What bubble?

I have been surprised and amused at the rapidity with which some analysts have switched from worrying about a China collapse to fearing a China bubble. This switch is, however, consistent with the speed of many upgrades to GDP forecasts. Our forecast of about 8% GDP growth in 2009, made last fall, was for a long time over consensus by 30-45%. Now, this forecast is slightly below consensus.

The over-exuberant increases in GDP forecasts are driven by the same approach – expecting straight-line progression of the latest economic or policy trend, either up or down – that has led to many of the bubble calls. A tendency toward overexcitement about China’s prospects, in either direction, is not new, but there is an additional problem this time: the lack of clear understanding of what constitutes a bubble. I think many observers today are confusing the early stages of a major asset price inflation cycle with a bubble.

So what can we say about the current state of China’s two key asset classes, residential real estate and equities? Prices have clearly been rising, but is this a bubble or just asset price inflation which is justified largely by underlying fundamentals?

By one simple measure, China’s residential property market certainly looks like a bubble, rising rapidly largely due to irrational expectations. We have compiled a weighted index of average daily property sales in 14 cities, based on official data. In August, this index rose at the alarming rate of 152% year-on-year before slowing to "only" 104% in early September.

However, the high year-on-year rate is largely the result of two factors: a very low base and the sudden release of pent-up demand for housing. In late 2007, concerned about rapid rises in home prices, Beijing made it more difficult to buy an apartment, effectively killing the property market. Transaction volumes evaporated, and prices soon began to fall. The market remained very weak until late 2008, when the government reversed course.

With sales volumes rising at over 100% year-on-year in four of the last five months, we would be worried about a bubble if this pace looked likely to continue. But, fortunately, it doesn’t. Our index of sales fell 11% month-on-month in August, and sales declined in 11 of the 14 cities we track.  In the first nine days of September, the index rose 2% month-on-month.

I am not, however, arguing that China’s property market is weak. To the contrary, it is growing at a healthy, sustainable pace, driven by fundamental demand. Around 70% of urban families are homeowners, among the highest shares globally – and three-quarters of them are still living in the small, poorly-built and poorly-maintained flats they received at a nominal cost from the government a decade ago. Consequently they are highly motivated to upgrade to a larger, commercially built apartment. In my view, we are in the early stages of a long-running, moderately-paced inflation cycle in residential real estate prices in China.

The major concern is that supply is becoming tighter, which will contribute to the speed of price increases, although with demand recovering and banks now encouraged to lend to developers, new housing starts have picked back up as well. Fixed-asset investment in real estate is likely to remain strong in the latter part of this year and in 2010, and we should see this translated into a reasonable supply-demand balance by mid-2010.

It’s possible that the government will grow nervous at the acceleration of property prices in some cities. Beijing may then tweak the micro tools at its disposal to rein in the market – it controls the banking system and therefore mortgages – but it probably won’t take steps designed to slow overall economic growth. Property is an important source of jobs (construction) and a key driver of consumption, as new home-owners also buy furniture, appliances and cars.

Finally, if there is a sharp price correction, the Chinese economy and banking system should be relatively well-equipped to deal with it, thanks to the very low degree of leverage in the market.

While it is estimated that one-quarter of US homeowners are "under water" on their mortgages, only about one-quarter of middle-class homeowners in China are paying off a mortgage at all. As for the wealthy who speculate in property, anecdotal observations indicate that high levels of cash are involved, and the minimum down-payment for these mortgages is 40%. There are no zero-down, no-document or pay-option mortgages in China.

The Shanghai Composite Index (SCI) climbed quickly in the first seven months of the year, rising 91% to 3,471 points on August 4. But that journey seems insignificant compared with the rise of 382% between the end of 2005 and the October 2007 peak of 6,092.

Although the market is down 53% from its last peak and endured a difficult August, the SCI was still up 57% for the year through September 4, outperforming most other markets. Is this evidence of a brewing bubble, or was the Shanghai market riding both optimism and fundamentals?

One source of concern has been that a significant share of the huge increase in first-half bank lending leaked into the stock market. It is impossible to provide a precise answer to this question, but my view is that while some of the new lending certainly made its way to the market, this was not a primary market driver.

One researcher at a government-affiliated think tank estimates that as much as 20% of first-half lending – or US$216 billion – entered the equity market. This figure seems much too high. According to market officials, there was a net inflow of about US$73 billion into A-shares over the period, which would be equal to 7% of new lending.

It is possible that a portion of this money came from corporate accounts that had been fattened up by new lending, but more than 80% of the inflows came from individuals. The growth rate of household bank deposits slowed to 24% year-on-year in August from 34% in January. Some money went into the equity market, and some into real estate.

So although the huge increase in lending and liquidity certainly contributed to that period’s stock market rally, I believe most of the impact was indirect. Loan growth helped boost economic growth, which stabilized employment and raised consumer confidence, and raised expectations for corporate profits.

The government is likely to ease off on lending for the rest of this year and in 2010. This will take some of the steam out of the stock market, but it will not be anywhere close to a fatal blow. In fact, the market will cool off to a healthier, more sustainable pace for the long run – assuming that economic fundamentals and corporate profits continue to hold up next year.

It’s important to note that China’s stock market remains a relatively small part of the mainland economic picture. The tradable market cap is equal to only about 32% of GDP (versus 87% in the US) and market officials estimate that there were no more than 30 million active retail investors at the peak of the rally in 2007 – 2% of the total population, or 7% of the urban adult population. Participation is broader if we include the 99 million mutual fund accounts, but the participation rate is still much lower than in the US, where almost half of all families are in the market.

Even if an equity bubble develops and then bursts next year, the macroeconomic and social impact would not be dramatic.