to now. And there are any number of charts that tell the same story. You probably don’t even need a chart; even if you have not seen it in living color, you’ve likely been aware of the housing build up.
What is doubly concerning is putting the implications of these two charts together; to have a huge build up of real estate but still have prices out in the tail.
Contagion in China. The bane of market risk isn’t a cascade in one market, it’s a spread to others. That’s happening in China, multiplying risk to its financial system.
To give a sense of how bad can get worse, as this chart shows, high yield rates are soaring. From under 10% to nearly 30%, accelerating over the past weeks. This is the start of contagion from real estate developers, Evergrande in particular.
To other developers. Sinic and Fantansia have missed payments, Kaisa is at risk of following suit.
And to the financial markets through high yield. Of course, the developers are largely shut out of the market, but the rise in borrowing rates propagates to other financial system areas. Funding is the financial market’s life blood, and China’s could shortly be in the throes of a stroke.
And from there to the broader economy, most immediately because companies won’t be able to borrow to fund their inventory. This somewhat obscure part of financing is the first effect for most businesses, It shows the banking crisis in 2008 first hit the real economy.
What about spreading to the broader global system? There are offshore, dollar-denominated bonds, but not enough to propel the crisis beyond China’s borders in the grand scheme of things. China has deliberately stayed aloof from other markets, which now looks like a good thing.
So what is the big worry for us? Well, when a country has internal trouble, they often do a head fake toward trouble coming from abroad. Check out 2034: A Novel of the Next War to see how that might turn out. Maybe before 2034.
Source for graphic 1: Numbeo via New York Times; graphic 2: Figure 24 in Peak China Housing, NBER Working Paper by Rogoff and Yang, Source for graphic 3: Ice Data via Financial Times.