oftwominds-Charles Hugh Smith

Favorite Line Ever Written
and, A Healthy Debate on Chinese Real Estate
September 13, 2008

Longtime correspondent David V. recently posed an excellent question, and provided his answer:

An interesting question for your readership: What is the single best line ever written? Or the most moving, most sad, etc.
I seem to be haunted by the opening line to Dante's Inferno....

"In the middle of the road of my life, I awoke in a dark deep woods, and discovered the 'Way' was wholely lost to me".

Great idea, David, thank you--and that is a haunting line, to be sure.

Reader commentaries:
Mike D. (Mike is a China-based correspondent)

I'd like to comment on your contention that "China's property real estate bubble is enormous and the popping will have consequences." I don't believe that the residential real estate market in China can be directly compared with the US market for the following reasons:

1. By law, you can not buy a house in China with less than a 30% down payment. This is a far cry from the 0% down payments extant in the US market recently. The obvious result of this rule is that homeowners/investors are not going to find themselves "under water" any time soon as they have a healthy equity cushion and are unlikely to consider walking away from their investment.

2. Chinese banks do not have the array of exotic payment methods that have plagued US borrowers with the inevitable resets after the first couple of years. Mortgages here are blandly non-innovative. Pick your amortization, prove that you can cover the monthly payment...oh! and forget fixed rate.

3. I refer you to a recent report in the New York Times at: China Housing Slowing. China is clearly seeing a slowing of housing demand everywhere and even falling prices, especially in the south-east (Guangzhou, Shenzhen, etc.). However, foreclosures are extremely rare and you must admit that foreclosures accelerate falling prices.

4. Chinese banks do not bundle mortgages, slice and dice them, and sell them off to third parties. There are no agents' and brokers' fees as you just deal with your local branch. All in all, buying a house in China reminds me of the way we did it in Canada back when I bought my first house in 1972.

I am inclined to the view that we are having a serious correction in housing prices (especially in the hot areas), but we are not looking at the popping of an enormous bubble a la the US situation. Would the US housing market be in such a perilous situation now without the "innovative" mortgages, lack of down payments, exorbitant fees and overall lack of due diligence?

Thank you, Mike, for an insightful commentary. As always, you provide a realistic, fact-based appraisal which I appreciate very much. I agree, the bubble popping in China will not be as severe as it is in the U.S. for the reasons you state, but I do still expect it it exceed expectations for these reasons:

1. A huge number of units are held for investment. If the speculator/owners' incomes take a hit, some of those could end up in default.

2. The problem with the 30% down payment is that the equity does not protect the owner from a cash flow crunch, i.e. inability to make the payment; it only provides a cushion to the lender. I have no way of tracking the accuracy of reports coming out of China, of course, but apparently declines of 30% or more are hitting coastal areas. That would imply owners and lenders are already facing zero equity or are underwater despite the hefty down payments.

3. Due to the issues of transparency and "face" I mentioned, I suspect impaired mortgages will be held on the books and hidden in much the same fashion as impaired mortgages here in the States are masked with legerdemaine. therefore the true "health" of total housing/speculative debt will be difficult to assess.

This uncertainty is a major factor in "the credit crunch" and that will probably be a major factor in China as well at some future point. Also, managers have a major incentive to cloak the true size and scope of impaired debt; there is literally no reason to be accurate as only bad things can happen to your career if you provide an accurate accounting.

4. Though the Chinese banks do not bundle mortgages into MBS, they have a long history of playing fast and loose with credit, i.e. extending it freely to cronies and political insiders as favors to boost their careers. I believe anecdotal evidence is very strong that the Chinese middle-class also fell prey to the bubble mentality in real estate, i.e. that it can never go down, the Party wouldn't allow real estate to plummet, etc., which fueled the bubble and subsequent crash in the Chinese stock market.

5. Commercial real estate lending in China appears to have been very extensive to developers, many of whom are now going under. In other words, the bubble won't necessarioy take down homeowners but the subsequent effect on the banking sector and economy could nonetheless be quite severe.

6. Our Chinese friends seem in total denial that real estate in China could actually fall and keep falling--the same disease which continues to infect Americans and Europeans. I have heard for years from friends in the U.S. that housing would not fall in their locale, and now they have all been proven wrong. Even now at this late date there is enormous denial that the housing bubble is a long way from bottoming. I detect the same myopia in China.

7. For many years I have engaged in fruitless quasi-religious debates with several very intelligent readers about China "decoupling" from the U.S. and an export-based economy. I say "quasi-religious" because the views of believers in decoupling are simply beyond reason, i.e. similar to religion. Good numbers are hard to come by, but I think it is self-evident that the capital flows and outsized profits in China's economy are all export-based.
Once the export sector (i.e. non-domestic manufacturing) starts shrinking dramatically, so will capital inflows and profits, both of which are being reflected in the stock market's speculative collapse. Once the export sector begins declining, real estate will follow suit.

8. Based on a number of cultural and macro factors, I believe the evidence is overwhelming that all major Asian economies are still fundamentally export-based. Despite years of trumpeting "domestic growth," statistically the domestic economy in both China and Japan has been lackluster. South Korea has boomed only because lavish consumer credit was unleashed on an unwary populace. Now the South Koreans are facing the same wrenching credit contraction and "hangover" the debt-strapped U.S. consumer faces.

9. Lastly, I continue to focus on the tremendous disappointment which will inevitably sweep China as the "Chinese economic miracle" is revealed to be a standard-issue business cycle just like any other economy throughout history. The belief that China's boom would be never-ending is so near and dear to peoples' beliefs (both Chinese and Westerners) that there is great resistance to seeing this entirely normal financial ebb.

The low-hanging fruit of rapid development is gone, and China faces the usual challenges of a maturing growth-cycle. Global recession will complicate that, as will a global credit contraction and various currency issues.

I believe that disappointment is a sorely underestimated political wild card which will play out in dynamic fashion over the next four years as the global recession rapidly morphs into a global depression.

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An excerpt from Weblogs & New Media: Marketing in Crisis :

10. As supply/demand imbalances in FEW (food, energy, water) and the iron hand of demographics tightens its irreversible stranglehold on government's revenues and entitlement expenses, a global loss of faith in institutions will foster backlash/blowback and social disorder.
Expectations (i.e. our private inner maps of the future), lofted so high by the past 25 years of global expansion, cheap commodities and wealth creation via financial "innovations" (previously known as asset bubbles and debt), will be a powerfully destabilizing force globally.

It is a psychological truism that those with few expectations for betterment tend to persevere and be happy despite low status and income as they view themselves as sacrificing for the future benefit of the family and their children.

But those with high expectations for wealth, status, prestige, leisure and artistic expression find even modest disappointment a bitter gruel indeed. Thus the economic downturn in Hong Kong had little effect on the happiness of the city's many maids, but it exacted a devastating toll on their status/wealth-driven, high-expectation employers.

Thank you, Debbie J. ($25), for your very generous and much-appreciated contribution to this site. I am greatly honored by your support and readership.