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China’s per capita income could reach $20,000 by 2030
By Andy Xie
30 July 2013
Some financial accidents, e.g., trust products defaulting, may occur in the coming months. Their impact on the real economy will be limited. As the land bubble deflates, the resulting reductions in production costs and consumer prices should support the real economy by boosting exports and consumption.
When a few financial incidents occur simultaneously, the sense of panic may spread. The impact, however, should be short-lived. China’s land bubble has become almost entirely a financial phenomenon. Its problems should be contained within a small though vocal community.
To minimize the panic from a deflating land bubble, the central government should prepare contingency plans for unwinding trust products, property developers and local government financing vehicles.
The biggest mistake that the government can make is to, in a moment of panic, use taxpayer money to bail out all failing financial products or institutions. The resulting financial burden would limit the government’s ability to pay for the forthcoming reforms to rebalance the economy and launch a new growth cycle.
If China leaves the bubble economy behind and embarks on another wave of reform and opening up, its per capita income could top $20,000, excluding inflation, by 2030, making China the largest economy in the world.
The land bubble deflates
China has experienced rapid increase in land prices in the past decade. Some of it can be justified by income and productivity growth due to the country joining the World Trade Organization. Most of the increase is a bubble phenomenon.
While household income may have tripled in a decade, the average land price has risen by over thirty times. Whatever income growth is to come cannot justify the current price of land. Nor can a supply shortage.
China has no shortage of land. High-rise urbanization makes demand for land quite low relative to the population. The sustainable land value is probably 70% to 80% below current levels.
Any bubble occurs due to excessive monetary growth. An added condition in emerging economies is a stable exchange rate. Both conditions occur when an economy is taking off and the dollar is weak.
It happened in the 1980s in Latin America and in the 1990s in Southeast Asia. The last decade was China’s turn. The dollar peaked in 2002 and began a decade-long decline. China’s economy took off at the same time, as the country joining the World Trade Organization attracted a massive amount of foreign direct investment (FDI) and reallocation of manufacturing to it.
The combination allowed China to increase its broad money supply at 19% per annum for a decade while the exchange rate appreciated. China had rapid monetary growth before 1994, but experienced currency devaluation with it.
China’s land bubble is deflating for the same reasons as elsewhere.
First, the spurt of productivity growth after joining the WTO is tapering off. The country’s exports are facing a saturated market. Further productivity increases must come from improving value added, not from mere quantity expansion.
Second, the dollar is returning to strength. The combination will cause monetary growth to slow sharply. The odds are that China’s broad money growth rate would be less than 10% in 2014, half of the average in the preceding decade. A land bubble requires more and more money to support it. Slowing monetary growth is sure to trigger a bursting.
China’s property market will adjust similar to what happened in Japan and Taiwan rather than in Hong Kong or Southeast Asia. The former was gradual, and the latter fast.
In 1998, banks in Southeast Asia owed short-term dollar debts to Western banks. When the debts weren’t rolled over, these countries had to raise real interest rates enormously to contract domestic credit in order to pay off foreign creditors. Surging real interest rates caused their property markets to drop off a cliff.
After land prices peaked in 1992, Japan and Taiwan faced much less pressure because they didn’t have short-term foreign debt. Their land prices declined gradually and in waves, i.e., every recovery had lower highs and lower lows in both price and volume.
To some extent they are still in this process two decades later. For example, the current recovery in Japan is likely to be short-lived too.
China’s land market reached a turning point last year. The reasons are, first, that the quantity expansion-based growth model reached its limits, and, second, that the U.S. economy began to recover and with it the dollar.
The market recovered in the last quarter of 2012 and the first quarter of 2013, which was a bounce in a bear market. Now begins the second leg down.
There could be another recovery in early 2013. Like in Japan and Taiwan, lower lows and lower highs in both prices and trading volumes will track every wave. China’s land price will reach bottom in 2017 at the earliest.
The bottom in 2017 is contingent on the country successfully reforming its growth model. If reforms aren’t carried out and money is used to keep afloat bankrupt financial products, developers and local governments, the price of land will fall for many more years.
Two decades after its peak, Japan’s land price is still declining. It’s a lesson to all who believe that time alone will bring back every market.
Withstanding the bursting
The debts in China’s property bubble are mostly held by local governments and property developers. Total household debt is one-third of gross domestic product, compared to nearly 100% when the United States’ bubble burst in 2008 and Japan’s in 1992.
On balance, the bursting of the property bubble will boost China’s household demand. The lower property prices will decrease the need for savings.
China is experiencing widespread shortage of blue-collar labor. The shrinking of the working age population will worsen the shortage. This is a major source of inflation. As the cooling property market decreases labor demand somewhat, it won’t lead to serious unemployment and may decrease the inflationary pressure in the labor market.
China’s position as the factory of the world would be strengthened too. Rising costs have pushed some industries to Southeast Asia. A major source of cost inflation is rising property prices, as wage demand is driven by property prices. As the property bubble deflates, the migration of export industries will certainly slow and may even reverse.
A less tangible but more important factor is the change of psychology. The property bubble has devalued hard work and elevated speculation and corruption. Especially since 2008, fewer and fewer businessmen believe in building a long-term franchise.
There has been one road to riches: holding a piece of land and waiting for its price to skyrocket. This may be the most important factor that, despite a vast economic boom, few Chinese companies have built a good brand or developed technologies.
When the bubble bursts, the incentive for businessmen will change. The reward will go to those who build better products, not those sitting on a piece of land. I believe that many great companies will rise up in the next decade. Even the property industry will be better.
Beyond the bubble, the property industry is just like others. It makes money from building a quality product, not for offering a gambling chip. China’s property industry will become far better.
Contagion is the scary part of a financial crisis. When one product or institution fails, investors or depositors may run for the exits from all similar products. The snowball effect can trigger the bankruptcies of healthy companies, which could bring down the whole economy. In China’s case, this risk is relatively small.
Trust products backed by land are most likely to fail. Such failures have very little impact on the real economy. The borrowing company is mostly a piece of land. The ripple effect on the real economy is quite limited.
Investors in such products are high-net-worth individuals. They knew the risks before buying such products. The significant risk for the economy is the knock-on effect on the banking system.
Often banks are the senior lenders before trust loans. If many trust loans go into liquidation at the same time, the resulting liquidation value may not even cover the senior lenders.
When a trust product fails, China’s financial regulators should step in as soon as possible. Debt equity swaps, for example, could contain the risk quickly. The original owners of the underlying assets should be kicked out or diluted massively, while the investors in the trust loan should become shareholders. It buys time for orderly liquidation.
The most meaningful impact of financial failures is the reductions in local government revenues. China’s credit growth has mostly gone to local governments as loans or revenue from the property sector.
The reduced local government spending may slow the economy in the short term. This effect is mitigated by the rising purchasing power of the household sector due to declining property prices. The declining production costs due to less local government spending will also boost China’s export competitiveness. This is essentially a necessary step in rebalancing the economy.
Avoiding panic-driven bailouts
When a wave of financial failures occurs, the sense of panic could permeate all segments of the economy. The fear of a total economic collapse could push a government into bailing out investors indiscriminately.
Indeed, it would be in the interests of the vested interest groups to exaggerate the impact of a financial crisis on the real economy to justify wholesale bailouts with taxpayer money. These are the people who created the bubble and want to cash out with government help.
When some trust products fail, possibly in a few months, talk of a massive financial crisis and economic doom will surely surface. It would be a big mistake for the central government to rush in with a bailout. Just give it some time and the whole thing will calm down.
If the financial regulators prepare contingency plans now, this risk can be contained. If not, they shouldn’t rush into decisions when some financial failures occur.
China’s next growth cycle depends on raising productivity and labor income. The required reforms may need huge amounts of funds to strengthen the social safety net and improve education and research-and-development. If massive amount of funds are spent on bailing out bubble legacy problems, China’s future could be crippled.
Some argue that the property bubble is essential to China’s economic prosperity. This is utter nonsense. While the property industry has become bigger relative to the economy over the past decade, it mostly consumes resources and doesn’t enhance overall productivity.
It is the main driver for China’s inflation. If it shrinks, the economy may suffer temporarily. However, overall productivity will rise. The resulting income growth will bring back more sustainable economic prosperity.
Also, a bubble bursts sooner or later. Government help merely prolongs it, as the Chinese government did in 2008. And the longer a bubble lasts, the more damage it inflicts upon bursting. The economy is suffering because of what happened in 2008.
The country has sufficient capacity to absorb whatever non-performing loans may come out of this bubble bursting. It could be 20 trillion to 30 trillion yuan ($3.26 trillion-$4.89 trillion). But the waste in the bubble economy could have been 5 trillion yuan.
China could overcome the legacy of the bubble in four to five years. Further, better productivity from post-bubble reforms could add another 2 trillion to 3 trillion yuan per annum. The post-bubble recovery could happen in three years.
Japan couldn’t get its economy growing after its property bubble burst. The main reason is that its per capita income was already among the highest in the world.
China is still a middle-income economy. Improving productivity is not that difficult. Reaching per capita income of $20,000 by 2030, excluding inflation, is quite possible, which would make China the largest economy in the world.