China and Spain: Is It Different This Time?

by Michael Pettis

Among economists (at long last) we are beginning to see an increasing reluctance to respond to evidence of bubble-like behavior in China with explanations of how these things don’t mean the same thing in China as they do in other countries. Our normal understanding of economics doesn’t apply to China, we are earnestly told by the China bulls, because either:

1) China has a different set of economic rules under which it operates, and so the economic processes that have adverse consequences in other countries are unlikely to have the same consequences in China (how many times, for example, have we heard someone say that China cannot have a real estate bubble because, unlike in the US, surging real estate prices have not been fueled by a deregulated mortgage bubble?), or

2) China’s very wise policymakers have invented a new and brilliant form of economics that isn’t understood in the “West”, although strangely enough it seems well-understood by the many Westerners who regularly proffer up this explanation. (For an especially hard-hitting counterargument to this kind of claim, much beloved of China bulls, check out this article by Minxin Pei.)

We still hear the China’s-economy-is-different nonsense from non-economists, but among the many academic economists and research analysts who used to trot out these arguments regularly even two or three years ago, there is a growing awareness, I think, that they are starting to wear thin. There is no such thing as a different kind of economics, and even a very cursory glance at Chinese economic history should have made clear that if China really does exist in a different economic universe, with its own set of rules, then this has been a fairly new phenomenon. For most of its history the same old set of rules seemed to apply to China that applied everywhere else.

The massive credit expansion in China, with its associated problems of overinvestment and asset price bubbles, is no different than any other credit bubble. I mention this because until recently it was not just China that was supposedly following a new set of economic rules, and I was reminded of this after reading an article in the Financial Times about the Spanish bank Bankia. According to the article,

During Spain’s housing boom, mortgage lending at Caja Madrid, the largest of the savings banks that formed Bankia, started to grow so quickly that, by 2007, some executives were trying to slow things down. After its mortgage book expanded by 25 per cent in 2006, Carlos Stilianopoulos, Caja Madrid’s then head of capital markets and later Bankia’s chief financial officer, said: “We don’t want to grow this fast. We are a savings bank so we don’t have to keep shareholders happy. We prefer to have a solid institution.”

At the same time, warnings from abroad about the overheating of Spain’s property market were dismissed. “Perhaps in other countries this pace of growth would be seen as a bubble,” he told Euromoney. “But not in Spain.”

“Perhaps in other countries…but not in Spain.” This statement alone should have been a warning signal. We know why it is impossible for property prices ever to become unsustainable in China – actually I don’t know, but I have been told that it is because of the immutable urbanization process, of which more later – but why is that the case in Spain?

This, it turns out, I can explain. I remember in 2003 my mother had a New Year’s Eve party at our family home in Málaga, in southern Spain, at which over 80 people sat for dinner, including most of my old friends still around from high school days. That night I had one of those epiphanies (as you often do on New Year’s Eve, I guess) about the real estate market when I suddenly realized that nearly every one at the party was involved in one way or the other in real estate. Most of the people there (including my Persian sister-in-law) were real estate developers, real estate agents, real estate lawyers, architects, or owners of building and construction companies. All of them lived off (and had prospered mightily from) the real estate boom in southern Spain.

But this cannot be, I thought in my naiveté. If the only industry around is real estate, then we must be living through a real estate bubble of enormous proportions.

Later that night I spoke to one of my old high-school friends, Andy, who was at the time a prosperous real estate agent with houses in Marbella (purchased on borrowed money, naturally), a Mercedes, and all the trappings that accrue to an immensely charming and self-confident real estate agent during a real estate boom. In our conversations, and ones that took place subsequently over the next few years, I warned him that the property market in the south of Spain looked out of control, and it would be a good idea from him to diversify his savings out of real estate.

Same old same old

Of course Andy didn’t. He explained to me that what we were seeing in southern Spain was not a bubble because there were very strong reasons to believe that real estate prices were undervalued and were going to rise a lot more. Europe, he told me, is aging rapidly, and old people, as everyone knows, like nothing better than to retire in some warm and sunny place, preferably on the beach. With an infinite supply of European old people and limited European beachfront property, mostly in Spain, Italy, and Greece, where in addition you had great food, warm-hearted people, and plenty of immigrants to keep the prices of services (and servants) down, it was certain, Andy explained, that real estate prices would not decline. The demand was insatiable at almost any price.

This seemed like a perfectly reasonable argument on the face of it, and it was widely proposed to justify ever-soaring Spanish real estate prices for many years, not just on the Spanish coast but also, perhaps a little bizarrely, in every nook and cranny of the country, including some pretty gray and inaccessible building projects outside cold, northern industrial cities.

The weakness in the argument, of course, was that although there might have been near-infinite demand, this could not justify near-infinite increases in prices, especially since the demand itself was likely to be highly pro-cyclical because the Spanish economy had itself become dependent on real estate development. As long as the economies of the cold northern European countries were booming, in other words, the demand from retirees for beach houses would stay high, but any slowdown in the economy would reduce demand in Spain at the worst possible time.

And as Spanish real estate slowed, the impact would be exacerbated by a much sharper slowdown in the Spanish economy caused by the slowdown in real estate, which had become a major driver of the economy. If a substantial portion of the Spanish workforce depends on a booming real estate market – and not just those directly dependent, but also those indirectly dependent, like bankers, restaurateurs, retailers, travel agents, and so on – then any slowdown in the real estate sector is itself seriously self-reinforcing.

We have now seen how this works in Spain, but in China we are still using a similar argument to explain why real estate prices cannot drop significantly. Our Chinese version of the old-people-love-to-live-on-the-beach argument is the urbanization argument. As long as Chinese workers continue to move from the country to the cities – and urbanization has been one of the most dramatic consequences of Chinese growth in the past three decades – then there is likely to be a near infinite demand for city property, and so prices can only go up. And because prices can only go up, speculative demand for real estate is not speculative, it is precautionary.

This claim seems at least as plausible as the Spanish argument justifying infinite price increases, and was probably true a decade ago, but it runs into the same problem that the Spanish story ran into (and indeed that nearly every previous case in history of a real estate bubble, which has always started with a plausible story). First, no matter how much demand we can project into the future, rising prices can nonetheless outpace rising demand because rising prices can themselves stimulate further demand, in which case rising prices are unsustainable. This should be obvious, but the point is often lost in the giddiness that accompanies rapidly rising prices.

Second, and this is key, the rising demand is itself pro-cyclical. This is the most dangerous part of the process and perhaps the least well understood. Rising demand driven by the urbanization process is itself subject to underlying growth in the economy, since it is growth in turn that drives the urbanization process.

What’s more, when we reach the point as we did in Spain several years ago, and have reached in China too, in which a substantial part of the growth that drives the urbanization process is itself created by real estate development, then any slowdown in underlying growth is likely to be seriously exacerbated by a corresponding slowdown in real estate development. This is because the economy is caught in the reverse side of the feedback loop that helped drive prices on the way up – slowing growth leads to slower demand for urban real estate, which leads to slower real estate development, which itself leads to slower growth.

This is part of the reason why declining real estate prices and slowing sales, which Beijing has insisted for years it wanted to see, is causing so much worry. It is both a consequence and cause of economic slowing, and these kinds of self-reinforcing relationships always lead to unexpectedly sharp outcomes, both on the way up and on the way down.

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