Property Market Will Lead Future Economy

| Zuo Xiaolei

Chief Economist, China Galaxy Securities

Beginning in 2009, China invested 4 trillion yuan in economic stimulus while adopting a loose policy on money supply to stimulate domestic investment and consumer spending. While it has succeeded in raising economic growth to eight percent, some side effects cannot be overlooked.

I think the most noteworthy thing here is the excess of capital that flowed into the property market under the loose monetary policy and is now parked there. This year China's economic growth rate will be about eight percent, yet the money supply has grown 29 percent. Meanwhile, property values in Beijing, Shenzhen, Shanghai and other major urban markets have returned to pre-financial crisis levels, up 30 to 40 percent. In some localities they've even continued to set new highs. It's clear that surplus capital is overly concentrated in the property market to the point where many economists are now fretting about an asset bubble.

On the market, some businesses and speculators continue to talk a good game, like citing China's rapid economic growth as driving a major spike in housing demand that will continue to prop up high property values. But the reality is with prime real estate in China's top urban areas going for nearly 20,000 yuan  per square meter, land values have already far eclipsed what the average wage earner can afford. In China's property market the vast majority of buyers are investors and speculators motivated entirely by profit.

China's property market is overheated on a massive scale and behind that lies the even more telling massive bank lending over the past several years to a degree which could potentially pose a systemic risk. Consequently, China's property bubble is not simply a matter of depressing property values, of popping the bubble to make everything all right.

Chinese authorities have been paying attention and two recent policy moves illustrate that:

I. China has been employing administrative measures to begin demanding that banks reduce their exposure to real estate lending. Whether commercial and residential property developers or homebuyers, far fewer of them will be getting loans in the future. The policy hopes to reduce risk to banks so if the bottom falls out of property values, there will be no U.S.-style wave of defaults that could constitute a systemic risk to the financial system.

II. The National Development and Reform Commission's recently proposed guaranteed housing policy is another policy move that must be taken. Plans currently passed by the State Council set initial goals of providing 1.8 million state housing rental units and 1.3 million state housing units for sale. I believe that beginning in 2010 additions will continue to be made to those target numbers.

There are two objectives behind the guaranteed housing plans. The first is to provide sustained economic stimulus and channel investment into the basic lives of the people. The other is the Chinese government's effort to restore order in the property market. On the one hand, they can't allow the market to overheat. But at the same time, they must allow property developers (generally an important source of tax revenue for local governments) to survive and the production chain to keep developing.

In implementation, these policies need to overcome numerous challenges. Over the past several years, for example, some local governments have become grossly over-reliant on selling land to generate revenue. Land sales now account for half of all revenues in some areas. Local governments have to diversify their sources of revenue, so they don't have to constantly rely on land sales. Otherwise, they will ultimately be left with no leverage with which to depress land prices, creating higher costs, and pricier future land values.

Additionally, banks need to exercise more self-discipline when it comes to screening loan applications, such as with documentation and loan-to-value ratios. Banks cannot be overexposed in the property market.

I believe regulation of bank lending in the property sector and guaranteed housing policies will be intimately related to how China's future economic development pans out.

If the previously mentioned steps can be taken, Chinese property values can begin coming in for a soft landing and a restoration of normal market supply and demand forces. The adjustment in property values will hit only speculators who gambled and lost and won't amount to a total meltdown.

---

Hot Money Arbitrage Forcing China into Tough Choices

| Tao Dong

Chief Regional Economist for Non-Japan Asia, Credit Suisse

One of the most noteworthy risks in China's economy is the hot money engaged in arbitrage trading, which is currently flowing into China at unprecedented rates.

Recently, I often found myself saying the operative letter in global economics in 2009 was "D," with everybody worried about an economic depression. Starting this year, the operative letter in global economics remains "D," only now this "D" stands for "dollars."

During the second half of last year, a weakening U.S. dollar ignited a wave of U.S. dollar arbitrage trading that has now become a "time bomb" for both global assets and commodity prices. If the U.S. Federal Reserve were to raise interest rates, that time bomb would ultimately explode. And the impact of this issue would be particularly severe for China.

Exactly how much hot money has fled to China? Generally speaking, foreign exchange reserves are basically equal to the value of the nation's trade surplus plus total direct foreign investment. What remains after subtracting those two items from foreign exchange reserves is what is known as "hot money" – inexplicable foreign funds.

And this number as of the end of October 2009 approached US$160 billion. Further, beginning in the second half of last year, the pace of unexplained foreign funds flowing into China has accelerated monthly. In October alone US$30 billion flowed into China.

Hot money is driving up China's property and equity prices, raising secret fears of a bubble. But even more important is the indirect influence of all that hot money on the Chinese government's monetary policy.

In interest rate policy, raising rates is one effective measure to fight inflation, and to cool speculation in the domestic property market and elsewhere. But the Beijing authorities have been very restrained on hot money, fearing any hike in interest rates could help widen the profit spread on arbitrage trading between U.S. dollars and renminbi, and further accelerate the inflow of hot money. Consequently, their recent efforts to rein in property prices have always involved administrative measures, not rate hikes. It is evident that China is facing some tough choices in its Macroeconomic Control policy and monetary policy.

I think the central government won't even consider raising interest rates until the second half of the year at the earliest, after they've had a chance to look at the figures for inflation and international monetary flows. And the annual rate of increase in China's consumer price index for 2010 will be 3.3 percent, up from the 0.3 percent decline for 2009.

Much the same can be said for exchange rate policy. There is considerable political pressure internationally demanding that the renminbi be allowed to appreciate. According to economic theory, there is considerable room for the currency to appreciate. We still see, however, that the Chinese currency depreciated 8.5 percent last year against a basket of currencies.

In China, exchange rate policy is a political decision and not one left to the free market to decide. The Chinese government is now considering not only the pace of the recovery in export trade, but also the appraisal of the hot money arbitrage traders, so the room for appreciation in the Chinese currency is quite limited.

All that hot money is obviously a huge worry for Chinese authorities. But short of putting a lock on interest rates, options for resolving the issue are quite limited. China has recently launched a crackdown on cross-border underground banks, and that is one option. But there are signs that indicate some of that hot money is coming from domestic state- and private-owned businesses via loans in U.S. dollars from overseas. The arbitrage is domestic. I'm afraid China will need to undertake some internal control measures.

Translated from the Chinese by Brian Kennedy