Over the past several weeks, a number of news reports and market figures have caught my attention, which appear to indicate that China’s economy may be approaching a crisis.  I use the word “crisis” in the traditional (or medical) sense, meaning a critical turning point when tensions or contradictions are resolved, for better or worse — sometimes in unexpected ways.  One potential interpretation of this crisis is that China is entering the terminal stage of a bubble, and that what we are seeing are the early signs of a much broader collapse.  But it may not be that simple.  I have been saying since the year began that China is due for a correction, and just last week I told the Globe and Mail that such a correction could be a lot worse than most people expect.  How exactly the situation will unfold, though, and whether we’ve already reached a tipping point or not, remains to be seen.  For the moment, I’m reminded of that song:  Something’s happening here; what it is ain’t exactly clear.  But — and this is the real point — something is happening, and people both inside and outside of China are right to be nervous.
Let’s start with real estate.  For the past several months, China’s official media have been touting official data indicating that while most Chinese cities are still seeing housing prices rise, a growing number of cities are starting to see a plateau or even decline in prices — evidence, they say, that the central government’s cooling measures are finally working.  More significant, in my eyes, are reports — which began emerging in late August — that in several cities across China, prices in primary housing markets (developers selling to homeowners) have begun falling away from those in secondary markets (homeowners selling to other homeowners).  The effected markets include not only 1st tier metropolises (Beijing, Shanghai, Guangzhou, and Shenzhen) , but also 2nd tier (Chongqing, Wuhan, Tianjin, Zhenghou) and 3rd tier (Ningbo, Foshan, Wuxi) ones as well.  In late August, reports had secondary market prices for many downtown properties in Chongqing at 4-10% higher than primary prices.  Last week, another report put the price gap in 1st tier cities like Beijing and Shanghai much higher, at 20%.
What could explain the growing price gap?  Back in April 2010, when the central government first announced its intention to “cool” the real estate market, property developers were skeptical.  They’d seen this movie before:  the market, they figured, might stall for a while, but as soon as policymakers saw the negative impact on investment-led GDP growth, they’d rush back in to support the sector.  Six months, tops, they would be right back to business as usual.  In the meantime, savvy developers better get ready for the next round by continuing to borrow and build.  That’s precisely what they did, which is why, despite jittery buyers and slumping transaction volumes, investment in real estate (in yuan) rose 33% and new construction (in square meters) climbed 26% in the first eight months of 2011, compared to the same period last year — data that China’s National Statistics Bureau touts, by the way, as proof that the Chinese economy is still going strong.
All of this continued building was predicated on the assumption that China’s cooling policies could not last.  In fact, since developers kept building, there was no negative impact on GDP, and no reason for policymakers to pull back.  To the contrary, inflation rose, and the cooling measures targeted at real estate were broadened into a more general credit tightening policy aimed at reining in lending.  As developers piled up more and more inventory — the primary market inventory in Shanghai, for instance, now starts at an all-time high, 12.5% higher than in December 2008 — they had to borrow to stay in business.  With credit conditions tightening, they systematically ran through the credit lines available:  first the banks, then high-yield bonds in Hong Kong, then the private wealth management vehicles that have been popping up all over China, then the loan sharks.  Finally, they ran out of options, and had no choice but to start selling some of their inventory at whatever price they could get.
That’s why primary prices are dropping:  hard-pressed developers offering steep discounts on property they’ve been holding out on, in order to get cash.  Investors who already purchased homes, often as a place to stash large amounts of cash, don’t face the same pressure and so you don’t see the same price drop in secondary markets.  However, it’s important to note how small and illiquid those secondary markets are.  In the U.S. and Europe, the ratio of existing homes to new homes sold (in normal, non-crisis times) is something like 13 to 1.  In China, it’s more like 1:1, or 2:1 at most.  The price gap may be less of a real “gap” than a “lag.”
Frustrated by their inability to cool the property market, China’s bank regulators say they are intentionally trying to squeeze developers to force a correction.  The thing is, they may get more than they bargained for.  Consider what might happen if a lot of developers hit the wall at the same time, and start dumping their inventories.  Sizeable discounts would have to be offered, and prices in the primary market would crater.  True, investors who have already bought — in many cases — multiple properties might not face the same cash pressures, but absent a liquid secondary market they have been marking their investment to primary market prices, and looking to them for assurance that their properties are a reliable “store of value.”  If primary prices collapse, that assurance is gone.  And if they decide to cash out, even in part, they will find — as they might have known all along, had they cared — that there is no secondary market to cash into.  The result could be a panicked rush to the exits.  Even if just the primary market crashes, the rationale for the supposed solvency of a whole host of Local Government Financing Vehicle (LGFV) bank loans and bonds — that local authorities can always sell land to pay them back — falls apart.
To be clear, this chain of events has not unfolded — yet.  But there’s mounting evidence that it could, that the fabric of China’s investment-led growth is starting to fray and unravel.  In Shanghai, primary market property sales for Sept. 1-18 were down more than 50% year-on-year (contrasted with the all-time high inventories I mentioned earlier).  In Beijing, nearly 5% of the city’s property agents have shut down in the past two months.  The global price of copper, 40% of which is driven by Chinese demand, including wiring for all those new homes and office buildings, is down almost 25% since the beginning of August.  But more dramatic, and worrisome, is what is happening in Wenzhou.