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Monday, June 28, 2010

My thoughts on the Chinese real estate logorrhoea

Today I am going to try and burst the most subtle and insidious bubble of them all: the enormous growth in doomsday logorrhoea.

Frankly put, we face a bubble about bubbles. As I have noted before, it is a recipe for instant fame. Purport to identify a bubble—even if you have to use false facts—and you will be immediately thrust into lights. Afterwards, comparatively hum-drum folks like the RBA and yours truly are left to dismantle the voodoo.

Jeremy Grantham, who runs a leading investment firm, was recently in Australia and captured countless headlines by informing us that Australian house prices were “7.5 times family income” and would have to deflate by 42 per cent to return to their long-term trend. The problem is that Grantham was spinning pure fiction. The best estimate of Australia’s dwelling price-to-income ratio suggests that the correct ratio is, in fact, 4.6 times. The Deputy Governor of the RBA demolished Grantham’s rhetoric when he commented, “People feel that house prices in Australia are quite high…But, if you look across the whole country, the ratio of house prices to income is not that different from most other countries.”

Many respected authorities allege that the biggest bubble that threatens global economic prosperity is located in the Chinese housing market. This is important for Australians to understand. China is Australia’s number one trading partner, accounting for 21.6 per cent of our exports and 17.8 per cent of our imports. Our major banks, such as ANZ and CBA, are looking to expand into the region. And the central bank has made analysis of the Chinese economy a first-order priority

Now I did not intend to write about China’s housing market. I had observed the headlines with bemusement, and frankly had the intuitive reaction that one would expect to see large price adjustments in the cost of housing given China is experiencing the greatest mass urbanisation in human history.

As it turned out, I recently had a drink with an economist that I hold in high regard. She had travelled to China for the explicit purpose of understanding their housing market. And while our conversation was not conclusive, it lent much weight to my priors.

In tackling this subject, I have been greatly assisted by economists from UBS and Macquarie, who kindly made a lot of their data available to me. And if you want to read an excellent primer on Chinese property, I would recommend to you a May report by UBS’s Tao Wang and Harrison Hu.

Let’s start with a simple yet fairly fundamental question: has China’s house price growth been unusually strong? China’s national bureau of statistics (NBS) publishes a monthly price index for both ‘newly constructed’ and ‘established’ residential homes in 70 medium and large cities. While the ‘newly constructed’ home index recorded 14.2 per cent growth in the year to March 2010, the ‘established’ home index rose by only 9.5 per cent.

Contrary to popular myth, the rise in housing costs across these 70 cities have not been noticeably different to the house price gains registered in Australia (13.1 per cent), the UK (10.7 per cent) and Canada (11.6 per cent) over the same period (see first chart below). Of course, since each of these countries has experienced radically varying economic trajectories over the last year or so, one would expect significant differences in their housing outcomes.

What about over the longer term? Say the last 10 years, which helpfully encompasses the period in which house prices ramped-up most quickly prior to the GFC. The next two charts show the change in monthly year-on-year house price growth rates across the countries surveyed above.

We can take a few things from this analysis. First, Chinese house price growth underperformed most other nations prior to the GFC. Second, the GFC induced an unusually ‘synchronous’ downturn and subsequent recovery in house price changes across the globe. And finally, the amplitude and timing of the housing correction and rebound in Australia, Canada and China was, for understandable reasons, closely correlated. Australia and Canada are commodity economies with strong trading ties to China. All three countries benefited from banking systems that skated through the crisis mostly unscathed, which meant that they were not subject to the extreme credit rationing that we saw in the US and UK.

One distinguishing feature of the Australian housing market in the charts above, which both the RBA and we have drawn attention to, is the marked deceleration in house price growth following the last boom in 2003. In this respect, Australia’s housing downturn led most other countries.

The insights above are further confirmed by taking the simple average of the year-on-year growth rates over the last 10 years. Average annualised house price growth in China since January 2000 has been 5.9 per cent, which is less than the growth experienced in Australia (9 per cent), NZ (8.3 per cent), the UK (8.2 per cent), and Canada (6.8 per cent).

Unfortunately, China’s ‘established’ (as opposed to ‘newly built’) home price index only provides year-on-year growth rates beginning in July 2005. Given China’s relative outperformance during the GFC, starting any analysis at this date arguably introduces an upward bias. Acknowledging this, we compare the performance of each country’s housing market over the period July 2005 to March 2010 in the next chart. What is remarkable is the striking convergence in housing market outcomes across Australia, Canada, New Zealand and China’s two 70 city indices. Once again, there is no evidence of a booming bubble.

With 1.33 billion residents, China is the world’s most populace country (just shaving India at 1.14 billion). Aggregating across 70 cities conceals a lot of cross-sectional diversity. This is no different to the 30 per cent growth rates Perth generated during the mid 2000s while Sydney house prices fell. In a similar fashion, high growth metropolises like Beijing, which with 22 million people is the same size as Australia, have experienced much more rapid house price appreciation than the national aggregates.

Centaline, a leading Chinese real estate agency, measures established house price changes in major cities. And this is presumably the source of the bubble trouble. House prices in the 'tier-1 cities'--Beijing, Shanghai, Guangzhou, Shenzhen and Tianjin--fell significantly during the GFC. Yet once the worst of the GFC passed, they retraced and then surpassed their previous peaks (see next chart below). In the year to March 2010, established home prices in Beijing and Shanghai have risen by 35 per cent and 38 per cent, respectively. But with just (!) 41 million people, these two cities account for merely 3.1 per cent of China’s total population. In numerical terms, that is like comparing house price movements in the Gold Coast with the overall Australian market. On a value-weighted basis, it is more akin to a small city. A suitable Australian comparison is probably Darwin, which is depicted by the blue line in the chart below.

The most sobering characteristics of China’s real estate market are found in its ‘institutional’ features and relative debt ratios. This is where the doomsayers' claims really unravel.

In China today first time buyers require an extraordinary 30 per cent deposit, which has been boosted by the central government from 20 per cent. Downpayments of that size have a huge impact on purchasing power and are about six times more than first timers need in most developed countries. Buyers of a second home are required to have an even larger 50 per cent deposit (it was 40 per cent). And in major cities like Beijing, Qingdao and Shenzhen, where housing supply is particularly tight, the government bans buyers of third time homes having any mortgage debt at all while prohibiting lending to foreigners. In fact, Beijing residents are being currently restricted to one additional home per family.

What about those debt ratios that are cause for so much concern around the world? According to UBS, Chinese household debt as a share of disposable income is just 57 per cent. Mortgage debt to disposable income is even lower at 33.5 per cent. Compare this to the US where the equivalent ratios are 124 per cent and 94 per cent. (Australia’s household debt to income ratio is over 150 per cent or nearly three times higher than China’s.) Total Chinese household debt as a share of GDP is just 24.4 per cent. In contrast, US and Korean household debt to GDP shares are multiples of this at 95 and 86 per cent, respectively.

This is not to say that leverage in China has not risen quickly. It has, but off a very low, non-industrialised base. The following three charts show the time-path of China’s household and mortgage debt-to-household income ratios, and the household debt-to-GDP ratio, compared with the US and Korea since 1990. Long story short: there is nothing here to worry about.

According to UBS, household income in China has also consistently outpaced residential property prices. They deflate the change in two measures of housing costs—the price of newly built homes and implied housing prices based on the sales value and floor size of homes—by official measures of urban income. As you can see from the following diagram, the overall cost of Chinese housing has actually declined since 1999 when deflated by disposable household income.

As in Australia, house price-to-income ratios are the doomsayers’ weapon of choice. In China, the crude house price-to-income ratio is a very high nine times. But as UBS point out, the people buying new homes in China are not earning the official ‘average’ incomes, which are underreported anyway because of non-disclosed ‘grey’ earnings. UBS argue that home buyers tend to be in the top 20-30 per cent of the urban income distribution. If one takes the official view that the top 20 per cent of income earners generate 2.2 times average income (the top 40 per cent earn 1.7 times), which UBS believes is an ‘underestimate’, we get a ratio a little more than four times. This is in turn nearly identical to Australia’s current house price-to-income ratio of 4.6 times (see chart).

The final elephant in this debate is, of course, urbanisation. Today more than 53 per cent of China’s population still lives in non-urban areas. According to Globalis, China is the 157th least urbanised country in the world (Australia is the 11th most urbanised nation).

An alternative fact that reveals the extent of both urbanisation and industrialisation that China has yet to endure is the share of the labour force still employed in farming. Today around 40 per cent of China’s workforce is allocated to farming, whereas UBS analysis suggests that the typical developed economy average is 3-8 per cent (see the next two charts below).

In closing, the case for a secular and debt-fuelled real estate bubble in China is not compelling. If you are hunting around for a bubble, Macquarie’s Rory Robertson has an idea—that most valuable of non-income producing investments, gold. In a proprietary research note published over the weekend, Rory remarked, “My clearest get-rich-quick dream is “shorting” gold at some yet-to-be-determined extraordinary price, just before it collapses under the weight of the investor herd rushing to exit.”

Today I will leave you with a comparison of the Australian dollar price of gold per ounce with another bubble that many purport to be brewing: Australian house prices (Rory provided similar analysis). You get the picture.