China's real estate frenzy

Real estate is taking off like a rocket in China. Worse, debt is its main booster.

Ten major cities in China saw home prices jump 20 percent from a year ago, up from six cities a few months ago. Along with that increase, long-term household loans surged from 20 percent of all new loans in China at the start of the year to 40 percent in August. "A study by China’s Haitong Securities Co. shows that total home loans are expected to make up 30 percent of China’s GDP this year, up from less than 20 percent three years ago," the Wall Street Journal reported.

It's part of a larger game of debt musical chairs China has been playing. The country's overall amount of debt soared from 150 percent of GDP 10 years ago to 260 percent today — a little over half of which is corporate debt, at 145 percent of GDP. Around 40 percent of new loans are taken out to pay interest on existing loans. Then the money began flowing out of corporate debt and into housing earlier this year, as China relaxed rules and eased credit to soak up the unsold housing supply. The resulting binge on housing debt has clearly taken Chinese authorities by surprise.

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Obviously, in a post-2008 world, rapidly rising housing debt chasing rapidly rising housing prices conjure up some scary memories. But the question of whether China is headed towards its own housing crisis and Great Recession is complicated.

The basic idea behind debt is to smooth out consumption and investment over time: In a perfect world, everyone would always borrow just the right amount to increase their productivity now, without overburdening themselves with debt repayments in the future. But it's not a perfect world, so populations periodically borrow too much, and then the economy goes into recession as money is drained away to pay off the debt overhang.

The thing about the 2008 housing crisis, though, is that it was driven by very creative financial engineering and lots of outright fraud that made mortgages guaranteed to go bad look like triple-A safe investments. It was debt correction on a colossal scale, supercharged by the X-factor of Wall Street shenanigans. The question is whether what China now faces is just a regular correction, or if there's another X-factor at play.

A shadow banking sector not unlike the one that presaged the financial crisis here in the U.S. appears to have popped up in China. It uses convoluted arrangement to pump borrowed money into real estate through what are essentially junk bonds. Loans in China's shadow sector now total 16 percent of standard loans — a big increase from just 4 percent in 2012.

And China pretty clearly seems to be in for some sort of correction. Back in 2008, it took three dollars of investment to deliver one dollar of GDP growth in China; now it takes six dollars.

At the same time, China went through another boom-and-bust in housing stock in 2013 without the world ending. The massive price increases in housing appear to be limited to China's biggest cities. And Chinese regulators in as many as 20 different metropolitan areas are already trying to cool things off with new requirements like higher down payments.

Another thing that could dampen the severity of any crisis — and which makes the mechanics of China's economy a lot harder to predict than for modern Western nations — is the country's weird post-communist hybrid of market capitalism and state-run enterprises. As much as 40 to 55 percent of the corporate debt is owed by companies owned by the government, and so far officials have only allowed a trickle of bond issuers and state-owned enterprises to default. That effectively puts the government on the hook for the debt. Which means, if it comes to it, the government could monetize the debt, print a bunch of Chinese currency, and flood the system with money to pay off the loan obligations. With the country's very low inflation rate, there would be plenty of room to do it.

"[China's] banks are not at the brink of default," Minyuan Zhao, management professor at the University of Pennsylvania's Wharton School, said in July. "If anything, the government still has money to pump into the system to bail out banks. With the implicit endorsement from the government, the likelihood of a bank run or financial crisis is remote."

One last bit of comfort for America, ironically enough, comes from our trade deficit with China. Such low exports to China (they're less than 1 percent of our GDP) also mean very few jobs here in the U.S. rely on demand from China. This has the happy side effect of insulating our economy from the ups and downs in the Chinese economy. China could go into a massive recession, and Americans would barely feel it.

All told, for those outside China looking in, the risks posed by the country's real estate and debt binge are exceedingly minimal.

And for the hundreds of millions of people in China, the risks of a massive Great Recession-style crisis are probably far lower than those of a long slow grind into stagnant growth. China's debt load is largely a product of the struggles the country and its government have had refocusing the economy away from manufacturing and towards services. If it can't figure that out, and its demographic challenges catch up with it, China may not face a sudden cataclysm — but it could face many years of bleak economic prospects.

China's remarkable growth in the last few decades has given the world a spectacular reduction in global poverty levels. Yet there's still a long way to go: On a per person basis, China's economy is still quite poor. It would be one enormous tragedy if that work was cut short.