The China Bears Are WrongShaun Rein
China may have passed Japan as the world's second-largest economy in August, but that hasn't stopped bearish analysts from forecasting hard times for the Chinese economy. Such skeptics as short-seller Jim Chanos warned earlier this year that China's real estate bubble is a thousand times worse than Dubai's. Former Morgan Stanley economist Andy Xie has argued that China is in a real estate bubble because 25 percent to 30 percent of the country's homes are vacant and the typical consumer has to work a full year to be able to afford a closet. And Businessweek.com columnist John Lee argues that China has become ever-more reliant on an unsustainable economic model built on exports.
They're not the only ones who have been sounding off on China in pessimistic tones. The mantra of these China bears is that the world's second-largest economy is set for a massive slowdown, at best—and an explosion, at worst. Either way, the rest of the world had better watch out, the argument goes.
Most of the bears' logic simply does not hold up to even basic scrutiny. First, the argument made by Xie about high prices relative to average salaries and empty units does not make economic sense. Vacant units are not a problem if they have been sold to consumers who can afford them and are not held by developers who need to sell in order to pay back their loans. China's real estate developers are not sitting on empty units; they've sold to consumers who hold onto them as investments, much as many investors buy gold bars. Holding these units would be a problem if the investors were overleveraged, as in the U.S. before the crash, when even subprime borrowers could buy multiple houses at zero percent down. That's not what's going in China, where home buyers must pay 30 percent up front if they want to take out a mortgage on their first home, and 50 percent if it's their second. In Beijing, a full 60 percent of second homes are completely paid for up front.
In other words, the people buying homes can afford them. They are not overleveraged. Even if prices drop 20 percent, as they might, the fall won't threaten China's economic stability because there won't be panic selling. Mortgages won't go underwater and investors will still pay back their loans.
Soft landing is well under way
Moreover, it does not matter much from an economic risk standpoint if prices are too high for everyday Chinese. Certainly having adequate housing for low-income Chinese is important to preserve social stability, but that is a different problem altogether. As we think about the Chinese economy, what is important is whether the people who buy homes can afford them. Yes, they can.
Want proof that strict real estate policies implemented earlier this year are working to create a soft landing? Sales have plummeted—sales volumes last month dropped 70 percent year-on-year in the 15 biggest markets—but prices remained stable. That is hardly the sound of a bubble popping.
In commercial real estate, the bears are right: There is cause for concern. Last year many local governments established real estate arms that took out loans from big state-owned banks such as Bank of China and ICBC to get liquidity into the system because they cannot issue debt the way cities in the U.S. do. Nonperforming loans will definitely rise as a result. Investors should be wary.
Still, local debt as a percentage of gross domestic product is only about 12 percent to 14 percent. Add that to 22-percent-to-24-percent central government debt and China debt is only 34 percent to 38 percent of total GDP—far lower than the 65 percent to 70 percent proportion in the U.S. and Britain. The debt level is manageable and can be reduced by increasing taxes or simply reimplementing taxes that were temporarily rescinded last year as a result of the financial crisis. For instance, to help companies during the worst of the crisis, Shanghai's government rolled back many taxes aimed at small and midsized enterprises; policymakers could reinstate them now that corporate profits are back up. The central government is also preventing most companies that report directly to Beijing from engaging in new real estate projects. Last month, state-owned Agricultural Bank of China (1288:HK) even put a moratorium on all real estate lending.
The second argument that bears growl about is inefficient government infrastructure spending. Peking University professor Michael Pettis has fretted that China's infrastructure spending will leave it with economic stagnation comparable to that which afflicted Japan in the 1990s. John Lee, in his Businessweek.com column, "If Only China Were More Like Japan," agrees.
Infrastructure: investing for growth
Neither Pettis' nor Lee's analysis takes into account the differences in infrastructure spending between the two countries. The infrastructure investment going on in China is quite different from that in Japan, where the government has built roads and bridges to tiny hamlets that would go bankrupt without long-term government subsidies. In China, the situation is dramatically different. If anything, the Chinese are under-investing in infrastructure because such a large portion of the country's population lives in a less-than-optimally served area the size of the U.S. Eastern Seaboard. The government is investing in meaningful projects that improve economic efficiency because they increase the communications and connections between and within cities. Take, for instance, the new high-speed rail link that has cut transportation time between Shanghai and Wuhan from 12 hours to 5 hours. Over 30 million people live in these cities. Improved transportation links allow increased investment and trade, much as President Dwight D. Eisenhower's interstate highways facilitated U.S. interstate commerce from the 1950s onward.
Or take Shanghai, which is building a subway system more extensive than New York's. Not only does this alleviate congestion, but it allows the city's business areas to expand to the outlying suburbs. Overall, China's infrastructure investments are helping to promote more efficiency, rather than propping up areas and businesses that should be left to decline.
Finally, Pettis argues that incomes are not rising as fast as GDP and that it will be impossible for domestic consumption to offset slowing export growth. Official statistics, however, do not adequately estimate the size of the underground economy. Most economists put China's underground economy at 10 percent to 20 percent of the total economy. My firm, the China Market Research Group, puts it at above 50 percent. In China, evading taxes is common; many businesses such as restaurants or hair salons pay set monthly taxes, regardless of the revenue and profits they generate.
If we take this underground economy into account, domestic consumption suddenly accounts for 40 percent of GDP, rather than the 30 percent figure that alarms Lee and other China bears. Multinational companies focused on Chinese consumers know this, as Starbucks (SBUX), Ford (F), and others are enjoying strong sales. Keep all this in mind the next time you see another bearish forecast about China's economy.
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