China's Bubble Continues to Deflate

Various economists have been warning about China's credit bubble for years, yet China's booming economy kept enough air coming in to keep the bubble from popping or deflating too rapidly. Last spring, it finally appeared that the real estate market might have hit an inflection point as real estate sales stagnated, and prices began to fall in some of the Chinese markets. There was a concern that China was following Japan's path in the late 1980's. 

Ambrose Evans-Pritchard writes in yesterday's Telegraph:

Zhiwei Zhang, from Deutsche Bank, says China faces a "fiscal cliff" this year as Beijing attempts to rein in spending. "This year, China will likely face the worst fiscal challenge since 1981. This is not well recognised in the market," he said. 

The International Monetary Fund says China's budget deficit topped 10pc of GDP in 2014 if measured properly, including borrowing by the regions through "financing vehicles" as well as land sales - a patently unsustainable form of funding that makes up 35pc of local government revenue. This is the highest deficit of any major country in the world, and far above safe levels. 

A budget squeeze is already emerging as the property slump drags on. Zhiwei Zhang says land revenues fell 21pc in the fourth quarter of last year. "The decline of fiscal revenue is the top risk in China and will lead to a sharp slowdown," he said.

 China's Development Research Centre (DRC) - the brain trust of premier Li Keqiang - has issued a new report on the bankruptcy of California's Orange County in 1994. "It is a warning to China that the country needs to improve its tax system," said the paper. 

Interestingly, the DRC has also published a report recently on the decline in China's electrical, mechanical and car industries, a finding that might surprise some in the West. 

The Chinese tax system is highly leveraged to the property cycle, like Ireland's before the boom broke in 2007. The scale is epic. A study by the US Federal Reserve found that property investment in China has risen from 4pc to 15pc of GDP since 1998. This is even higher than in Japan in the blow-off years of the late 1980s.

 The denouement is well under way. Home prices fell 3.1pc in January from a year earlier. Average sales have dropped 7pc from a year ago in the large Tier 1 cities, 22pc for Tier 2 and 15pc for the Tier 3 towns. 

The inventory overhang has risen to 18 months, three times US levels. New floor space has dropped 30pc on a three-month moving average.