China - is this a bubble soon to burst?

Today it was announced that Chinese inflation hit a 16 month high, meaning potentially higher interest rates. The annual rate of consumer price inflation rose to 2.7% in February, up from 1.5% in January, and ahead of analysts' expectations of 2.3%. In addition, new loans exceeded forecasts, adding to the case for the government to cut stimulus measures. The People’s Bank of China hasn’t raised benchmark interest rates since December 2007, but the central bank has ordered commercial lenders to increase their capital reserves three times since last December. However it has been pointed out that the figures should not set alarm bells ringing, as the New Year in 2009 fell in January not February, economists say the rate of increase in consumer prices in February 2010 was boosted as it is being compared with weaker spending last year.

China's exports in February were up 46% from a year ago, which was more than analysts' forecasts and the economy grew by 8.7% last year, exceeding government expectations driven partly by the Rmb4,000bn ($585bn) stimulus programme. The Shanghai Composite (SSE) is down 7% year to date to 3,052.

In addition to inflation concerns, some commentators worry about the Chinese property market increasingly looks to be entering a bubble phase. But an interesting perspective was offered by the FT.com today, "Unlike the dramatic increase in household leverage that precipitated the US subprime crisis, Chinese household debt amounts to approximately 17 per cent of gross domestic product, compared with roughly 96 per cent in the US and 62 per cent in the eurozone. Home buyers in China are required to make minimum downpayments of 30 per cent before receiving a mortgage, and at least 40 per cent for a second home.

Although price increases in the Chinese residential market appear rapid (more than 20 per cent in 2009), such headline figures cannot be viewed in isolation. Over the past five years, urban household incomes grew at a 13.2 per cent compound annual growth rate, compared with an 11.9 per cent CAGR in home prices. Pockets of overheating can be found in some regional markets. In Beijing, Shanghai, Shenzhen and Hangzhou, for instance, prices outpaced income growth by more than 5 percentage points over the same period. But, this can be seen as a symptom of new urban wealth being put to speculative use, rather than the profligate use of leverage.

The combination of excessive leverage and mortgage securitisation were at the epicentre of the US subprime crisis. Both these factors are absent in the Chinese context. The commercial property sector has inspired just as much concern, with prices rising 16 per cent in 2009, in spite of low rental yields and prime office vacancy rates as high as 21 per cent and 14 per cent in Beijing and Shanghai, respectively. Yet occupancy and rental rates have started to pick up for prime properties.

The crux of the problem with the Chinese real estate sector is that property is seen by the country's investing class as a store of value, within an economy that offers its citizens limited investment options. I share many of the concerns about flawed incentives and overheating in the property market - but even if prices were to correct, this would not trigger the type of devastation that might arise in an over-leveraged economy."