The Chinese property market has been crashing since the late 2007. Personally, I think it’s a good thing that the Chinese property and stock markets crash from time to time. You need a very sharp drop every now and then to remind people that they are dealing with risky assets, which they should use their Vegas money to gamble with.

The trick is to have a system that allows the real estate and stock markets to crash without destroying the entire financial world. If you need to ask yourself what happens if property values in Shanghai drop by 60%. If the answer is, some rich people become much less rich, but the world goes on, this is good.

If you look at Chinese state banks, they aren’t very heavily exposed to real estate. If someone wants to invest their own money in a stupid real estate deal, that’s fine as long as it’s their own money.

If they start borrowing massive amounts of money that come from checking accounts, then we have a big, big problem, because when the bubble bursts, it will cause everything else to crumble.

Pettis does make a good point that boom times can hide a lot of bad loans, but we are now in the middle of a bust, and if the banks did have bad loans, then would have exploded by now.

greg: Not necessarily. Does that portend a significant slowdown or even crash of the overall Chinese economy?

I don’t think it does. The Chinese real estate and stock markets have crashed before. It hasn’t taken down the banks. Also, I think don’t think that a real estate bubble exploding is going to really cause even slow growth.

You look at a building that is half rented or half built, and then ask what is the most economically useful thing that you can do with it. If the building is built with equity capital, then the owner puts out a sign “CHEAP APARTMENTS FOR RENT” just takes a loss. If you have the building built with borrowed money, then you are looking at extreme pain and agony as people sort out what happens next.

Meanwhile you have an ugly mob outside the bank wanting to know where their money went.

Anders: He seems to think they are going to consume less and save more, thus slowly down the growth of any export based economy. Seems right to me.

Except that China’s economy is not strongly export based. Where I think Pettis is wrong is:

1) I think he vastly underestimates the ability of the Chinese government and economy to change, when there is an strong incentive to change.

2) I also think it vastly underestimates the importance of non-numerical measures. If you want to understand the difference between US and Chinese banking, you simply cannot just look at numbers. There is this idea that the only way you can control an economy is through things like interest rates, currency values, etc., when things like the fraction of security that you require for mortgages makes a huge difference.

The other thing is that my guess right now is that the ultimate source of financing for real estate projects in China didn’t come from Chinese banks but rather from Western ones.

I think Pettis is using the U.S and E.U consumer to predict China’s trendline growth. He seems to think they are going to consume less and save more, thus slowly down the growth of any export based economy. Seems right to me.

This is one of Pettis’s better blog post. It reflects the view of a particular foreign investor, on the real estate market of a particular city in China, based on his cursory inspection. It’s one interesting data point.

Does that lead one to conclude that the crash of Chinese property market is imminent? Not necessarily. Does that portend a significant slowdown or even crash of the overall Chinese economy? Far from it.

Don’t get me wrong. I also think China’s real estate markets in some major cities are over-valued based on my own experience and assessment. But for a lot of reasons, I suspect it can and will stay that way for quite some time, including cultural and structural. The important questions that are of interest to our discussion here are 1) is it going to impede the growth of overall Chinese economy significantly? and 2) is the potential real estate market downturn, if it occurs, pose some serious systematic risks to the financial system?

My answer to both question is no, not likely as it current stands.

China’s housing market is pretty young and will definitely experience ups and downs; there will be quite some changes to the sector (property tax, for instance). To use real estate market to predict China’s trendline growth is not appropriate. And that’s where I disagree with Pettis, not whether a particular sector has problem or not.

This is something that you can check by looking at bank lending. One thing I think people seriously got wrong pre-crisis was over estimating the degree to which Chinese real estate was financed by the state banks.

The problem with bank loans funding real estate (or stocks) is that real estate prices (and stocks) crash, and if you are funding risk investments from risk-free demand deposits, you are going to be sunk when the inevitable crash happens.

As point of fact, Chinese banks *don’t* lend a spectacularly large amount to real estate projects, and real estate projects usually get their loans from places other than banks, which is *really* important. If you get your money from an investment pool of rich investors using their own money, and the project blows up, you don’t put the rest of the world at risk.

Anders: No ne can buy real estate at the prices the developers want, and there will be no more speculative bets on stocks and on inventory build up.

The big other problem with using bank loans to fund real estate is that you can’t take a loss when you need to. If you fund a real estate project with borrowed money, then it is *painful* to drop the price, because if you drop the price of real estate, the bank forecloses and you lose everything.

If you own the project 100%, it’s much, much easier to drop prices. One important point is that China has had both a major stock market crash and a major real estate crash (and it has these once every few years). Because people are doing things with their own money, it doesn’t collapse the banking system when you do have a crash.

Anders: Basically we don’t know where the money goes and we don’t know how it’s spent, so it comes down to if you expect the worst or the best of the system. It could be a little of both.

If you don’t know, figure out what you need to know, and then go find out. If you have to find a dozen real estate developers in Shanghai and find out the ultimate source of their money.

One important thing about Chinese banks is that many of them are listed in HK or NYSE, so they have to issue financial statements that are as good as any that you can see in an American bank.

Also, if you don’t know the details, then you have no basis for judging the soundness of the system. If your judgment is based on guesses as to whether the system is good or bad, then what do you use to figure out if the system is good or bad?

It’s actually “I don’t believe it.” Whether or not it is true or not is something that we need to argue about. “It’s not true because I don’t believe it, and I don’t believe it for the following reasons which you can contradict.” is a lot stronger argument than “It is true because everyone else believes it, and I haven’t done any fact checking to explain why.”

If I agree with the conventional wisdom, then I tend to shut up, because there’s no point in me talking.

The fact is that American banks blew up. Chinese banks didn’t. This was against the conventional wisdom, so if you want to explain what China and the United States should do next, it’s not unreasonable to ask you to explain why you think that it.

But as many people have argued, as Wang Qing in his articles above, and me in Pettis’s blog, China’s stimulus is mostly about infrastructure spending, earth-quake reconstruction, social programs and consumer subsidiaries. They’re NOT about investing in excess manufacturing capacity,

I still think that a lot of the bank loans (or stimuli) were spent on real estate developers refinancing of their ongoing projects, the starting of new real estate projects, on speculative bets in the Chinese stock market and on inventory build up.

If you are right that most of the money went into reconstruction after the earth quake, social programs and consumer subsidiaries then all is good.

The thing is if I guessed right then a pull back of credit from the Chinese banks (because of inflation fears) will cause problems, because no ne can buy real estate at the prices the developers want, and there will be no more speculative bets on stocks and on inventory build up.

Basically we don’t know where the money goes and we don’t know how it’s spent, so it comes down to if you expect the worst or the best of the system. It could be a little of both.