Chinese Decision on Rates Seen as ‘Turning Point’

China’s central bank raised the yield from its weekly sale of three-month central bank bills on Thursday; the first time in nearly five months (NYT – Chinese Decision on Rates Seen as ‘Turning Point’). While the .05% sounds very small, central bank tightening is highly directional, and today’s action is likely a harbinger for future rate increases.

While Chinese government and business leaders have begun to express concerns over inflation and seemingly speculative investments in real estate, today’s interest rate hike represents the first tangible move to tamp down the country’s bourgeoning money supply. Actions always speak louder than words and we saw a similar development in mid-2007 as China took aggressive actions to counter inflationary forces in its economy (though it took about 6 months for the stock market and economy to feel the full effects of their actions).

Today’s action by the central bank follows on public comments made by the CEO of Vanke, China’s largest property developer. The Wall Street Journal provided the following quote in a December 4th article (“Vanke Sees China Bubbles”):

Nationwide, "things haven't risen to a property bubble yet," said Mr. Wang, who founded his company 25 years ago and has built it into the biggest housing developer in one of the world's fastest-growing housing markets. But "in individual cities, and in some of the main cities, there is clearly a bubble. There's no doubt about that ... I'm very concerned." Mr. Wang said he fears the trend could "infect second-tier cities, which would be similar to the nature of the Japanese bubble decade" that imploded in the early 1990s.

The 58-year-old said he is, overall, "cautiously optimistic" about China's economic outlook. But he expressed concern about the prospect of continued inflation in asset prices next year because of the massive stimulus, which he said could prove hard to reel back in. "This kind of monetary expansion, which goes into fixed-asset investment, into infrastructure -- you can't just stop it by saying stop," he said.

While it is always difficult to identify a “bubble” and I will concede that there seems to be a “bubble” in the growing use of the word bubble, several data points support the view that housing is getting overheated in China. Firstly, home price/median income ratios are off the charts in China (~9x in Shanghai vs. 3x in the US). Also, banks and many companies have heavily gotten into the real estate business. The government has mandated that state-owned banks increase their lending and much of that is being directed into real estate – some press reports have indicated that up to a third of new loans has been directed to such activities. Common sense should leave one skeptical that a government controlled economy/banking system can effectively allocate 25% of GDP in 6 months (which represents the 1 trillion yuan of lending made by Chinese banks in 1H 2009 benchmarked against the country's 4 trillion yuan economy). Tremendous excess capacity is being built in all parts of the Chinese economy, with housing receiving the most attention.

Admittedly, China lacks the systemic flaws that devastated the US housing market. Chinese consumers are limited to borrowing 70% of the price of their houses (and less for second properties) and the irresponsible securitization of mortgages is non-existent in China. In fact, many Chinese investors are paying 100% cash for their homes.

However, as I have made clear to a few friends who have debated me on the topic, asset bubbles can still be inflamed with 100% equity. If my memory serves me correctly, I lost a ton on tech stocks in 2000/2001 and I am proud to say I didn’t use one penny of leverage!