By James H. Nolt
Last week I argued that China is not much of a military threat to peace and East Asian stability. Chinese leaders are most concerned with promoting stability and social harmony while avoiding chaos. The greatest China threat is not what Chinese leaders deliberately do, but what they might be unable to avoid within their own nation: the disruptive consequences of a major asset crash.
During recent weeks we have already seen one indication of the vulnerability of Chinese asset values when its stock market lost about a third of its value. This was a crash more severe than any in the U.S. since the great stock market crash of 1929. However, the consequences of this latest crash will not be so drastic. China’s stock market has been on a roller coaster in recent years, exhibiting multiple boom and crash cycles, but China's stock market is fairly small relative to its overall economy.
The truly gargantuan asset market in China is the real estate market. It has not been quite as volatile as the stock market, but it has turned down in recent years after a fast bubble-like rise. A falling property market exposes much more of China’s institutional and individual wealth to diminution. Relative to GDP, real estate is more important in China than in any other large country. Thus, any downturn in property values has ripple effects throughout the economy. In fact, the most recent bubble in both the Chinese stock and bond markets was propelled by investors liquidating stagnating property assets to invest in some other hot market. Now that stocks have crashed, the bond boom will get some added push from investors fleeing stocks until bonds also crash.
The turmoil in China’s asset markets derives from difficulties in its real economy. For roughly three decades China’s economy has been booming based on exceptional rapid growth of exports and real investment. Both of these engines of growth are now slowing. Investment is the one most likely to crash.
Investment is a term used in several senses, so it is important to keep them distinct. Ordinary people often speak about investing their money in various assets to gain income and capital appreciation, including stocks, bonds, and real estate. But when economists talk about investment in relation to GDP or total economic output, they are talking about new factories, productive equipment, and construction, but not stocks and bonds. Investment in this sense is part of GDP, which also includes consumption spending on the myriad products and services we buy, government spending on goods and services, and net exports (exports minus imports).
Investment is typically the most volatile part of GDP. When economies are booming, investors expand productive capacity and new construction to allow production of ever-increasing quantities of goods and services. Since factories to produce things are often large and complicated, their up front cost is high, but after this initial investment they may produce for decades. Thus, during boom years when productive capacity is being added, investment is typically a growing share of GDP. This was certainly true in China during recent decades.
On the other hand, when economies crash, many factories, offices, commercial buildings, and apartments are partly or fully idle. Capacity to produce exceeds demand in a slowing economy. When excess capacity emerges, investment spending not only slows down, it often drops disproportionately because it makes no sense to add any new capacity when usage of existing capacity is falling.
As China’s economy slows, people argue about whether it is due for a “soft landing” or a “hard landing.” A soft landing means the economy might slow gradually, but with no major crashes in asset prices or employment. A “hard landing” is a recession or depression. Whether China’s landing is hard or soft depends on how quickly investment spending and asset prices fall, and whether there is any compensating increase in some other category of GDP demand, such as consumer or government spending.
The reason bubbles tend to burst quicker than they inflate is that, in a boom, the most bullish investors borrow to leverage their gains with other people’s money. If the yield on an asset (income plus capital gain) is higher than your cost of borrowing, you will make money the more you borrow. For example, if I can borrow money at 6 percent interest and buy apartment buildings that earn annual rent that is 5 percent of their cost and also appreciate in value 5 percent per year, my wealth is increasing 10 percent per year, but my cost of borrowing is less than that. The more I can borrow to invest, the more money I make. Virtually nobody gets rich by investing only their own money. They get rich by borrowing other people’s money and investing it for a higher gain. This is the bulls’ creed.
On the other hand, if the value of apartment buildings stops rising, all I get is the rent. If I have to pay 6 percent interest and the rent is only 5 percent of the value I borrowed to buy the apartment building, now I am “underwater,” losing money. I could cut my losses by selling my buildings and paying off my loans.
Every economic crash, every bursting bubble, starts with bullish investors getting squeezed by either rising interest rates or falling asset values or both. Asset values do not need to actually fall to cause a problem. As long as they are rising less than the cost of their borrowed funds, they are underwater, and the owners must liquidate if they do not expect a quick recovery. As the most bullish (most leveraged) investors liquidate, this addition to selling pressure tends to further lower asset prices. A snowball effect is possible, with each price drop pushing more investors underwater and thus forcing additional liquidations. The greater the boom, the greater the leverage, and, eventually, the harder the fall.
China’s asset markets are heavily influenced by government authorities, but China’s governmental institutions are not merely one huge undifferentiated mass. Local government authorities tend to be more bullish, particularly on real estate, relative to the central government. Local governments throughout China derive much of their revenue and political support from stoking local property values by using generous credit to inflate prices and help local authorities to profit from redeveloping and flipping property. The central government in Beijing often takes a more bearish stance than local authorities, attempting, with uneven success, to restrict excessive growth in credit. I will consider China’s property market more next week, including more on how it effects the world economy.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo Courtesy of Wikimedia Commons]