China's Looming Real-Estate Bubble

A massive Keynesian spending program has misallocated capital and set the stage for a crisis.

American enthusiasts of more stimulus have been urging this country to look to China for guidance on how to beat a recession. As they see it, while our politicians debated and dithered and fell short, China's wise autocrats moved quickly to inject a massive stimulus and restore robust growth.

Despite the global downturn, China's economic growth rate remains above 10 percent. But there is mounting evidence that Beijing has misallocated vast amounts of capital, touching off a real-estate crisis that could yet drag the world's second-largest economy down to earth.

When the global marketplace went into meltdown mode two years ago and Chinese exports dropped off, Beijing mounted a stimulus several times bigger relative to the size of its economy than in this country. It announced a four trillion yuan ($586 billion) stimulus for infrastructure projects and housing developments. Some of the stimulus was used to encourage local governments to lend money to state-owned companies to develop housing complexes, roads and bridges, on the theory that these are big employment generators because they boost heavy manufacturing—steel, cement—and other sectors of the economy.

Beijing also lowered capital reserve requirements for its state-owned banks ordering them to dole out loans to "support growth." Though official data are unreliable, in 2009 Beijing apparently handed out somewhere close to 10 trillion yuan in new loans—more than twice the year before—and expanded the country's total loan portfolio and money supply by one-third, according to Patrick Chovanec, associate professor at Tsinghua University's School of Economics and Management in Beijing.

Prominent progressives in this country hailed the moves. Paul Krugman wrote: "China is doing what I'm constantly urging the Obama Administration to do, which is to reverse the economic decline by a large-scale stimulus." Dean Baker, co-founder of the Center for Economic and Policy Research wrote in TalkingPoints Memo last year: "If only we could export our Blue Dogs and deficit hawks to China, we might be able to compete."

But that ignores the nasty side effects. Fueled in part by this massive injection of liquidity, housing prices that had started dropping due to the recession began to soar again. Over the past year they increased nearly 12 percent, according to the latest figures from China's National Bureau of Statistics. So many middle-class Chinese (especially young couples wishing to move out of their parents' home) are being priced out of the market that their travails became the subject of a popular TV series called Dwelling Narrowness. Beijing banned the show, fearing it would cause unrest.

The problem is that government money is going to build homes not for occupancy but for ownership. Speculation, if you will. Andy Xie, a Shanghai-based economist formerly with Morgan Stanley, believes almost 25 percent to 30 percent of private commercial and housing stock in China is vacant. Entire cities, such as Ordos in inner-Mongolia, erected literally from scratch, stand empty.

"Chinese treat homes like gold bars buying multiple units as a store of value," notes Chovanec. Chinese avoid the stock market because it is still volatile and risky, and banks and bonds offer a low yield. Hence, Chinese are content to buy homes and let them sit because, thanks to the absence of property taxes, holding costs are negligible. Having never experienced a housing slump since China privatized its housing market in the 1990s, they believe that home prices only rise.

This can't last, but backers of China's stimulus believe there won't be any serious economic downside when the bubble bursts. Homeowners won't be thrown on the street because Chinese buy their first homes outright through their savings—not loans. And when house prices drop, the excess stock will quickly get scooped up—not boarded up.
While Chinese homeowners are not generally leveraged, those who buy second homes do finance them. And developers, including local governments and state-owned companies, are massively leveraged. This poses a big problem—Shen Minggao, Citigroup's Hong Kong-based China economist, estimates in Bloomberg Businessweek that at least 2.4 trillion yuan of the stimulus is already in nonperforming loans.

China's autocrats understand that they have a bubble on their hands. They've mandated minimum down payments of 50 percent on second homes and are considering property taxes to rein in speculative purchases. However, this will mean that the houses put on the market will find fewer buyers.

Beijing is in a dilemma. It can cut spending and rein in its monetary expansion, releasing over time capital for more productive endeavors (especially if it opens up hitherto closed investment options) and putting the economy on a healthier footing. However, that would mean slower growth, lower home values, rising unemployment and potential political unrest. Alternatively, it can buy a few more years of faux-growth and stability by propping up the real-estate market—and risk making the day of reckoning far worse when it arrives.

Either way, Beijing's mandarins haven't discovered some magical formula to spend and inflate their way out of a recession. Pouring liquidity into real estate is the Keynesian equivalent of digging ditches and filling them with stones. Unfortunately, the Chinese economy has fallen into one—a ditch, that is. The U.S. might have endured a bad recession. But so long as it avoids the second stimulus that China enthusiasts are advocating, it might be up and running while China is still digging itself out.

Shikha Dalmia is a senior analyst at Reason Foundation and a Forbes.com columnist. Anthony Randazzo is Reason Foundation's director of economic research. Reason Foundation research assistant David Godow provided research support. This article originally appeared in The Wall Street Journal.