This article was originally published on December 16, 2011.
As China goes, so goes the world.
My column of June 24, 2011 (“China Yield Inversion May Portend Economic Slowdown”) opened with the following sentence:
“The yield on Chinese bonds are inverting at an accelerating rate. This does not portend well for the Chinese economy, and this may have negative implications globally.”
China’s contribution to global economic growth this year is nearly 40%.
The reason: property construction in China boomed significantly during the previous decade.
The Chinese government controls all the allocation of land. Beginning in 1998, Chinese authorities permitted individuals to buy the “right” to use property for 70 years. Domestic capital controls, which limited investment outside China, increased demand for this asset.
As a result, property construction boomed. The increased supply resulted in high levels of employment, income, and demand for residential and commercial properties.
The problem: insufficient demand to absorb the excess investment in property development.
According to the National Bureau of Statistics in China, real estate development for 2011 will total nearly $1 trillion, a 32% increase over last year. This investment represents approximately 15% of GDP, as calculated by the World Bank.
According to Jonathan Anderson of UBS, this is “the single most important sector in the entire global economy, in terms of its impact on the rest of the world.”
The reason: significant, productive economic activity is dependent on this sector.
Forty percent of Chinese steel use is related to property construction. China produces more steel than the next 10 steel producing countries combined, deeming it the most important procurer of iron ore, a key input for steel manufacturing.
Other essential steel manufacturing inputs are copper, cement, coal, and power generation. These activities generate a significant amount of income that is used to purchase global products and services.
Today, the average home price in China equals 9 times average annual income. The price for luxury apartments in Versailles Residentiel de Luxe La Grand Maison, located in the city of Wenzhou, are 350 times average annual income.
The perspective: at the peak of the U.S. real estate bubble, this ratio was 5.1. It is currently near 3, the historic average.
Using the current income level in China, real estate prices would need to fall by two thirds to be sustainably priced. Should income rise 50% in the coming decade (4% per annum), prices could fall 50% to achieve a stable equilibrium.
In the past year, real estate transactions (sales) and prices have fallen dramatically. At the current rate, prices may drop 50% within over the coming decade.
This decline has been due to low income demand at the current price level and the tremendous supply of inventory (approximately 20 years based on current vacancies, pending projects, and future population projections).
Demand for property development is decreasing. Less construction translates into lower income, personal, corporate, and governmental (local government derives 40% of its income from property sales). Smaller incomes suggest lower demand for global products and services.
In addition, lower property values imply less collateral for future credit, thereby limiting growth prospects.
This portends poorly for the global economy.
China’s annual trade surplus has been halved since 2008 to roughly $150 billion. This reflects a decrease in export and import growth, with exports declining at a greater rate. This decline is partially a manifestation of decreased demand by the eurozone and China’s domestic market.
In recent years, China increased the required reserve ratio for bank deposits to limit monetary growth, reduce aggregate demand, and minimize inflationary pressures.
However, due to the impending global economic slowdown, China recently reduced the reserve requirement to foster economic growth.
Deleveraging of the massive global debt, which is 3 times global income, will reduce monetary velocity (transactions) and income over the next decade.
Increases in monetary aggregates, credit, and liquidity may provide meager assistance in the immediate term.
In fact, it will delay, and possibly exacerbate, the underlying economic dysfunction, thereby extending anemic global growth for years to come.
Moreover, the increased money supply, without much increase in value added product supply, will increase transaction demand for existing products, thereby placing upward price pressures.
Lower government revenues may require additional debt issuance at higher interest rates to attract scarce capital. Existing economies of scale may not be sufficient to offset a possible increase in borrowing costs. Upward pressure on retail prices may result, creating an inflationary spiral.
Global stagflation may be the new paradigm over the coming decade.
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