Friday, April 16, 2010

Is China's Real Estate Bubble A Global Economic Threat?

Charlie Rose recently conducted an revealing interview with James Chanos, the founder and president of the hedge fund Kynikos, which manages roughly $6 billion. Kynikos specializes in short selling, or betting against investments that it considers overvalued.

Ten years ago, Chanos bet against Enron, predicting that it was on the brink of ruin. He was right, and his bet paid off handsomely.

Chanos now predicts that the Chinese real estate market is overheated, overvalued, and headed towards a similar fate. In fact, he calls it a "world-class property bubble."

The problem, as Chanos sees it, exists primarily with high-rise buildings of offices and condos.

As Chanos defines it, "A bubble is any kind of debt-fueled asset inflation where people are borrowing money to buy the asset, where the cash flow generation from the asset itself — a rental property, office building — does not cover the debt service and the debt incurred to buy the asset.

"So you depend on a greater fool, if you will. I think Hyman Minsky called it the 'Ponzi finance', meaning you need the greater fool to come in and buy it at a higher price because, as an income-producing property, it’s not going to do it. And that’s certainly case in China right now."

In 2009, Chinese real estate went up 50 percent. But the amazing thing is that a lot of those apartments are empty.

According to Chanos, when you buy a high-end apartment in China, you get an empty shell that doesn't even come with internal walls or floors. And the investors who buy more than one property typically keep them empty because it’s much easier to sell an unoccupied apartment to the next speculator, who will, in turn, flip it.

Chinese developers are planning extravagant projects like indoor ski resorts and a new Times Square in suburban Beijing that will include 32 Broadway theaters.

The stunning reality is that 50-60% of China's GDP is construction, so the government — determined to promote vigorous growth — is letting this bubble expand. According to Chanos, too much construction has been geared toward real estate development and not enough toward infrastructure, such as airports and high-speed rail.

And the problem is that the real estate being built is not for the masses. It is not affordable housing for the middle-class; it's all high-end condos and office buildings.

The typical new Chinese condo is 1,100 square feet and costs between $100,000-$150,000. However, the typical two-income Chinese couple in their 30s makes approximately $7,000 or $8,000 a year. That just doesn't add up, notes Chanos.

Since China doesn't have property taxes, state and local governments make almost all their money from land developments. Chanos says many of them simply recycle bank loans to do more land speculation and raise more government revenues. So these governments have taken on a lot of debt. And when these debts go bad, Chanos says China will have to nationalize a lot of them.

This already happened in China during the mid-’90s, when there was a banking crisis. Property prices collapsed. The government nationalized the bad debts and the private equity investors got burned.

In Chanos' estimation, the bubble will likely burst and run its course in late 2010 or in 2011. And when that happens, all the foreign investment money will want to escape intact. But will it? Will the government allow this? Will the government simply inflate the currency to bail out everyone, including foreign investors?

China is facing a lot of pressure to revalue its currency higher relative to the dollar. But if China has to nationalize lots and lots of bad real estate debts, its currency — the renminbi — may be devalued. That could potentially spark a trade war.

The Chinese government has a lot riding on this. They are determined to – they need to – maintain the country's exceptional GDP growth. Their $500 billion stimulus package last year proves this. And Chanos says a lot of that money ended up in real estate.

As Harvard economist Kenneth Rogoff has noted, "In my work on the history of financial crises, we find that debt-fueled real estate price explosions are a frequent precursor to financial crisis."

Imagine if the Chinese government has to use its US currency reserves to solve its own financial and economic crises. Imagine if it has to sell off its US Treasuries to fill the void?

Why does all of this matter to America? The concern is that there are similarities between the Chinese bubble and the American housing bubble, which led to the global economic meltdown.

If the Chinese bubble bursts, it would affect all US companies that sell commodities to China, particularly the variety that go into construction, such as steel, most of which goes to China at present.

What the Chinese may soon come realize in their experiment with capitalism is that, without capital, there is no capitalism.

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