Why China Can't Cool Its Overheated Real Estate Boom

Even among Western analysts who live and work in China, the major role played by municipal governments in fueling China's increasingly speculative real estate boom is underappreciated. The actions of those local authorities are at the heart of China's property bubble, and they explain why the central government's attempts to cool lending and construction are failing.

China's central government has attempted to douse the speculative flames of its real estate bubble -- prices rose 9.5% in January alone -- by calling on banks to curb real estate lending and by increasing the level of reserves banks must maintain. But those moves are offset by the incentives local governments have to put money into real estate speculation.

The key difference between China's current real estate bubble and the U.S. bubble that popped in 2007 is this: In the U.S., it was individuals and lenders who made overleveraged, speculative bets via subprime mortgages. In China, explained Northwestern University researcher Victor Shih to NPR, the leveraged debt fueling the speculation comes from local governments, which have borrowed trillions of dollars worth of funds from China's banking system to develop real estate projects in their jurisdictions.

Shih has found that almost 50% of the Shanghai government's revenues come from land sales, and local governments have come to rely on this income.

"Local governments now are forming their own real estate developers and would actually buy land from themselves. As this becomes more common -- and it is becoming very, very common -- then local governments have a high stake in maintaining and increasing the value of real estate in their own jurisdiction," Shih observed.

Unsurprisingly, these incentives to boost land values have led to sky-high prices. The right to develop a plot of land in downtown Shanghai was recently purchased for a record $1.35 billion.

Beijing's Own Policies Undermine Its Fiscal Goals

The incentives to local governments start with targets set by the central government. Respected analyst Andy Xie, formerly of Morgan Stanley, observes that local government performance in China is measured by GDP and fiscal revenue -- and both of those numbers can be quickly boosted by real estate development. This makes pouring municipal funds into development a "win-win" for local leaders, even if there's no consumer or business demand for the new buildings.

Xie says this has led to a politically driven bubble, supported by local governments' need to meet the central government's growth targets.

The dependence of local governments on development fees and skyrocketing land values is also fueling a "moral hazard" dilemma. Speculators sense that the government will never let values fall, which encourages further reckless speculation.

In Terms of Real Growth, the "Boom" Is a Bust

Paradoxically, this channeling of China's capital into real estate development is hurting the country's long-term prospects by diverting the capital from other more productive uses. Ultimately, Xie says, this decreases capital efficiency and thus lowers domestic consumption. Though China has been trying to promote domestic consumption for a decade, private consumption as a percentage of GDP has declined every year.

This overreliance on real estate development also threatens the nation's financial stability by increasing debt levels and by relying on overvalued land as collateral. And it creates another systemic risk: Because property prices have increased faster than middle-class income, many otherwise-prosperous households have been priced out of the housing market. This fosters resentment as hard-working people see a handful of local officials and developers becoming wealthy from a bubble that has left housing unaffordable for the vast majority of wage earners.

Moreover, as the white-hot property market creates winners and losers based solely on speculation and political influence, other determinants of income such as education and experience have been marginalized: Ordinary people feel their own efforts won't bear fruit because the system appears to reward only speculators and insiders.

A Feedback Loop of Ever-Inflating Values

All land in China remains government-owned; developers get only leases. But while ownership is clearly in the hands of the state, which level of government is authorized to grant a lease on a given parcel can be unclear. As a result, leases may be negotiated at the local level and essentially rubber-stamped without much oversight by higher-level agencies.

This ambiguity gives local authorities leeway to negotiate leases with companies they partly own and lets them transfer the land at inflated valuations.

Since local governments generate revenues from transfer fees when they lease land to developers, this feeds two bubbles: First, local governments inflate the land prices in order to increase the transfer fees they collect. Then, those ever-inflating values encourage individuals to try to get rich quick by speculating on ever-rising housing prices.

Local governments don't just sell land leases to developers, they also invest directly in developers. That creates additional "one hand washes the other" incentives to play fast and loose with loans and land valuations.

See full article from DailyFinance: http://www.dailyfinance.com/story/real-estate/why-china-cant-cool-its-overheated-real-estate-boom/19371786/?icid=sphere_copyright

Why Asset Bubbles Will Always Surprise Us

Below is a nice article on price bubble i read recently on the Harvard Site:

It would be nice if we could predict bubbles; even nicer if we could prevent them. Unfortunately, this would violate the laws of nature: asset bubbles occur because of the limits of our ability to process information and coordinate activity in a market setting, where no-one is in charge, and no-one has a complete view of the big picture.

Here's how it works. On occasion, the enthusiasm for some growth opportunity or new technology attracts interest from people in the capital markets. Financing is suddenly available. Sooner or later the flow of new money starts to have an impact on the value of the assets being financed. But it takes time for people in the market to become fully aware of that impact.

In the case of the US housing market, prices began to accelerate beyond their sustainable path sometime around, say, 2003 thanks to global capital flows from savings-rich economies, advances in securitization technology, and an insatiable appetite for housing on the part of American consumers and investors. But it took until 2007 for the securitization markets to shut down. It took the broader equity markets another year to understand the severity of the housing crash and the resulting damage to the banking system. The government finally took steps to stabilize the system with TARP in late 2008 and stress tests for the banks in early 2009.

Why did it take so long for us collectively to come to our senses? Because consumers, mortgage brokers, lenders, investment bankers, regulators, CDO managers, rating agencies, and investors in distant countries didn't understand individually what the totality of their actions would mean for US home prices, the financial system, or the global economy.

We may criticize individuals, firms, leaders, and regulatory policies. But it would be unrealistic to think we could expect immediate, collective self-consciousness on the part of any group of people operating in a market setting. Each individual faces a practically infinite quantity of information in our complicated world. And we all have extremely limited resources with which to process this information. No system can be perfectly self-conscious. The kind of immediate social awareness that would prevent bubbles from forming or bursting is a physical and mathematical impossibility.

The inevitability of surprise does not mean that our financial system cannot be made more resilient — the key is to prevent the build-up of leverage (which makes outcomes more severe) and react more quickly during the crisis so that we can speed on our way to recovery. Here are some steps we can take now:

• Make sure public leverage does not become excessive. In addition to bringing down US Treasury debt levels, we should put Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System into run-off, which would help pay off roughly $3 trillion in so-called "US Agency" debt (a close cousin to Treasuries).

• Identify sources of "hidden leverage," such as the reliance by many institutions on similar statistical models (like Value-at-Risk) or credit ratings. We should reform the rating agencies so as to break up the oligopolistic market position of Moody's and Standard & Poors.

• Impose shorter term limits on certain public officials, for example the chairman of the Federal Reserve, to prevent the build-up of excessive investor confidence in the power of personalities or institutions to forestall economic crisis.

• Develop systems to recapitalize the financial system more quickly, with less taxpayer exposure, such as so-called "contingent capital," which consists of debt that automatically converts to equity during a crisis, stabilizing an institution without requiring protracted negotiations among investors or enactment of emergency government programs.

• Develop better corporate governance protocols, so that boards of directors can react more quickly to crisis including, if necessary, replacing CEOs who are caught in the grips of "cognitive dissonance" and unable to react to crisis or change.

Here is the link to the original article:

http://blogs.hbr.org/finance-the-way-forward/2010/06/why-asset-bubbles-will-always.html