China’s riskiest property market just collapsed. Is this how it starts?

February 25, 2013

A lot of these apartments, in Phoenix Island, Hainan province, are probably empty. (Wang Zhao/AFP/Getty Images)

The real estate market in Phoenix Island, a development project in the Chinese island province of Hainan, was so inflated, so outrageously expensive and unsustainable, that it became known as the Dubai of China. With its palm tree-lined streets, glimmering high-rises and ostentatious sports cars, it even looked a little like Dubai. And now, also like Dubai but maybe more in the vein of south Florida, the Phoenix Island real estate market that drove so much local economic growth has imploded.

Phoenix Island is an extreme case, but it's in many ways symptomatic of China's skyrocketing real estate market, which is both a blessing and a curse for China. A blessing because it helps to drive economic growth and domestic consumption, which the country's economy needs more of to be healthy. It's a curse because, as Americans are well aware, it can burst, pulling down much of the national economy with it.

If the national real estate market collapses in China, it would be disastrous not just for China but for the entire world economy, risking a third wave of the global crisis that began with the U.S. financial collapse and worsened with the Euro crisis. Is Phoenix Island an outlier, a crazy market so extreme that it tells us little about China? Is it the start of a major but recoverable setback? Or, in the worst-case scenario, is it the beginning of the end for China's astounding 20 years of miraculous economic growth?

In some ways (but not all), China is even more exposed to the dangers of a real estate collapse than America was. Washington Post business reporter Jia Lynn Yang pointed out last fall that urban housing stock constituted 41 percent of Chinese household wealth of 2011. The number was 26 percent in the U.S. In other words, Chinese families tend to invest almost twice as much of their money in urban real estate than do American families. So, if you thought Americans were hit hard when that real estate suddenly lost value, it could be even worse for Chinese, who also tend to put much more of their earnings into long-term investments than do Americans. That said, it would also take a bigger drop in prices for the market to collapse, as Chinese buyers tend to put down larger down payments.

And here's the really scary number: 13 percent of Chinese GDP in 2011 came from real estate investment. 13 percent! If that investment stalls abruptly, as it did in Phoenix Island, the rest of the Chinese economy could follow. That could cause political instability in China and, much more certainly, would set back the global economy.

The problem is that the Chinese tend to put their money in real estate because they perceive it as a safe and reliable investment. This drives up prices, which leads more Chinese to invest, which drives up prices more. But because people are treating housing as an investment, the market is artificially inflated. People buy apartments but don't live in them. One day, it's possible that Chinese consumers will wake up and decide that those investment apartments aren't such safe investments after all, or maybe they'll just need to free up the cash they used to buy them, at which point they'll want to start selling. That will lead prices to drop, perhaps catastrophically. If you're a standard Chinese family with 41 percent of your money tied up in real estate and that real estate loses more than half of its value, as it did in Phoenix City, then it's like a whole bunch of your money just disappeared.

I asked Patrick Chovanec, whose economics teaching at China's prestigious Tsinghua University has made him a respected and much-cited source on China's economy, how we would know if the Chinese real estate bubble was bursting. In other words, when do we start panicking?

"As long as the money supply keeps expanding aggressively (15%+ per year), and people (absent alternatives) are willing to plow that money into real estate and hold it, this [real estate market] can persist for some time," Chovanec explains in an e-mail. "But when the flow of new money slows — either because of the need to rein in inflation, including housing inflation, or the need to roll over and refinance bad debt (often at rising rates of interest) — the whole thing begins to unravel."

Is Phoenix Island, in Florida-like Hainan province, the beginning of the end? Chovanec writes, "Some of the quotes (besides mine) in the article suggest this could be happening in Hainan — we'll have to wait and find out if that is what's happening, and whether it signifies a broader deleveraging that would have implications beyond Hainan."

How, I asked Chovanec, would the market actually collapse, if it does? It turns out that, because China's economy is so "opaque" – much of the action happens informally, which makes it really hard to watch for indicators – the market basically collapses when Chinese consumers believe it is collapsing. Here's Chovanec, with my emphasis added:

It's very very hard to tell. First of all, because so much financing has gone outside the banking system, the standard measures of money supply (M1, M2) don't tell us very much any more about the amount of "money" (i.e., credit) in the Chinese economy. Most of the credit expansion we're seeing is off balance sheet. In fact, a lot of credit growth that we're seeing is inter-company or buyer credit -- companies pretending they have sales when in fact they may or may not ever get paid.

Second, it's hard to tell how much of that credit expansion is being "eaten up" by the need to roll over bad debt at interest, rather than financing new investment. That's where the real crunch comes, and why we're seeing, consistently, the returns (in terms of GDP growth) to credit expansion decline. In other words, it takes more and more credit expansion to deliver less and less economic growth -- less bang for the buck.

So it's an opaque process that depends, in large part, on the willingness of everyone to believe that they will, somehow, get paid in the end. If that ever comes into doubt, credit suddenly disappears and everyone rushes to cash out, and there isn't enough cash to meet all claims. I don't know if and when that will happen, but even if it never happens, the dependence on credit expansion to roll over more and more bad debt inevitably puts a squeeze on growth.

As long as Chinese consumers wake up every morning feeling basically okay about having 41 percent of their money invested in real estate, we're probably okay. But if they start to change their minds, whether for political or economic reasons or out of sheer panic, the Chinese economy is not ready to cash them out. It would be like a run on the bank, except that the bank is an overinflated real estate market that's worth 13 percent of the 2011 GDP of the world's second-largest economy.

A real estate collapse in little Phoenix Island or in less-little Hainan is probably not the starter pistol for that bank run, unless Chinese consumers decide it is, in which case it is.

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Max Fisher · February 25, 2013