Is Chinese Property Overheating or Cooling Off?

China’s National Bureau of Statistics released the March real estate data today, and the record 11.7% y/y increase in the 70-city price index is making waves. The major coastal cities saw large increases (Shenzhen, 20.1%; Beijing, 12.3%; Shanghai, 10.7%), while central and western cities typically saw smaller gains. The rise in property prices in the two cities on Hainan Island was a jaw-dropping 50% y/y. Even the month-on-month data should give pause to those arguing there is no bubble in Chinese property. Prices jumped 1.1% m/m, accelerating from the brief pause for the Chinese New Year in February, when prices were up 0.9% m/m.

Property price increases are either back to their mid-2007 pace or beyond, according to the price index. Housing starts jumped 87% y/y (as measured by floor space) and real estate investment was up 35% y/y in March. It looks like not only is the bubble growing, but more investors (presumably well-levered) are piling in.

But perhaps it’s not time (yet) to predict the imminent collapse of China’s house of cards (Or China’s heart attack on the “treadmill to hell.”).

Rumors of a coming property tax and a slowdown in bank lending probably contributed to a slowing of transactions in March. Transactions slowed to 58% y/y by value and 36% y/y by volume. Most of that was due to base effects, but the decline in the implied average price per-square-meter has less to do with changes in the base. Price gains by this measure slowed from 23% y/y in the first two months of 2010 and 21% in 2009 to 16.1% for all of Q1. The average price per-square meter sold in China actually fell from RMB5,750 in the first two months of 2010 to RMB5,200 for the year through March, though it was still up from RMB4,700 in 2009.

So is the Chinese real estate bubble blowing bigger or slowly deflating?

My best guess is that the bubble is probably still getting bigger, but we may be near the peak.

The apparent easing of price gains implied transaction data looks to be mostly due to a Simpson’s Paradox: the national average saw prices increase by 16% y/y in Q1, but the prices in the eastern region were up 17%, those in the center were up 19%, and the west saw prices climb 17%. This is possible because transactions slowed more in the eastern area than in the central or western regions. This decreased marginally the share of eastern transactions in the national total, and since prices there are about double those in the interior, the national total showed a more severe slowdown in price gains than any of the regions individually.

Since most of China’s regional property bubbles are in the coastal cities, a slowing of transactions in the east seems to imply that we may be past the worst of the excesses. March’s slowdown in bank lending would be helpful in that regard, if it were to continue into Q2. However, long-term loans to households barely declined to RMB149.8 billion in March from RMB153 billion in February and an average RMB164 billion in the previous twelve months. Given that most of the slowdown appears to be due to strained capital positions, there’s little reason to hope for a more severe contraction in the coming months—mortgages carry a lower risk-weighting than most corporate loans, so we’re more likely to see a surge in long-term household loans as a percentage of total new lending in the coming quarters. Banks are probably selling more bundled corporate loans (CDOs?) to trusts (SIVs?) to move them off their balance sheets, and replacing them with mortgages.  The slowdown in credit growth is likely much less than implied by the bank lending data.

Until local officials get on board with the regulatory clampdown, the excesses of Chinese property look to keep on blowing.

Right now, the only carrying costs for Chinese property investors is the interest on their mortgage. Most are bullet loans, where the principle is only paid back in the final payment, which further reduces the carrying costs. Still, Shanghai and other cities are said to be considering property taxes for the first time, which should scare off some investors in the coming months given the rise in carrying costs.

The bigger worry is what will happen to consumption and the financial sector if prices collapse. Consumption would be affected less, at least directly, given that there is almost no consumption financed by equity in property in China and the leverage ratio on mortgages is relatively low.  Banks would be harder hit, and there’s little chance that the government could avoid a bailout if developers and local governments suddenly find the value of their collateral to be less and the net-present value of the projects they financed with bank loans to be lower. Michael Pettis had a great post last week on the knock-on effects on consumption from the last bailout, and things would probably look similar this time around. Despite the lower leverage ratio and the government’s strong asset position, a property bust would weigh heavily on China’s growth in the following years.

Hopefully, the signs of cooling in the property sector are real, and China can avoid a painful bust in the coming years. Tightening credit conditions now would be far less painful than waiting for the bubble to inflate even more.

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