My F&M

China Syndrome

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Economic growth in China has been the envy of the world for years.  But an apparent property bubble combined with tightening credit raises the specter of economic retrenchment there, with significant global implications. 

Much economic data from China is considered suspect, but China just reported better than expected GDP growth of 7.4% in the first quarter of this year.  That's certainly strong on the surface, but anecdotal evidence points to possible trouble ahead.  Apartment construction, sale, and furnishing accounted for 23% of China's GDP last year.  That's up from only 10% as recently as 2006, and higher than the share of GDP represented by housing in the US at the peak of the US housing boom, indicating a likelihood of overbuilding.

China's real estate market may be at less risk than the US real estate market at its peak because mortgages in China require large down payments and they have no sub-prime or "Alt-A" mortgages.  On the other hand, real estate may represent more risk to China's economy because property is estimated to represent about two thirds of its household wealth - about twice that in the US at the peak of the housing bubble.  Moreover, the slowdown in real estate activity in China would have far reaching effects.  For example, taxes and fees on real estate sales represent about 40% of the revenue of local governments in China.

In one "second tier city" in China, it's estimated there is a 6-8 year overhang of supply of apartments, and at least one developer there cut apartment prices by 40% in February.  More broadly, in the first quarter of this year, real estate sales were 40% lower than a year ago in China's four largest cities. 

The rapid rise in real estate prices in China in recent years was fueled by a massive credit expansion.  Private credit in China grew from 125% of GDP in 2008 to 190% of GDP in 2013.  Now, bank credit appears to be getting tighter as bankruptcies are on the rise.  Structural issues in China's financial sector (notably, the lack of a profit motive in bank lending, and issues surrounding China's "shadow banking system") could magnify fallout from a real estate bust.

Warnings about an imminent "hard landing" for the Chinese economy have been both frequent and wrong for years.  But similarities between China's real estate boom and our own at the peak of our bubble are too striking to ignore.  We're not forecasting, we're just sharing an observation of conditions that bear watching.

China represents a small portion of Emerging Market equities and a smaller fraction of world equities.  Our own average exposure to China (through Emerging Market mutual funds) is only 2% of total equities managed.  But China's recent growth has been a significant portion of world economic growth, and a slowdown there would have a material impact on Emerging Markets in particular and on worldwide economic growth to a smaller but still meaningful degree.

We would like to expand our exposure to Emerging Market equities, and a few years of significant underperformance leaves the valuation of Emerging Market equities more appealing than that of the US, Europe, or Japan.  But a credit fueled real estate boom in China doesn't look like a solid economic foundation, and our assessment of risk in China leads us to defer expanding Emerging Market exposure for now.