09/29/2021: Real estate bubbles are pernicious problems for advanced economies because they often involve outsized levels of debt. When they pop, financial crises ensue, prompting lenders to withdraw credit for fear of insolvency. History is littered with real estate bubbles and busts. One notorious example was Japan’s land bubble of the late 1980s. Between 1956 and 1986, Japan’s land prices skyrocketed by as much as 5,000 per cent. At its peak, Tokyo real estate was selling for as much as $139,000/sq ft, nearly 350 times as much as equivalent space in Manhattan. At one point it was ignominiously estimated that the Imperial Palace in Tokyo was worth as much as the entire US state of California. Japanese banks financed the bubble, helped by deregulation, low interest rates and a strong Yen. When Japan’s real estate market burst, the country’s banks were buried under mountains of bad loans, leaving them unable to lend to other industries. The economy-wide credit restriction exacerbated Japan’s economic crash in the 1990s and resulted in a more than 50 per cent plunge in the Nikkei 225 over the decade, sending the country into secular decline.
The US suffered a similar real estate bubble, fueled by easy – bordering on irresponsible – credit availability, combined with policymakers’ desire to enable more Americans, including low-income households, to share in the American dream of home ownership. Lawmakers got their wish. By the end of 2007, nearly 70 per cent of American households owned their own home. Financial market stress came to the surface in late 2007, but the crescendo wasn’t reached until the Lehman Brothers bankruptcy in September 2008. The Lehman default reverberated throughout the global financial system and caused a peak-to-trough market decline exceeding 50 per cent.
Now, it appears, a housing bubble has inflated in China and, like the previous bubbles in Japan and the US, it was years in the making. Beginning in the 1990s, China went “all-in” on growth, betting on exports and domestic real estate. The economy skyrocketed and property values surged. Buildings and infrastructure were the lynchpins of China’s success, helping to provide millions of jobs to rural Chinese workers migrating to cities in search of a better life. Thirty years later, real estate and related industries account for 30 per cent of China’s GDP, far higher than that of the US at the height of our housing bubble.
Leverage played an important role in China’s growth but, unlike the US, China’s borrowing was not used to fund tax cuts or social programs. Beijing instead accumulated massive debt to drive investments in manufacturing, infrastructure and property, which arguably made the economy more productive. Lately, however, China has had to rely on ever-increasing debt levels to drive the same economic activity. Between 2008 and 2019, total debt rose from 169 per cent to 306 per cent of GDP, while GDP growth fell from 10 per cent to 6 per cent, according to The Wall Street Journal.
Beijing, in recognizing this model was unsustainable, has attempted to pivot toward consumer-dependent growth. President Xi and the Communist Party hope to cut real estate’s share of their economy from roughly 30 per cent to 15 per cent. If Xi is serious about shifting away from real estate and toward manufacturing, investors should expect a painful adjustment ahead. A good deal of the pain would be felt among Chinese households, nearly 90 per cent of which own homes – far higher than the US homeownership rate at the peak of the US housing bubble – and with real estate comprising nearly 70 per cent of household net worth. A meaningful real estate correction could have a devastating impact on the Chinese middle class.
Moreover, a long-lasting decline in real estate prices limits policymakers’ ability to respond to other macroeconomic shocks. While China doesn’t have the same financial vulnerability as a capitalist economy, Beijing will nonetheless need to balance the interests of middle-class wealth, inequality and longer-term growth, which has been fueled historically by real estate. Chinese companies have accumulated massive debt, whether in real estate or in other industries. Access to capital would likely remain uninterrupted because Beijing would order Chinese banks to keep capital flowing. While the real estate sector might take a big hit, manufacturing and agriculture, for example, would likely be insulated.
The impact of the world’s second-largest economy downshifting from 6 per cent growth to 3 per cent growth will be felt well beyond China’s borders. China added as much as 2 per cent to global growth as recently as 2011, but that contribution is already on a downtrend. The five-year trend slipped from over 1.5 per cent to below 1 per cent between 2011 and 2019. China’s contribution to world growth will fall further.
Countries comprising China’s largest import sources, like Japan, Australia, South Korea and Germany, will feel the effect of slowing demand, particularly for construction-related inputs. Australia, due to its reliance on iron ore exports, will be particularly vulnerable. Spot prices for iron ore have already plunged more than 50 per cent since May. US and European companies operating in China are already feeling the pullback. In a recent survey conducted by the American Chamber of Commerce in Shanghai, 45 per cent of members said China’s strict rules have negatively affected their operations. US multinationals, like Apple, Nike and Tesla, have significant operations in China, and continue to believe in China’s demand story. It should also be noted that none of them derive more than 25 per cent of their revenue there. Foreign direct investment (FDI), while still important, has played a diminishing role in China’s growth. FDI over the last 12 months accounts for 3.8 per cent of the country’s GDP; while significant, that figure is down from 20 per cent in the late 1990s. While China will remain a dominant force in the global economy and in geopolitics, the country’s shift inward will undoubtedly be a drag on global growth.