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Tuesday, July 13, 2010

Do property bubbles always lead to crises?

Many of the world’s biggest economic crises in recent years originated from property bubbles. The list includes the US “subprime” crisis (2008), Japan’s economic stagnation (1992 onwards); and the financial crisis in Sweden (1991), Finland (1991), Norway (1987) and Spain (1977).

They were all largely triggered by property bubbles popping.

Today, it is therefore understandable that investors are concerned about property bubbles in Asia, especially in China; how would the property bubble affect China’s economy, and by extension Asia’s and the world’s economy.

The important question today I believe is not whether major economic crises are usually triggered by property bubbles, but do property bubbles always lead to banking and economic crises.

Property bubbles certainly increase economic downturn risks, especially when they pop. However, we do not think it will always lead to a banking and economic crisis.

First, property bubble-induced economic crises occur largely because there is cheap money (i.e. low borrowing cost) and excessive bank lending, giving rise to investment frenzy, including speculation. When the bubble pops, banks’ non-performing loans (NPLs) rise, causing banks’ capital to be insufficient.

Confidence about banks’ financial health then comes into question, which may lead to a bank run. Banks are then forced to cut back on credit, which in turn affects the economy, turning the property price collapse into an economic crisis.

The key to see if a property bubble burst leads to an economic crisis or not is whether there is excessive lending (high margin, lax lending) and substantial lending (high total banking exposure to property).

One case in point is the China property bubble burst of 2008 where some house prices in Shenzhen dropped as much as 40% (yes, there was one, overshadowed by the much bigger US property bubble popping) but there was no banking crisis.

Surprisingly, NPLs of Chinese banks did not rise in 2008 (as one would expect when property bubbles burst); instead they continued to fall (China’s total bank NPLs have fallen from above 12% of total loans in 2004 to 1.4% in 2010).

Until today, China’s banks are relatively secure because many buyers are required to pay high down payments (from a minimum of 20% to 30% for first mortgage, to 40% to 50% for subsequent mortgages). This high commitment of home buyers partly explains the lower risk for banks and the low default rate of mortgages (NPLs for China banks in mortgage loans are traditionally low, now at about less than 1%).

Another example is high-end properties in Hong Kong and Singapore. While there is no doubt it is a property price bubble, the systemic risk to the banking system and economy is less because it is more prevalent to luxury properties, coupled with less excessive bank lending.

Second, the size (volume and price) of a property bubble determines the negative impact to the economy when it pops. To illustrate, if the price of a single property unit increases significantly and then crashes sharply, there is really little impact to the economy. However, if there were millions of such transactions built up over the years, chances are that when the bubble pops, it will have very severe damage to the economy.

In Asia, recent property bubbles had relatively short time to build. Take, for example, the high-end property bubbles in China, Hong Kong and Singapore, which started approximately from about 2006 before they tumbled in 2008.

Compared with the build-up for the last supersize property bubble of the US (estimate from 2001 to a collapse in 2008) or Japan (estimate from 1986 to 1991), the run-up in Asia’s property bubbles today (essentially from 2009) has perhaps less time to accumulate high numbers of property transactions to reach a supersize bubble.

For example, on Sept 30, 2006, US Federal Deposit Insurance Corp data showed real estate loans might be in excess of 40% of US banks’ total lending. As comparison, according to a PIMCO report in 2010, the share of loans in China’s real estate sector is less than 20% of total lending.

So, should we be worried about the impact of property bubbles bursting in Asia, bringing Asian economies towards an often quoted “double-dip recession”?

I don’t think so, largely because of the following reasons:

·Asia’s banking system is resilient after the 1997/98 Asian fiinancial crisis revamp and remained strong, during and after the 2008 global financial crisis.

·Asian governments are acting very fast in curbing property bubbles, not allowing them to get too big; in particular Asian governments believe in market intervention as compared with Western preference to let free market forces decide.

·Asian bank housing mortgages are “recourse financing” (meaning one is liable for all losses even if the property is auctioned) as compared with “non-recourse financing” in the US (meaning after the property is foreclosed by the bank, one is no longer liable for further losses), therefore Asia’s borrowers are more committed.

·It is a cultural norm and quite common in Asia for an extended family to chip in during times of difficulties to help mortgage repayment.

·Asia’s property developers are also more careful in managing risks after experiencing the 1997/98 Asian financial crisis; many, such as in Malaysia and Singapore, use joint ventures with land owners to mitigate some of the risks.

By The Star

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