China's Overinvestment Quandary
China is finding out the hard way that investment is not an end in itself. The object of economic is to satisfy consumption. Investment is merely a means of getting there. High rates of investment are fine – so long as someone can afford to buy all the new housing and all the fruits of new factories and offices. Clearly in China the absurdity of investment rates of 45 percent of gross domestic product – compared with maximum sustained rates of 35 percent in Japan, Taiwan, Korea etc during their periods of maximum growth – is finally coming home to roost.
The danger for the world is that China’s leadership will see another export drive as a way out of the hole they have dug for themselves. If they try, one can confidently predict a surge in protectionism that will undo two decades of liberalization, or US policies aimed specifically at trashing the dollar’s value in order not only to undermine China’s export push but the worth of its almost US$2 trillion worth of securities.
For sure, China would like to avoid the sort of overconsumption now coming home to roost in the US. But its overinvestment now has similarities – including on defense-related industries – which have a few echoes of the Soviet Union of 50 years ago.
There are several end-product industries in China that have grown far faster than the incomes needed to make them viable. In turn their overexpectations have propelled investment in capital and energy-intensive basic materials industries such as steel and aluminum which have eaten up vast amounts of money – money which would have been better spent on boosting household incomes.
Take cars. There are few better illustrations of the income gap which has developed in China than that between the car owner and the bicycle owner. China has had relatively
little of the intermediary-income stage that propelled the motorbike industry throughout Southeast Asia. Indeed many Chinese cities actively discriminate against motorbikes to create more space for cars. The car industry itself has meanwhile shown a tendency to move up-market as both local and foreign-owned manufacturers try to keep not too far behind the product standards of Japan, Korea and Germany. Such progress can help them get into the exporting business, but tends to drive up standards and prices to levels which restrict sales. Thus today even though fuel prices have fallen, car demand is falling further and further behind capacity. In turn this is adding to the stockpile of steel, aluminum and copper piling up at other plants.
Another example is the housing market. Improvement in housing standards has been one of the greatest accomplishments of the reform era after decades of Maoist failure. But price bubbles have been developing over the past two or three years, varying in pricing and timing depending on location, which have made much of the new development, especially in the bigger and better known cities, unaffordable. The bubble spawned hundreds of new developers with access to easy money and helped along by cozy deals with local authorities who control the land supply.
Land prices escalated, municipalities and the early developers profited immensely. But now there is a massive overhang of completed and half-completed properties which are beyond the reach of median income earners. The developers meanwhile are reluctant to cut prices to market-clearing levels either because they still have inflated expectations of profits, or because to do so would bankrupt them. Indulgent bank managers allow them to hold out for a price recovery rather than sell at prices that people can afford.
Matters are being exacerbated by the fact that many developers were inadequately capitalized in the first instance and relied on increasing sales to fund building commitments rather than on progress payments from buyers. Others too had been expecting to raise capital through equity listings – before the bottom fell out of the new issue market. For almost all of them, this was their first experience of a property slump.
There are a handful of listed developers such as Vanke and Country Garden, who mostly should survive the crunch. Well-capitalized Hong Kong developers such as Kerry Properties (the Kuok group) are also a factor in some major locations. They can either hold on in hope of recovery or are strong enough to slash prices without going under. Some acquired their land banks a few years ago so can still sell at a good profit. But most developers are small, local and un-listed so have no ready access to outside capital to seem them through.
Government help has come in the form of easier mortgage terms – lower interest rates and long repayments – as well as cuts in transaction costs and staggered payments for land. Banks have generally been accommodating. But some developers have been borrowing at high costs in the informal money market. Only measures which increase affordability are of much help to the market as a whole. Some measures simply delay the day of reckoning. Nor do they encourage buyers who fear that a developer will go bust before completion.
The government itself is also aiming to greatly increase its output of low-cost housing to meet latent demand as the drift of people from farm to cities continues despite the overall slowdown. Low-cost housing was too long ignored by private developers who are now stuck with excess inventory of unaffordable buildings and over-priced land. In the longer run government action will spur construction – but it may also reduce the potential for the private sector to change its product mix.
For now the weakness in housing is adding to the glut of steel, cement and other materials. The downturn is far from uniform. Generally those cities where prices rose most rapidly have the bigger gluts, particularly in suburban locations. Inland cities are reportedly less impacted than coastal ones.
But overall, the worst has yet to come. The longer that developers hold off cutting prices to market-clearing levels the longer it will be before a new building cycle can get underway. It is not just that the developers are unwilling to face reality, or not being forced to do so by their bankers. The government itself is in two minds whether it wants prices to stabilize to protect lenders, stock prices and land revenues, or can see the merit in focusing on demand and affordability. Unfortunately, like many in the west it is still hooked on the notion that high property prices are a good thing, a reflection of success. In reality they are a barrier to consumption, denying households good accommodation at a low price and forcing them to save so much for property purchases that they cannot afford those fancy new cars and panel TVs.
Despite official resistance, market forces will probably eventually prevail. That means that it will be well into 2009 before developers admit reality and drop their prices significantly. There will be plenty of corporate carnage – and much cheer for the families who want to buy an apartment.