Will the Bubble Burst in China?--From Historical Evidence Perspective

    In the previous posts, I talked about the housing bubble in Japan in 1980s, the present housing bubble in China, and we compared the two bubbles and found some similarities and differences between them. A distinct difference is that bubble in Japan burst at last whereas bubble in China still exists although it has remained for a long time. After stating the reasons that the bubble still maintains in China, there is still one thing we are curious, when will the bubble burst? In this post, I will find some historical evidences about the prerequisites that may cause a bubble burst, and plug in these conditions into current Chinese housing market and banking system to see if these conditions may burst the bubble in China. If they cannot, what else conditions may be needed to burst the Chines housing bubble.

    From the flow chart above, we can observe the relationship between the banking system and the housing market. All the arrows in the graph actually connected the whole process and they are also the key points containing the potential risks of the process. Either one of them having a problem may cause the bubble in China burst.

 

• Assumption of Problem Hapening in the Housing Market System

 

    From the historical evidences of bursting house bubble, we first consider the problems happening in the middle two and the bottom two arrows. Actually, these arrows are largely connected. Let us start from the left middle arrow. If the individual borrowers cannot afford their mortgage, the bank will recall the house and auction it to other people. If only a few individual borrowers default, this could not be a problem as other buyers will bid the houses and bank will get their bills paid by others. But if a lot of individual borrowers default, auction may not be successful as everyone in the market is lack of funds. The house price will fall dramatically as bank only care if they can get their cost back. This is what exactly happened in the USA 2007. Therefore, massive individual borrowers default may cause the bubble burst in China.

 

    Turn to the right middle arrow. When the housing price is extremely high and almost no buyers for the houses, then some real estate companies may fail to pay the loans within the specified time because they are lack of liquidity. At this point the bank may cut the successive loans to these firms and may even force them into bankruptcy and sell their houses at the auction in order not to lose. In this case, the supply of the houses will increase and the price will fall to a certain point, at which the bank can get their cost back and there are bidders for the houses. This means that the house price may fall in some certain extent but not lead to the burst of the bubble. But if there are a lot of bankrupt real property companies and not sufficient bidders or some of the bidders of the auction do not have enough cash. Then these buyers may bid by using individual debt, then the potential problem may happen similarly to the first individual borrowers' default case. So, the problems happening in the middle two arrows which may cause the burst of bubble are: massive individual borrowers default and a lot of real property firms’ default. The above situations would only happen when the credit of the banking system is too easy. As long as the central bank controls the credit standard, these two scenarios tend not to happen.

 

• Assumption of Problem Happening in the Banking System

    So what cause the easy credit? We turn into the top two arrows to find the answer. When central bank decides to low the discount rate and down-regulate the legal reserve ratio, the commercial banks will tend to lend more money out to the public and the credit will become easy. When the credit becomes easy, latent defaulting dangers may emerge. As the bubble has formed, it means that easy credit has already dominated in China. Actually from some data, we can get some results. The residential mortgage rate in commercial banks is 6.55% for long-term loan. This number seems reasonable. But if we take account of the recent inflation rate in China, the real loan interest rate is only approximately 3.5%. This figure may indicate that the credit has become easy in the banking system. If the central bank of China suddenly tights the monetary policy, takes aggressive behaviors such as, enhance the reserve ratio or up-regulated the discount rate to a very high level within a short time period, the tragedy will happen. This is what exactly happened in Japanese crisis. So the Chinese central bank may act to let the housing market ‘soft land’, meaning that constrain the credit standards gradually within a long time horizon rather than behaved radically.

 

• Assumption of Problem Happening in Land Price

    So far I considered about the factors that may burst the bubble by plugging in historical evidences and found some factors, but I still omitted a crucial reason that may prick the bubble---the land price. As we mentioned before, Chinese government has the monopoly control on providing land. If it considerably and suddenly dropped the land price, the housing bubble would burst automatically, because major cost of the real property enterprises come from high land price. However, this behavior may be very dangerous and may cause an economic catastrophe in China. It is good for the government also to take the ‘soft land’ strategy in this case---gradually decrease the land price.

 

    In conclusion, housing bubble bursting conditions I get from the historical evidences and personal views are: easy credit, massive individual loans default, real estate property loans default as well as the dramatic fall in land price. There are a lot of other conditions that may burst the bubble I omit. Whether the bubble burst in China depends really on how the government and the people act. There are too many uncertainties in the housing market. What we could do is try our best to prevent the tragedy from happening by both previous bad experiences and every possible reason we could figure out.