Asset bubbles develop because investors either don’t know that prices are too high or care more about the short-term profit potential than the long-term fallout. China's property market seems to have passed from the first explanation to the second, and things could end badly – even for U.S. stock investors who haven’t bought in.
Land prices in China are up 800% since the first quarter of 2003, according to Jing Wu and Yongheng Deng of the National University of Singapore and Joseph Gyourko of the University of Pennsylvania's Wharton School, who released a startling working paper on the matter in July. The central government has been one of the most fervent bidders, paying an average of 27% more than other investors for comparable properties.
That prices are higher doesn't necessarily mean they're too high, of course. To spot a bubble, an investor must compare prices with some relevant benchmark of underlying value (as in the price-to-earnings ratio for stocks) or a measure of means to pay (as in the ratio of college costs to starting salaries). In America, Robert Shiller and Karl Case, creators of the Case-Shiller index of house prices, deserve credit for warning well before house prices peaked in 2006 that price-to-rent and price-to-income ratios had reached record levels. Data for that hasn't been available for China – until the aforementioned trio compiled it for their study.
Price-to-rent ratios in Beijing and seven other large markets are up 30% to 70% since the beginning of 2007. If the booming economy was behind rising property prices, one would expect prices, rents and incomes to rise more or less in tandem. As of the first quarter of this year, the price-to-rent ratio had topped 45 in Beijing and Shanghai and reached 65 in lovely Hangzhou, 80 minutes from Shanghai by high-speed train.
How high is too high? In April 2007, I calculated that the ratio of median single-family house prices to median rents had doubled, to 20, from 1940 to 2005. In Manhattan, controlling for square footage, it was 22.
The study's authors reckon that if expectations in China suddenly shifted toward commonplace growth rates, prices would have to plunge at least 40% to compensate.
Frothy house prices in China would matter little to ordinary investors in the U.S., but for two things. First, housing bubbles tend to precede economic crises. According to Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard, authors of “This Time It's Different: Eight Centuries of Financial Follies,” local house prices rose an average of about 25% in three years prior to the "big 5" banking crises since World War II: Spain in 1977, Norway in 1987, Finland and Sweden in 1991 and Japan in 1992. Each was associated with a long decline in economic performance.
The second reason for concern is that U.S. firms depend on China for a meaningful portion of their sales and a large portion of their growth, and they're quickly adding exposure.
China is now worth more than $150 billion in yearly sales to U.S. firms, the U.S.-China Business Council reported earlier this week in testimony prepared for Congress. U.S. exports to China totaled $69.5 billion last year, while U.S. companies operating in China brought in sales of $98.4, a fourfold increase from 2000. For comparison, the average member of the Dow Jones Industrial Average records about $90 billion in yearly sales. China is now a top 10 market for American firms, says Errin Ennis, vice president of the council, which represents U.S. companies that operate in China, such as Citibank (C) and Caterpillar (CAT).
Citibank announced at the end of August that it plans to increase its workforce in China from 4,500 to 12,000 over the next three years.
Caterpillar chief executive Doug Oberhelman said at an August analyst meeting, "We are stepping it up big time and putting our money where our mouth is with investments over there."
The above sales figures might understate the exposure. They're nine months old, and China's economy is growing at an estimated 10% a year. Also, the numbers don't account for U.S. sales to European companies that depend on China for part of their prosperity.
For now, with China’s property prices up 9% from a year ago and the Dow flirting with 11,000, there seems little to worry about. That alone is reason to worry.
Jack Hough is an associate editor at SmartMoney.com and author of "Your Next Great Stock."
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"Land prices in China are up 800% since the first quarter of 2003..." http://bit.ly/8XCpCM via Jing Wu,Yongheng Deng,Joseph Gyourko
RT @SmartMoney: China's Property Bubble Could Hurt U.S. Stocks http://bit.ly/aSv89j http://myloc.me/cTTsq
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