China May Not be the Driver for Global Economic Recovery

Since the 2008 financial crisis, the world has relied on Chinese economic growth to drive the global economic recovery. But that hope is increasingly diminishing since China has its own inflation and economic battles to fight and a possible real estate bubble burst just like the one that occurred in the United States prior to the 2008 financial crisis.

It is widely believed that the trigger of the 2008 global financial crisis was the housing bubble that occurred in the United States. This crisis affected the global economy like no other crisis before it and the world had hoped that China would be the vehicle for the global economic recovery. After all, China has the world’s largest population and its manufacturing sector is the strongest in the world. However, China’s manufacturing sector has weakened sharply, recording its worst reading since February 2009 during the depths of the global financial crisis and, in addition to inflation issues, there are indications that China might soon experience its own housing market bubble burst. If that happens, not only will China not be able to rescue the global economy but that its banks and other world banks, by virtue of global financial connectivity, will suffer as a result.

After the 2008 global financial crisis, many countries, including China, coordinated unprecedented monetary and fiscal stimulus plans in order to avoid a global financial meltdown and to save the global economy. And even though China was still growing at 6 per cent, the Chinese government followed suit and initiated the largest fiscal stimulus package (as a percentage of GDP) in the world, which was about three times the size of the US fiscal stimulus. That flooded the Chinese market with lots of cheap money that resulted in a sharp increase in its already healthy economic growth and helped many commodity-rich economies which have particularly benefited greatly from China’s massive economic growth. The manufacturing sector in China experienced the most growth and its housing sector grew at an unprecedented rate. The downside of that monetary easing, however, is that China is now battling serious inflation and a possible real estate market bubble just like the one that occurred in the United States which led to the 2008 financial crisis.

In order to try to bring inflation under control, China has embarked on an aggressive monetary and credit tightening policy and has raised interest rates for the fifth time since October 2010. But this has not worked as hoped and China continues its battle to rein in inflation. The potentially bigger problem in China’s monetary and credit tightening policy is that it may be damaging its economy dashing with it all hopes for China to help the global economy get out of its slump that it has been in since the 2008 financial crisis.

China is trying the difficult task of controlling inflation without crushing its economic growth. If China fails, then either inflation will spiral upward or a significant economic slowdown will occur. Either one of these two outcomes will mean trouble both for the Chinese and the rest of the world. If inflation continues, the Chinese people will have difficulties affording even the basic necessities, particularly food, let alone paying off their newly acquired loans and mortgages. And if their economy slows down, unemployment will be as problematic as it is here in the United States. And either outcome will also create big problems for the global economy which has relied on Chinese growth to drive global economic recovery. Yet a bigger problem for China and the world is a real estate bubble burst in China, which many economic observers believe may be inevitable.

“Real estate bubbles tend to burst when there are increases in interest rates, downturns in general economic activity, or exhausted demand”, as one analyst put it. All three of these issues will occur if China fails in its effort to control inflation resulting in an economic downturn, a diminished demand and a possible real estate bubble burst. Indeed, many studies suggest that there are signs pointing to a real estate market bubble bursting in China.

A recent study by the US’s National Bureau of Economic Research (NBER) discussed the already high price-to-rent ratio in Beijing and suggests that a significant price appreciation year over year has to occur to financially justify buying a property versus renting one. This means that if annual home price appreciation slows down to only 4 per cent, prospective home buyers would find it more attractive to rent than to buy. NBER also estimated that a slowing in real estate demand would likely trigger real estate price declines in Beijing of over 40 per cent.

Another study by Jim Chanos, a prominent China bear and hedge fund manager, shows an over-investment not only in Chinese real estate but also in Chinese fixed asset investments in general. Never in modern history has there been a record of a country that has invested so heavily in fixed assets (greater than 40 per cent of GDP) for such a sustained period of time, Chanos explains. He estimates that the overbuilding in commercial real estate has been so extreme that there’s a 5×5 cubicle for every man, woman and child in China.

Unless the Chinese economy continues to grow at a double digit year after year for several years to come, a burst in the real estate bubble is a likely scenario. If such a burst does occur, then all hopes that China will be the driver for the global economic recovery will be crushed. Even a moderate slowdown in Chinese economic growth will be significant. Fitch Ratings suggests that a Chinese slowdown to 5 per cent growth would result in a 20 per cent plunge in global commodity prices. This will affect many emerging markets particularly those commodity-rich economies that have benefitted the most from China’s impressive economic growth since the 2008 global financial crisis and before.

With the global economy so interconnected and so dependent on a continued double-digit economic growth in China, a real estate bubble burst in China will render it and its already unstable global financial system yet another severe blow. We reckon that the rippling effects of the 2008 global financial crisis are still unfolding.

* With contribution from Bruce H. Pugesek, President of Voyageur Research

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