For those who are awaiting my next installment of data points on the Chinese economy, never fear — I’m still on the case.  In the meantime . . .

The man was screaming at me.

We were standing in a shack at what could reasonably be called the roof of the world.  At over 15,000 feet (4,600 meters), the Khunjerab Pass is the main crossing point between China and Pakistan.  Outside, where the bus was revving its engines in the thin, icy air, the road traced a wide gravel path embraced by pristine mountains on either side, under a perfectly clear indigo sky.

The man who was screaming at me couldn’t care less about the view.  He was a Chinese border official.  Moments earlier he had stamped an exit stamp in my passport and – fatefully – proceeded to change my money.  When I counted it, I thought – just maybe – he had accidentally given me a bit too much in return.  But when I tried to ask about it, he must have assumed I was accusing him of shortchanging me. Before I could get a word out, he blew up.  Stark raving, barking dog, spit-flying-in-your-face screaming, like a human grenade had just gone off.   I beat a hasty retreat, with my extra money.

I couldn’t really blame him.  I was passing through; he had to stay here.  It was a two-day bus ride from Kashgar, a sleepy desert oasis that hosted the only city of any size that far west in China.  I had looked forward to what I thought would be epic scenery.  Instead, it was a journey of interminable boredom.   We arrived at Tashkurgan, which Marco Polo passed through on his travels, after sunset and departed before dawn, staying the night in a concrete shell of a trucker’s hostel.  In the twilight, I could barely a glimpse of the looming stone fortress that gives the town its name.  After that, the only people I saw all day, as our bus wound its way up the grey hills leading to the pass, were two Kirghiz tribesmen leading a camel.  They seemed to come out of nowhere, and dissolve back into nowhere.

Who do you have to piss off, I wondered, whose wife do you have to get caught fooling around with to get posted up here, about as far as you can possibly get from Beijing?  And for how long?  That customs official wasn’t screaming at me.  He was screaming at fate.

I reloaded my backpack back on the top of our wobbly old bus, which cranked up its engine and began wobbling its way across the pass.  The name “Khunjerab” supposedly means “blood valley” in the local Wakhi language, which suggests a certain level of drama.  If there was any drama that day, I missed it.  The pass is windy ice-cold, but there is no sense of dizzying height, no precipices to peer over.  It looks, more than anything, like a wide, dried-out riverbed.  The mountains on either side, which are among the highest on earth, seem more like gently sloping hills – although the bare rock suggest gently sloping hills on the moon.

My companions – I haven’t mentioned my companions – were mainly Pakistani traders with burlap bags full of silk, cotton, and other Chinese goods they had bought in Kashgar.  When we arrived at the Pakistani checkpoint, at the other end of the pass, they were greeted as conquering heroes.  They got off and traded cigarettes with the Pakistani border guards, in their Sandhurst-style khaki sweaters and light green berets.  At the time – after the Soviet withdrawal from Afghanistan, before the rise of Al-Qaeda – they paid little attention to a lone American traveler, besides cheerfully stamping my entrance visa and offering me a steaming cup of chai.  They chuckled when I told them about the screaming money-changer on the Chinese side.

By the time we climbed back on the bus, evening was approaching and the clouds were beginning to descend.  As we drove onwards, we entered a river valley and the mountains on either side began to grow larger.  The range we were crossing is called the Karakoram, which connects the Himalayas to the southeast with the Pamirs to the northwest.  It is one of the earth’s newest mountain ranges, and contains many of the world’s tallest peaks, including K2, second only to Mt. Everest.  Because there has been little time for erosion, these peaks – large and small – have a distinctively jagged, angular quality that makes them particularly treacherous, and beautiful.

On our way, we passed several immense glaciers that had pushed all the way down to the roadside.  Above us, grey glowering clouds swirled around rows of saw-toothed mountain peaks that looked like the monstrous teeth of a Great White Shark.  It was dark by the time the bus dropped me at a small log cabin-style structure that served a roadside inn.  With no electricity, there was little to do but to unroll my sleeping bag – the cot had no blankets – and go to sleep.  I would check in the next morning.

I awoke to what I can only describe as an awe-inspiring sight, framed in the window.  The clouds had lifted.  The jagged, saw-toothed row of mountains was still there, unveiled in all their glory.  They were right out of a picture book, the kind of zig-zag mountains a child might draw but you knew couldn’t be real.  They were what I imagined the Misty Mountains (filled with goblins and giant eagles) might look like when I read The Hobbit as a boy – sharp black forms rearing up into the sky, casting even sharper shadows across the valley floor.

The first order of business was to sign in – literally.  While I took a seat on the open porch, sipping a clay cup of chai, and nibbling a dry piece of bread, the innkeepers laid out a thick book where guests were expected to scrawl their name, country of origin, and passport number.  As I did this, they casually offered me a warning, should I go hiking.  Look at the glaciers, they said, but whatever you do, don’t attempt to walk on them.  It may look safe, but all it takes is one slip and you can fall down a crevasse where no one will ever find you.  You just disappear (perhaps to be unearthed thousands of years later like the “Ice Man” of the Alps, in a state of perfect preservation).

To drive home their point in a particularly alarming manner, they pointed a few entries up the page on which I was in the process of dutifully scratching my information.  All of the guests before me had a line through the entries, indicating they had checked out  — except one.  That guest, I learned, had gone missing the week before.  He hiked off one morning, and never returned to collect his things.  The army had sent rescuers to look for him, but not a trace.  They figured he had fallen into a glacier, and must be long dead by now; they were packing his belongings to send to his loved ones back home.

With this ominous fate in mind, I resolved not to step foot anywhere near a glacier.  I would stick to the road, and simply admire the view.  A village called Gulmit, topped by a tiny fortress, perched on the rocky slopes above the inn.  Below it to the east, on the other side of the road, the gravelly bed of the Hunza River wandered like a grey wound along the bottom of the valley, from north to south.  I began trudging back north along the road, towards Passu, another small village a couple kilometers distant.  To my left, the massive Ghulkin Glacier crept nearly to the edge of the road.  To my right, two long rope suspension bridges, planked with driftwood slats, stretched side by side across the river gorge.  From time to time, tiny figures could be seen clinging precariously to the guide ropes as they crossed to do their daily chores.

I was on my way back, just rounding a bend in the road, when I heard a clear voice, in English, shout “Hey, you!”  I looked around, but the only person I could see, standing a bit further along the roadside, was a local Wakhi woman covered in a shapeless, deep blue shawl.  SHE couldn’t be the one calling to me – in fluent English, no less.  After a perplexed moment, I started to walk on.

“Hey, you!”  It WAS the woman.  She waved slightly, but was otherwise motionless.  I had been told, and had read, that it was not a wise idea – quite dangerous, in fact – for a stranger to talk to a woman in this strongly tribal and deeply conservative country.  Was this some kind of trap?  I resumed walking.

“Hey!  Are you scared of me?”  Okay, that was it – I’m not running away from some local herder’s wife.  Cautiously, I approached and said hello.  I explained that I wasn’t afraid, exactly, but I didn’t realize it  was okay to speak to the local women.  “Oh, we’re not like that here,” she broke in a broad grin, “not like the people down south – they’re crazy.”

Needless to say, I was flabbergasted.  It turns out that the mountain tribes this far north are Isma’ilis, a branch of Shi’ite Muslims – outsiders in an overwhelmingly Sunni country, which helps accounts for their unconventional openness towards other outsiders.  Their hereditary leader is the Aga Khan, who happens to be one of the richest men in the world.  That’s why the woman who hailed me – and many other residents in the valley, including nearly all of the children – speak such excellent English.  The Aga Khan has poured millions into these incredibly remote areas, building some of the best-funded schools and medical clinics in the country.

About another kilometer down the road, I had another unexpected encounter.  A fellow hiker, wearing a bright polyester track suit, was sitting beside the road.  He had a thatch-colored beard, clear white skin, and piercing blue eyes.  He greeted me with a slight accent to his English that I couldn’t quite place, but assumed was from somewhere in Europe.  I asked him where he was from.

“Oh … I’m from here!” he replied.  Once we got over our mutual shock, I told him I had assumed, given his foreign-looking garb, that he was a tourist like me.  I didn’t mention his strikingly Caucasian features — but then, given the history I knew, I really shouldn’t have been too surprised.  Although most people in Pakistan’s high mountains have the olive complexions typical of rest of the country, the occasional blue eyes and blond hair stand out as genetic echoes of a long-forgotten past.

The people here claim to be descended from the soldiers of Alexander the Great, who passed through these mountains on the way to India in the 4^th Century BC.  It’s not as crazy as it sounds.  Alexander did come through here, and some of his men stayed behind to establish the Greco-Indo kingdom of Bactria.  Their legacy lived on in the great Kushan Empire, which clothed their statues of Buddha in Greek-looking tunics.  But in truth, the blue eyes and blond hair probably trace their roots back ever farther than that, to the ancient invasions of the horse-riding Aryans, who crossed these mountains into India from the steppes of Central Asia, and their Indo-European cousins, the Tocharians, who were the earliest known inhabitants along China’s Silk Road.  By the time Alexander showed up in this corner of the world, he would already have seen plenty of faces that looked familiar to a Greek.

By the time I returned to Gulmit, it was still light, so I decided to climb up the hillside and check out the village.  I soon attracted a pack of local children who were enthused to see a foreigner.  One little boy who – as usual – spoke excellent English offered to guide me up to the little fort above the settlement.   It was a lot longer hike than it looked, but the boy chased his small plastic ball up and down the path so many times he must have run four times the distance I walked.

When we arrived at the ruins, there was not much to see, so we sat down and talked.  He asked me about  the place where I came from, and told him that where I grew up (outside Chicago) the land was so flat you could see all the way to the horizon in every direction.  He was non-plussed.  Try explaining what the “horizon” is to someone who has never seen a flat piece of land larger than the village square – and even that wasn’t very flat.  I described the ocean, and he was even more confused.  Finally, he sang me some local songs (about mountains and hills, what else?) and invited me to come back to the village that evening for a festival they were throwing.

When I returned after dusk, the boy brought me to the local mir’s “palace,” which looked like a dusty old stone house with wooden terraces.  Inside it was surprisingly cozy, and one of the village elders (the boy’s father? uncle? grandfather? I never figured out which) proudly showed me various trapdoors, game antlers, and an ancient-looking blunderbuss once used to fend off a 19^th Century British military expedition.  Then it was time to join the rest of the villagers, who had gathered to form a circle in the darkness around the edge of village square.  All of the men and women, young and old, who had spent the day hoeing rocky fields or tending scraggly goats were chattering excitedly with one another.  The scent of roasted meat and tobacco smoke wafted through the crisp evening air.  One flickering shadow among many, I drew hardly any notice.

Above this scene spread an awesome, magnificent sight:  hundreds, thousands, millions of bright stars gleaming like diamonds in a pitch-black night sky.  The entire Milky Way could be seen, not as a faint smudge, but as billions of infinitesimal points of light.  The black shapes of the mountains on either side gave one the thrilling, unnerving sense of being hurtled through outer space; that if you didn’t hold on tight to the ground below, you might just fall off the earth.

Drums began playing: light tapping of fingers on taut animal skin, heavier thumping of tom-toms.  Some of the villagers began dancing inside the circle, not the rational, choreographed motions of a folk dance, but the easy, spontaneous spinning and whirling of dervishes.  When several broke away and asked me to join them, I could hardly say no.  The fire-lit faces began spinning, the drummers were spinning, the stars were spinning, the universe was spinning.  And we all fell off the earth, together.

Next installment:  Gun-slinging theology lessons in Kohistan, and tea with Saddam in Swat.

Wei Yao of SocGen, some of whose figures I cited, apparently reads this blog and posted a comment that offered some helpful insight into some of the numbers we’re working with.  He notes that while GDP figures reflect cumulative value-add, “investment in fixed assets” and “investment in real estate” are all-in sums that include not only construction value-add, but also material inputs as well as existing assets such as land.

Based on this observation, I think it would be fairer to say that the calculation I ran does include the impact on the output of upstream industries (such as steel and cement), whose value-add is included in the investment sum, but does not include the impact on continuing high rates of investment in capacity expansion by those industries, predicated on ever-rising demand.  The estimated fall-off in GDP I arrived at, therefore, reflects part, but not all, of the slowing impact on those industries’ GDP contribution.

I would argue that land sales should be included as a contribution to GDP, for two reasons.  I realize this is a somewhat unconventional claim, so let me explain.  First, part of what developers in China pay for when they acquire a piece of land is what is called “primary development” — removal of previous residents, demolitions, clearing and leveling, and basic infrastructure installation — which takes place before the plot is auctioned by the local government.  In Beijing and Shanghai, this process is fairly transparent and is limited by law to a modest portion of the overall land price.  In other cities, however, the process can be quite opaque and account for large mark-up in price, much of which makes its way into the pockets of local officials and their friends.  Whatever one thinks of this practice, the “value” added constitutes a form of (albeit dubious) economic activity, not a pre-existing asset.  The underlying value of the land itself constitutes a much smaller portion of the total investment amount than one might conclude by looking at auction prices.

Second, land revenues themselves may not reflect any upstream GDP contribution, but they do fund a great deal of downstream activity in the form of local government spending (the “G” component of in the C+I+G+X=GDP equation).  Land sale revenues account for roughly 40% of local government budgets across China.  We’re not even talking about local government-sponsored investment projects here, where are mainly funded by LGFV borrowing; nor are we talking about the ability to repay such loans — I’ll discuss both these issues in Part 2B.  We’re talking about day-to-day operating expenses:  police, hospitals, schools, and other social services.  Without revenue from land sales, that spending (which contributes to GDP) cannot take place — which is exactly what Caixin magazine reports is starting to happen already in cities throughout China.

So even though the real estate investment figures and the GDP figures are not an exact match, in terms of what they are measuring, I believe comparing them still give us a reasonable window into the direct impact of a real estate slowdown on GDP.

That said, I want to emphasize that the calculations I’ve played with here are not meant as a precise prediction of what actually will happen in 2012, but as a thought exercise that highlights just how dependent China’s rate of GDP growth has become on not just high, but ever-rising, levels of real estate investment.  The main take-away being, you don’t need a collapse, you just need the runaway rate of growth to slow, in order to drain the pool.

If investment actually declines — which is hardly unthinkable based on other property booms and busts — the picture is even worse.  For instance, if property investment falls 10% (in real terms) in 2012, GDP growth drops to 5.3%.  Even if investment grows at 10% (half last year’s growth rate, in real terms), GDP still drops to 7.9% — below the magic 8%.  You can plug in any numbers you like, and see what you get.  The point is, real estate has been a huge driver of growth, and even a modest real estate slowdown matters — it can’t just be brushed aside as though it were of minimal consequence for the broader Chinese economy.

I also want to emphasize — before we get totally preoccupied with the fate of the property bubble — that the property story is really just one aspect of a much broader investment boom that has been driving the economy.  If real estate accounts for 10-13% of GDP, investment in fixed assets accounts for roughly half.  The health of the property sector is particularly important in China because of the pervasive role that land values play in underwriting lending, but the risks to China’s economy extend far beyond the market for homes and offices.  For China, real estate is just the tip of a much larger iceberg, one that I’ll explore in my next “China data” installment.

Earlier today, I was interviewed on BBC about what these numbers mean.  You can watch the interview here.  You can also read my comments to the Washington Post here.

There are two pieces of data I saw today, easily lost in the fine print, that I found particularly revealing.  First, the NBS disclosed that real estate investment accounted for 13% of China’s GDP in 2011 (compared to Stephen Roach’s estimate of 10%), and grew at a rate of 27.9%. However, I noticed something that I admit I missed before, in my earlier calculations — that this is a nominal rate (not adjusted for inflation) whereas the GDP growth rate figures are real (they take inflation into account).  The real (and therefore comparable) rate of expansion for real estate investment in 2011 was 20.0%.

So I went back and re-ran the numbers, using these more accurate figures.  Given GDP growth of 9.2% (a higher starting point than I used in my initial calculations), a real growth rate of 20.0% for real estate implies a real growth rate of 7.6% for the rest of the economy.  If, in 2012, real estate construction were merely to level off at zero growth, and the rest of the economy was unaffected, that would bring overall GDP down from 9.2% to 6.6%.  That’s higher than the number I initially came up with, but still well into “hard landing” territory.  The fall-off of 2.6% is also closer to the 3.0% drop I initially calculated than the 1% decline predicted by Stephen Roach.  I errored in my back-of-the-envelope exercise, but my point remains a valid one.  Keep in mind, these calculations assume no impact on dependent industries like steel and cement, no impact on the financial system, and no correlation to related risks in the Chinese economy — the latter two of which I will expand upon in my next post of the series.

Here are my revised calculations, using a GDP index of 1000 for the base year, for those who wish to see:

How realistic is a leveling-off of real estate investment?  This is where the second piece of data I noticed fits in.  The NBS — somewhat curiously– did not publish December figures for property and other fixed asset investment.  However, the Financial Times did interview Wei Yao, an economist at Société Générale, who made some of his own calculations.  According to him, the growth rate for real estate investment saw a rapid deceleration from 20.1% in November to 12.3% in December (it’s clear from looking at the original source data that these are nominal rates; the real rates to plug into the GDP equation would be substantially lower).

The FT article also notes a nearly 25% decline in new housing starts in December and a 26% year-on-year rise in unsold property.  And it’s not merely real estate investment that’s decelerating.  Nominal growth in fixed asset investment as a whole — hitherto the main driver of growth in the Chinese economy — dropped from 25% y-on-y in October to 21.2% in November and 18.5% in December.  That’s precisely the kind of broader deceleration I’m going to be focusing on the next installment (Part 2B) of my analysis.

When people talk about a “hard landing,” they’re usually talking about a sharp deceleration in GDP growth, which brings with it both business failures and unemployment.  In two earlier posts (Parts 1 and 1A), I examined a variety of data points that suggest China’s real estate market is in the midst of a serious downturn.  In this post, I want to take the next step beyond this and explore the impact of collapsing property prices on the pace of broader economic growth, and the prospects of a “hard landing”.  (Originally, I promised to discuss the impact on China’s currency and inflation, but in thinking about it, I realized this places the cart before the horse.  I’ll turn to this question in Part 3).

There are two ways that the drop in the property market translates into slower economic growth:  direct and indirect.  The direct impact is fairly obvious:  to the extent that China’s real estate developers are overextended, and preoccupied with selling off their existing inventory in order to stave off bankruptcy, they won’t be commissioning any new projects — maybe not for quite a while.  That means no work for construction companies, which in turn won’t be buying any new construction equipment.  It also means less demand for steel (construction reportedly accounts for 40% of China’s steel demand), cement, glass, copper pipes and wiring, etc.  It also means less furniture and fewer appliances to fill those new homes (although, as we know, many Chinese investors already leave the units they buy empty anyway).  The estimates I’ve seen say these sectors dependent on property construction account for between 20% and 25% of China’s total GDP.

Frankly, you don’t need a real estate collapse in order to trigger a serious slowdown in these sectors.  All you need is a pause in the hitherto frantic pace of construction.  Let’s assume the bull argument that, due to urbanization and rising incomes, speculators are right:  all the units they’re snapping up today, and holding as investments, will ultimately be filled with end users.  That still assumes a catch-up period.  If real estate investment, which according to monthly official figures has (even into November) been growing at >30% year-on-year, keeps outpacing urbanization and rising incomes, the gap will never close.  At some point, the pace of construction has to moderate to give all that anticipated end user demand a chance to materialize, and start filling all those vacancies.  If demand isn’t what speculators imagine it to be, at today’s sky-high prices, the adjustment — and resulting slowdown — will be even more severe.

So what evidence do we have that a construction slowdown may be occurring?  Official data on housing starts does exist, but it’s not a reliable metric.  Developers stand to lose their land back to the government if they don’t do anything with it after a few years.  They are also under considerable pressure to show progress on “social housing” mandates that may be a condition of obtaining land.  For both reasons, developers will often dig a hole in the ground and call it a “start,” even if they intend to delay further work indefinitely.  Last month, China’s Ministry of Housing and Urban-Rural Development (MOHURD) estimated that as much as 1/3 of reported social housing starts were just “digging a hole” rather than actually building apartments.

A better approach is to look at the market for construction inputs.  The clearest picture we have is for steel.  According to a friend of mine who is an analyst in the steel and commodities sector, and recently completed a countrywide tour of talking to producers, sentiment in China’s steel industry is as gloomy as he has ever seen it.  In November, Chinese steel output was down -8.8% month-on-month, down for the sixth month in row. More importantly, it was down -0.6% year-on-year, indicating this was more than just a seasonal or partial fall-off from the all-time highs it hit in the first half of 2011, which were driven in large part by demand for cheap rebar for construction.  Apparently, the demand that drove that boom has almost entirely disappeared.  Interestingly, according to one report by Shanghai Security News, steelmakers say that actual sales in 2011 failed to match official “social housing” construction data.  Figures released by the China Iron and Steel Association last week indicate that steel output continued falling in December, by 3.87% month-on-month.

Not surprisingly, two things have happened.  First, domestic iron ore prices have plummeted as unused stockpiles have accumulated.  The China Iron and Steel Association recently announced that its iron ore price index has fallen 22% in the past four months, since the beginning of September, while iron ore inventories at Chinese ports rose to 96.8 million tons by the end of 2011, up 32% from the year before (Chinese iron ore imports were still up 10% y-on-y in December, but analysts expect buying to slow in coming months, due to flagging demand).  Second, Chinese steelmakers are suffering.  According to Caijing, more than 1/3 of them experienced losses in October and November, and the industry as a whole saw a net loss of RMB 920 million (US$ 146 million) excluding investment gains.  The magazine said industry executives foresee an even tougher year in 2012.

Cement and glass also show a marked deceleration in growth.  Cement output in November grew 11.2% y-on-y, but that represented a significant fall-off from 17.2% y-on-y expansion for the first 11 months as a whole, and the 17.3% y-on-y growth the industry saw in November 2010.  Glass also saw a similar deceleration, growing 7.1% y-on-y in November, compared to 17.0% y-on-y from the first 11 months.  Cement prices have been declining steadily over the past few months, a trend that Fitch projects will continue into 2012, due to overcapacity.  It notes that, because of their high level of investment in building even more capacity, major Chinese cement producers are cash flow negative.

Copper presents a more unusual picture.  China’s copper imports in December hit an all-time record high of 508,942 tons, up 47.7% y-on-y.  However, there is little reason to believe this was driven by end user demand.  Most analysts I’ve talked to believe it was primarily due to a resurgence in speculative arbitrage based on the gap between copper prices in Shanghai and London, and possibly renewed interest in using stockpiled copper as collateral for obtaining loans — both practices spurred by expectations of monetary easing.  In short, the Chinese are buying copper, like homes, to trade not to use.

Of course, land is also a key construction input.  I’ve already written about the dramatic fall-off in local government land sales to developers, here as well as here.  Newly released year-end figures show that Beijing’s overall revenues from land sales in 2011 dropped 35.7% compared to 2010, despite robust sales in the first half of the year.  Land sales revenues for residential projects plunged even more steeply, by 55.4%, while the average auction price for residential land dropped 30.5% (from RMB 7,317 per sq. meter to RMB 5,088).  In Shanghai, total land sales revenues dropped 20.0% y-on-y, and average the average price of residential land plummeted 41.0%.  On January 7, China’s Minister of Land and Resources stated that nationwide, land sales revenues in 2011 were up slightly over the previous year, but offered no details.  A few days earlier, however, the 21st Century Business Herald reported that nationwide land sales may have dropped as much as 20% year-on-year.

All in all, it certainly appears that some kind of a slowdown, prompted by a correction in the real estate market, is taking place in China.  What does this mean for the Chinese economy?  Not much, argues Morgan Stanley’s Stephen Roach, in a recent syndicated op-ed:

Moreover, it is a serious exaggeration to claim, as many do today, that the Chinese economy is one massive real-estate bubble. Yes, total fixed investment is approaching an unprecedented 50% of GDP, but residential and nonresidential real estate, combined, accounts for only 15-20% of that – no more than 10% of the overall economy. In terms of floor space, residential construction accounts for half of China’s real-estate investment. Identifying the share of residential real estate that goes to private developers in the dozen or so first-tier cities (which account for most of the Chinese property market’s fizz) suggests that less than 1% of GDP would be at risk in the event of a housing-market collapse – not exactly a recipe for a hard landing.

I think Roach is underestimating the problem.  First of all, 10% of GDP sounds a bit low to me.  Reliable statistics forwarded to me by Bloomberg researchers put residential construction alone at 9.9% of China’s GDP in 2010 (compared to 6.1% at the U.S. housing peak in 2005, 9.3% at Spain’s peak in 2007, and 14.0% at Ireland’s peak in 2006).  Roughly consistent with this figure, UBS economist Jonathan Anderson estimates that total real estate construction (including residential and commercial) accounted for 13% of GDP in 2010.  Second, this number does not include sectors such as steel and cement that are directly and heavily dependent on construction demand.  As I’ve noted, that raises the stakes to 20-25% of GDP.  Third, I’ve argued vigorously for some time now that contrary to what Roach maintains, the overhangs in China’s property market are not at all limited to first-tier cities, based not only on the data I have seen but on copious news reports and the evidence of my own eyes.  Far from being mere “fizz,” they are the pervasive outgrowth of deeply embedded structural issues in China’s economy.

Having said all that, let’s assume for a moment that Roach is right that real estate construction directly accounts for 10% of China’s GDP.  Now let’s assume that the growth rate for real estate investment drops from roughly 30% last year to zero in 2012.  That sounds catastrophic, but keep in mind, zero growth doesn’t mean a cessation of all construction.  It means China will build the exactly same number of condos, villas, offices, and shopping malls this year that it did last year — an astonishing rate of construction, by any historical standard.  If the property sector grew by 30% in 2010, and accounted for 10% of GDP, and GDP grew by 8.5% (roughly), that implies a growth rate for the rest of the economy of 6.1%.  If you take real estate expansion down to zero, and assume the rest of the economy keeps humming along, that knocks overall GDP growth down to 5.5% — a “hard landing” in most people’s book.  Again, that may sound extreme, but if we look to the U.S., Spain, or Ireland as an example of what happens when a bubble bursts, the most likely outcome isn’t a plateau in construction (zero growth) but a collapse (sharply negative contraction) followed by years in which hardly anything gets built.  I’m already being generous here in assuming that China is somehow “different.”

More importantly, we’re only looking here at the direct impact of a real estate downturn on GDP:  the homes and offices that aren’t built, the steel and other materials that aren’t ordered.  In the lead-up to the U.S. subprime crisis, Ben Stein (who I generally have a high regard for) famously opined that subprime mortgages comprised such a tiny portion of the nation’s assets that they weren’t worth worrying about:

. . . the total loss may be about ½ of one percent of the mortgages made and probably less, and a lot of it is insured. This is an absolutely trivial number in the context of a $14 trillion economy with net wealth in the realm of $60 trillion.

Stein later penned a mea culpa, admitting that “where I missed the boat was not realizing how large were the CDS [credit default swaps] based on the junk mortgage bonds.”  That insurance he was talking about actually turned to be a huge problem, not a solution.  It was the indirect effects of the U.S. housing crash — the way it triggered reactions throughout the financial system and apparently unrelated parts of the economy — that turned it into a real crisis.

So in the next post in this series (Part 2B), I will take the next step and explore the far more serious indirect effects of China’s real estate downturn on growth.  I’ll look at how the property market has been the lynchpin of a much broader investment boom that has been driving China’s rapid economic growth, and examine the concrete evidence that this boom is now starting to unravel.

UPDATE:  I updated my calculations on the impact of zero property growth on overall GDP growth, based on more accurate numbers released by the National Bureau of Statistics on January 17.  The revision also corrects an error I made in the mixing of nominal and real growth rates.  The conclusion, however, is essentially the same.  You can view the revised calculations here.

One of the main purposes of Geithner’s trip is to try to persuade China’s leaders to cooperate with the latest Western sanctions on Iran — in particular, a new U.S. law that President Obama signed on Dec. 31 that imposes tough sanctions on any bank that does business with Iran’s central bank, which facilitates most of Iran’s oil sales.  Since China is Iran’s #1 oil customer, accounting for 20% of Iranian exports, and relies on Iran for a hefty 11% of its imported oil supplies, that potentially puts the U.S. on a collision course with the Chinese banking system. 

Obama actually opposed the measure, which was slipped into the annual defense appropriations bill, saying in his signing statement that it encroached on his authority to conduct foreign policy and he would enforce it only as he saw fit.  There is a waiver provision in the law that allows the President to hold off on sanctions, if he gets some kind of cooperation in return.  But as I said on Bloomberg, it’s clear that the GOP front-runner, Mitt Romney, fully intends to use China as a stick to beat Obama throughout the election, which makes it hard for Obama to say he’s granting Chinese banks a ”free pass” on doing business with Iran.  For that matter, Obama does seem serious about trying to rachet up pressure on Iran to abandon its nuclear program, by isolating it economically and financially. 

The Chinese, on the other hand, are keenly aware that their reliance on imported oil over distant supply routes would be a major vulnerability in the event of any future conflict with the U.S.  With that in mind, there’s no way the Chinese will let the U.S. dictate who they can buy oil from and on what terms.  Given China’s half-hearted enforcement of existing sanctions on North Korea and Iran, there’s no reason to expect much enthusiasm now.  After all, from their perspective, Iran is America’s problem, not theirs.  That doesn’t mean, of course, the Chinese are above using the U.S. sanctions — and the growing reluctance of other customers like Japan to buy Iranian crude — as a means of leverage for squeezing a better deal out of Iran.

You can read some of my other comments, as well as additional details related to this story, in this Wall Street Journal article and this AFP report.

1. High-Speed Rail.  It was the best of times, it was the worst of times — China’s ambitious high-speed rail program embodied the highest highs and the lowest lows the country experienced this year.  In January, President Obama cited the planned 20,000km network in his annual State of the Union address as a prime example of how America needs to catch up to the Chinese.  As if to prove his point, June saw the grand opening of the much-heralded Beijing-Shanghai line, timed to coincide with the Communist Party’s 90th anniversary celebrations.   But even before then, there were signs of trouble on the horizon, starting in February when the powerful head of China’s railway ministry — the project’s godfather — was abruptly fired as part of a massive corruption scandal.  Then a crash on a line near Wenzhou, in which at least 35 people were killed, unleashed a wave of fury on the Chinese internet, forcing the government to re-think the entire project amid charges of cover-up and sloppy construction.  By November, with high-speed trains running at chronically low capacity and construction debts piling up, the railway ministry was asking Beijing for a rumored RMB 800 billion (US$ 126 billion) bailout just to pay the money it owed suppliers.

2.  Inflation.  Few issues preoccupied the average Chinese citizen — or Chinese policymakers — this year as much as rapidly rising prices.   The consumer inflation rate, which began the year just shy of 5%, rose to 6.5% by July.  The increase was led by food prices, particularly pork – a staple part of the Chinese diet — which skyrocketed by more than 50%.  Keenly aware of the potential for popular unrest, Beijing made containing prices its top economic priority — even if that meant reining in growth.  Throughout the year, the central bank repeatedly raised interest rates and bank reserve requirements, in an effort to bring the pace of credit expansion back under control.  The powerful state planning bureau leaned heavily on Chinese companies not to raise prices, and even hit consumer goods giant Unilever with a stiff antitrust fine for publicly discussing possible price hikes.  While CPI did decline to 4.2% by November, China still did not see a single month in 2011 in which inflation did not exceed the government’s 4% target for the year.

3.  Real Estate Downturn.  This fall, something strange began to happen.  Real estate prices in cities all across China, which have risen phenomenally in recent years, began to drop.  Property developers — who had borrowed heavily to pile up large amounts of unsold inventory, in the face of tightening credit conditions – began offering steep discounts (30, 40, even 50%) to get their hands on much-needed cash.  Recent homebuyers, furious at having paid full price, demanded refunds and in some cases trashed developer showrooms.   One property agency estimated that new home prices in Beijing plummeted 35% in November alone.  Transactions volumes in cities across China have stalled, and local governments — dependent on land sales to fund their operating budgets and repay debt — are starting to panic.  Chinese investors, many of them holding several empty units as a form of savings, are looking on anxiously, wondering whether the bubble has popped, hoping the government will somehow engineer a rebound in 2012.

4.  Wenzhou Credit Crisis.  In September, reports began circulating in the Chinese media that dozens of business owners in the southeastern coastal city of Wenzhou had fled for parts unknown, leaving behind a shambles of unpaid debts and ruined companies.  Two had even killed themselves by jumping from their office towers.  Facing pressure from rising wages and input costs, as well as a less competitive Renminbi, these entrepreneurs had apparently gotten themselves enmeshed in informal lending schemes that had gone belly up — China’s own version of a “subprime” crisis.  After Premier Wen arrived on the scene and directed local banks to extend emergency loans, many were quick to call it an isolated instance of Wenzhou’s trademark brand of seat-of-the-pants entrepreneurship gone awry.  But others saw it as an alarming example of a much larger trend:  an explosion in risky, off-books ”shadow” lending as a way around the government’s efforts to rein in runaway bank lending, a hidden, casino-like money market Fitch estimated at RMB 10 trillion (US$ 1.5 trillion).  If so, they argued, Wenzhou’s woes could be just the tip of the iceberg.

5.  Muddy Waters.  When research firm Muddy Waters, founded by former journalist Carson Block, accused Chinese timber company Sino-Forest of exaggerating its land holdings and profits, it set off an avalanche.  Not only did it cost hedge fund manager John Paulson — famous for betting against U.S. subprime mortgages – up to $500 million after the stock plunged over 85%.  It also sparked a widespread hunt to identify — and sell short – other overseas-listed Chinese firms that might have something to hide, particularly “backdoor” or “reverse merger” listings which had avoided prior scrutiny.  It signified a sea change in market sentiment: investors who, absent any direct knowledge, once assumed that all China stocks were winners, now feared they were all outright frauds.  In November, when Muddy Waters turned its guns on Chinese advertising seller Focus Media, the stock plunged 66% at one point due to short-selling, leaving Chinese overseas-listed firms feeling bruised and battered, and wondering which of them could be in the cross-hairs next.

6.  RMB Internationalization.  This year saw numerous high-profile predictions that China’s currency, the yuan (CNY) or Renminbi (RMB), is destined to supplant the dollar as the world’s leading reserve currency.  As if to realize this aim, the Chinese government embarked upon a number of steps intended to increase the use of the RMB beyond China’s borders.  It expanded its currency swap arrangements with other countries, authorized more dim sum and panda bonds to be issued in RMB, and encouraged Chinese exporters and importers to settle their trade bills in yuan.  One result was a dramatic expansion in holdings of offshore RMB in Hong Kong (CNH), which doubled to RMB 620 billion by October.  Critics, however, counter that the yuan is still a long way from free convertibility — a prerequisite for any truly international currency — and point to a late-year fall-off in CNH deposits as evidence that willingness to hold yuan was primarily driven by short-term speculative interest, rather than longer-term faith in the RMB.

7.  Eurozone Crisis.  The frantic efforts by European leaders to stave off a debt meltdown and save the Euro may have unfolded in Athens and Frankfurt, but all eyes were on Beijing.  After an emergency summit in October agreed to expand the Eurozone bailout fund to €1 trillion, the head of that fund flew immediately to Beijing, hat in hand, to ask the Chinese to chip in from their massive foreign reserve holdings — a move some said marked China’s emergence as the world’s top economic power.  Earlier, Italy had floated the idea that China’s sovereign wealth fund would step in and rescue its bond market, and make much-needed investments in its economy.  The Chinese, while undoubtedly flattered, in the end were cool to the notion of “saving the world,” insisting they had their hands full with their own problems.  Among them:  fears that a renewed downturn in Europe would hurt demand for Chinese exports, and slow China’s growth.  By the end of the year, however, China did make at least one major acquisition in Europe, when its Three Gorges power company bought the Portuguese government’s 21% stake in Energia de Portugal (EDP) for $3.5 billion.

8.  U.S. Currency Threats.  Despite the fact that China’s currency steadily appreciated throughout 2011, ending the year up nearly 5% against the dollar, the sluggish U.S. job market ensured that the exchange rate remained firmly in Congress’ political crosshairs.  In October, the U.S. Senate finally passed a long-threatened bill to impose wide-ranging trade sanctions on China in retaliation for its currency policies, by a vote of 63-35.  Chinese spokesmen reacted with predictable fury, but Speaker Boehner prevented the bill from reaching a vote in the House, saving President Obama from an awkward election-year veto decision.  While Boehner called the bill “dangerous,”  the front-runner for the Republican presidential nomination, Mitt Romney, racheting up his rhetoric on China, promising to declare China a “currency manipulator” on his first day in office – all of which suggests a rocky road for US-China relations as the U.S. enters next year’s election season.

9.  National Social Insurance Law.  Last November (2010), China passed a national social insurance law – a major milestone that replaces a confusing and inadequate hodgepodge of local programs and taxes.  However, when the law went into effect this July, foreign businesses in China had an unwelcome surprise:  a little-noticed clause that required foreign expats to pay into the system — despite the fact that no collection mechanism had been set up, despite the fact that in most cases it would be all-but-impossible for them to collect any benefits.  Then the northeastern city of Dalian — at the prompting of China’s Ministry of Finance — suggested it planned to lift the cap on income subject to payroll taxes, effectively subjecting foreign expats and other MNC employees to a 30% tax on top of China’s 45% income tax rate.  So far, appeals to modify the policy have gone unanswered, even though more labor-intensive foreign-run businesses, like international schools and hospitals, say it is a deal-killer for operating in China.  The new taxes, along with a secret circular restricting the ability to foreign firms to reinvest profits within China (which has since been scrapped), and an apparent crackdown on a commonly-used investment structure known as Variable Interest Entities (VIEs) all have contributed to a climate of growing concern and uncertainty that may help explain, at least in part, the recent decline in Foreign Direct Investment (FDI) into China.

10.  Telecom Antitrust Investigation.  In November, China’s two state-owned telecom giants, China Telecom and China Unicom, admitted fault and reached a settlement with antitrust regulators in an investigation into price-fixing and other anticompetitive practices in their broadband internet access business.  The case, which was brought by the powerful National Development and Reform Commission (NDRC) — and according to earlier reports involved billions in potential fines — was the first under the country’s new Anti-Monopoly Law (AML) that targeted a Chinese state-owned enterprise (SOE).  Previous cases had uniformly focused — many argued unfairly — on acquisitions or pricing behavior of foreign firms, despite the fact that Chinese SOEs often occupy semi-monopolistic positions in protected markets.   The investigation and its outcome, which the NDRC says will save consumers money, raises the encouraging prospect that Chinese regulators may — at least in some circumstances — be willing to impose discipline on powerful state companies, which often behave as a law unto themselves.

• First, two on-the-ground reports about the property bubble bursting in 2nd-tier cities.  Bloomberg offers this report on Sanya (on China’s southern island province of Hainan) where the frenzy to pick up vacation villas has taken a nosedive, with home prices dropping 28% year-on-year in November and sales volume off 52%.  Steve Dickinson, based in Qingdao (in the northeast coastal province on Shandong) reports on ChinaLawBlog.com that developers there are regularly offering 30-50% discounts and that construction on uncompleted projects has slowed.  He says “the collapse in the real estate market has already occurred” and the only remaining question is how the government will pick up the pieces.  In a related post, he relates the story of a Qingdao couple who now find themselves deep underwater after going into debt to buy a unfinished apartment at the peak of the market.  Events in Sanya and Qingdao reinforce my point that China’s property bubble — and its consequences — is really a nationwide phenomenon, by no means limited to Beijing and Shanghai.
• Caixin offers this report on the huge stress that plummeting land sales are putting on local government finances.  As one expert declares, “The land market is basically deadlocked” as developers enter “winter mode” and stop buying land for new construction projects — a description eerily reminiscent of my own warning, at The Economist China Summit last month, that “winter is coming.”  Again, the problem is even more serious in 2nd and 3rd-tier cities (Dalian’s revenue down 50%, Wuxi’s by 34%, Nanjing by 29%, Wuhan by 21%) than in Beijing (down 14.4%)and Shanghai (down 13%).  The revenue shortfall is making it hard for some cities to pay for basic services like police and hospitals, much less repay the massive amount of debt they borrowed for stimulus projects – which, according to this report from Bloomberg, may be much larger than official statistics suggest.  Interestingly, Caixin reports that some city governments are forcing local developers to continue buying land whether they want to or not — which makes local efforts to loosen up lending look less like real economic stimulus and more like a dangerous game of pass-the-buck.
• Anne Stevenson-Yang of J Capital Research here in Beijing sent me one of their reports, which outlines various ways developers are offering hidden discounts — such as group discounts, no-fault returns, buy-one get one free deals, and gifts (like luxury cars or bars of gold) — that don’t show up in official price statistics, which means the real price collapse may be even worse than those figures indicate.  Again, discounting was actually more severe in 2nd and 3rd-tier cities like Chengdu, Hefei, and Kunming than in Beijing and Shanghai.
• I was reading through a recent report by Pivot Capital when I came across the following factoid, which set me back a bit.  It turns out that the average home price in Guiyang – the capital of Guizhou, the poorest province in China — is now nearly the same as in Phoenix, Arizona, a city roughly the same size (4 million people) but with a per capita GDP about 10x Guiyang’s.

Finally, I just have to remark that I find it a real hoot when I read officials claiming — and credible media reports repeating the claim – that plummeting property prices across China are evidence that the government’s top-down “cooling” measures are “taking effect” and ”working.”  Keep in mind, the central government started putting its most prominent administrative controls, such as purchase restrictions, into effect in April 2010 — nearly two years ago — and began trumpeting their success a mere two weeks later.  The reason we are where we are now is because property developers ignored those measures and piled up unsold inventory for nearly two years in the not-unreasonable belief they could call the government’s bluff.  (I said as much at the time, on Chinese TV — see interview on May 18, 2010, beginning at point 23:50).  Even when rapid credit expansion caused inflation to balloon, forcing the central bank not exactly to tighten, but at least rein in the pace of that expansion, authorities turned a blind eye to an explosion in off-the-books shadow credit that kept funding land purchases and construction, and applauded when statistics showed real estate investment continuing to grow at 25-30% year-on-year – until this Fall, when the growing need to roll over bad debt while keeping inflation in check made it well-nigh impossible to keep throwing money at this boom.  That’s when developers ran out of money and had to start liquidating, and the bottom finally fell out of the market.  For officials to claim that their policies are “working,” in some kind of reliable fashion, is like a doctor standing over the stone-cold corpse of his patient claiming that he cured the man of his fever.  No more fever, right?

China’s Real Estate Bubble May Just Have Popped
A Host of Factors Are Set to Undermine the Country’s Economic Growth

by Patrick Chovanec

For years analysts have warned of a looming real estate bubble in China, but the predicted downturn, the bursting of that bubble, never occurred — that is, until now. In a telling scene two months ago, Shanghai property developers started slashing prices on their latest luxury condos by up to one-third. Crowds of owners who had recently bought apartments at full price converged on sales offices throughout the city, demanding refunds. Some angry investors went on a rampage, breaking windows and smashing showrooms.

Shanghai homeowners are hardly the only ones getting nervous. Sudden, steep price reductions are upending real estate markets across China. According to the property agency Homelink, new home prices in Beijing dropped 35 percent in November alone. And the free fall may continue for some time. Centaline, another leading property agency, estimates that developers have built up 22 months’ worth of unsold inventory in Beijing and 21 months’ worth in Shanghai. Everyone from local landowners to Chinese speculators and international investors are now worrying that these discounts indicate that “the biggest bubble of the century,” as it was called earlier this year, has just popped, with serious consequences not only for one of the world’s most promising economies — but internationally as well.

What makes the future look particularly bleak is the lack of escape routes. If Chinese investors panic and rush for the exits, they will discover that in a market awash with developer discounts, buyers are very hard to find. The next three months will be a watershed moment for a Chinese investor class that has been flush with cash for years but lacking a place to put it. Instead of developing a more balanced, consumer-based economy, an entire regime of Beijing technocrats — drunk on investment-led growth — let the real estate market run red hot for too long and, when forced to act, lacked the credibility to cool the sector down. That failure threatens to undermine the country’s continued economic rise.

Real estate woes are already sending shockwaves through China’s broader economy. Chinese steel production — driven in large part by construction — is down 15 percent from June, and nearly one-third of Chinese steelmakers are now losing money. Chinese radio reports that half of all real estate agents in the southern city of Shenzhen have closed up shop. According to Centaline, more than 100 local government land auctions failed last month, and land sale revenues in Beijing are down 15 percent this year. Without them, local governments have no way to repay the heavy loans they have taken out to fund ambitious infrastructure projects, or the additional loans they will need to keep driving GDP growth next year.

In a few cities, such as coastal Wenzhou and coal-rich Ordos, the collapse in property prices has sparked a full-blown credit crisis, with reports of ruined businessmen leaping off building rooftops; some are fleeing the country. The central bank’s decision on December 5 to lower the reserve requirement ratio for the first time in three years signaled a broader move to pump money into the economy. Beijing has directed banks in Wenzhou to extend emergency loans to troubled borrowers. Of course, officials could halt the sell-off simply by handing developers enough cheap loans to allow them to carry their inventory. But such a strategy risks re-inflating the bubble.

The impact of a housing downturn would have a significant impact globally. International suppliers who have been fueling China’s construction boom — iron-ore miners in Australia and Brazil, copper miners in Chile, lumber mills in Canada and Russia, and multinational equipment makers such as Caterpillar and Komatsu – could be hard hit. Heavy losses on real estate and related lending could damage investment and consumer confidence, undermining the rising tide of Chinese demand that has been a much-needed growth engine for everything from Boeing airplanes to Volkswagen and GM automobiles to KFC and McDonald’s fast food.

Understanding how this came to pass means parsing the host of distortions and mind games that characterize China’s real estate market. Residential real estate construction now accounts for nearly ten percent of the country’s total GDP — four percentage points higher than it did at the peak of the U.S. housing bubble in 2005. Bullish analysts have long argued that large-scale urbanization and rapidly rising incomes warrant such an extraordinary boom.

But new urban residents are not the immediate drivers of China’s recent run-up in real estate. Chinese investors, large and small, are the ones creating the market. For more than a decade, they have bet on longer-term demand trends by buying up multiple units — often dozens at a time — which they then leave empty with the belief that prices will rise. Estimates of such idle holdings range anywhere from 10 million to 65 million homes; no one really knows the exact number, but the visual impression created by vast “ghost” districts, filled with row upon row of uninhabited villas and apartment complexes, leaves one with a sense of investments with, literally, nothing inside.

The craze for vacant real estate is due in large part to a lack of attractive alternatives. Strict controls on capital outflows prevent most Chinese citizens from investing any real money abroad. Chinese bank deposits earn very low interest rates — lower, for the past year now, than the rate of consumer inflation. The public sees the country’s domestic stock exchanges, which have endured volatile ups and downs over the last few years, as little more than high-risk casinos. In contrast, real estate, which has not seen a sustained downturn since China first converted to private homeownership in the 1990s, has long looked like a sure bet.

Beijing’s response to the global financial crisis added jet fuel to the fire. To maintain GDP growth of nearly ten percent during a massive downturn in global demand, China’s leaders engineered a lending boom that expanded the country’s money supply by roughly two-thirds. Real estate was already the preferred place for the Chinese to stash cash; now, investors had that much more cash to stash. Prices rose accordingly: In many locations, the cost of prime new properties doubled in just two years.

But this run of speculation has bid up the price of housing and left people who actually need a place to live in the lurch. Given the prices prevailing earlier this spring, the average wage earner in Beijing would have had to work 36 years to pay for an average home, compared to 18 years in Singapore, 12 in New York, and five in Frankfurt. The bidding war has further pushed developers to build ever more costly luxury properties that investors crave but few ordinary people can afford.

By the spring of 2010, China’s leaders were growing increasingly worried that skyrocketing prices were sowing the seeds of social unrest. In response, Beijing imposed a series of cooling measures to rein in speculative demand. These included a stipulation for larger down payments, tougher qualifications for mortgages, residency requirements for home purchasers, and limits on the number of units a family could buy. Although these restrictions were mainly confined to Beijing and Shanghai, where central authorities hold the greatest sway, they were meant to send a clear signal that China’s leaders wanted property prices to level off.

Real estate developers, however, believed they had seen this movie before. They had witnessed earlier cooling campaigns, as recently as early 2008. Each lasted a few months before reverting back to business as usual. Local governments depend on a healthy real estate market to generate revenue from land sales (as the state owns the land), and property development has long been a key driver of the GDP growth that the central government both demanded and prized. Let them see the effects of a slowdown, developers figured, and China’s leaders would rush back in to support the sector. They always had before.

So the property developers bet against cooling. They continued borrowing and building, even in the face of a relatively soft and uncertain market. Until that point, Chinese developers had been able to move everything they built, usually pre-selling it before it was finished. But starting in the late spring of 2010, they began piling up substantial stocks of unsold inventory, for the day when the government would, so they thought, relent and demand would come surging back.

Because the industry kept on building, there has been no negative impact on GDP. Real estate investment has continued growing at nearly 30 percent annually. But inflation began to rise from 1.5 percent in January 2010 to a peak of 6.5 percent in July 2011, and authorities began to sweat. They broadened their cooling efforts. The central bank tightened credit expansion, and China’s economy began to slow. As 2011 progressed, developers scrambled for new lines of financing to keep their overstocked inventories. They first relied on bank loans (until they were cut off), then high-yield bonds in Hong Kong (until the market soured), then private investment vehicles (sponsored by banks as an end run around lending constraints), and finally, in some cases, loan sharks. By the end of last summer, many Chinese developers had run out of options and were forced to begin liquidating inventory. Hence, the price slashing: 30, 40, and even 50 percent discounts.

The biggest unanswered question is whether existing investors — the people holding all those sold but empty “ghost” condos and villas — will join in the sell-off, which could turn the market’s retreat into a rout. So far, that has not materialized. Unlike highly leveraged developers, most multi-home buyers invested their own money and do not face the same immediate pressures to sell. However, their willingness to hold idle properties depends on real estate’s reliability as a store of value — a rationale that seems to be disintegrating before home buyers’ eyes. While pre-owned home prices in Beijing fell only three percent last month, transaction volumes there and in other cities have plummeted (down 50 percent year on year in Shenzhen, 57 percent in Tianjin, and 79 percent in Changsha), suggesting that many owners would like to sell — so long as it is not at a loss — but are having trouble finding buyers. Would-be residents, who once felt pressured to buy before prices rose even further, now prefer to wait and look around for a better deal.

In recent weeks, a growing chorus has called on the government to lift restrictions on multiple home purchases — revealing, when push comes to shove, just how much the market has come to depend on investor, rather than end-user, demand. But both types of demand depend, in their own way, on the assumption of ever-rising prices. Unless that assumption can somehow be restored, neither looser regulation nor looser lending will persuade the Chinese to pile back into property. Just as elsewhere, China’s monetary authorities may find themselves, as it’s said, pushing on a string of unwilling demand.

Ironically, as Chinese investors start pulling their money out of property, many are putting it into bank- and trust-sponsored “private wealth management” vehicles that promise high fixed rates of return but channel the proceeds into investments — like real estate developers and local government bonds — whose returns are themselves predicated on ever rising property prices. Many fear this repackaging of real estate risk is laying the foundation for a follow-on crisis that some are labeling the Chinese equivalent of Wall Street’s collateralized-debt-obligation mess.

While frightening, the popping of China’s real estate bubble is not all bad news. Cheaper, more affordable housing could also unlock the savings of China’s working-class families, unleashing greater consumer demand and helping to rebalance the global economy. Investment long bottled up in idle real estate could flow to more productive pursuits. These adjustments have been put off too long. This is why at least some of China’s leaders appear determined to force a correction despite the risks. But they know they are walking a razor’s edge.

Before the fall of the Berlin Wall, Havel was best known as a leading signatory of the Charter 77 document, which called on the Czechoslovakian government to live up to its own commitments on human rights.  The document was denounced and banned, and Havel was sentenced to repeated stays in prison, the longest lasting four years.  Charter 77 became the model for similar protest documents in other countries, most notably China’s Charter 08, for which Liu Xiaobo is currently imprisoned and was awarded the 2010 Nobel Peace Prize.

We know that the Wall eventually fell and that Havel was elected to lead his newly freed country.  However, he must have experienced long periods in which he doubted his efforts and sacrifices would ever bear fruit.  About these times, he wrote:

“Hope is not a feeling of certainty that everything ends well.  Hope is just a feeling that life and work have meaning.” 

About the regime he struggled so long to unmask, he wrote: 

“We are all involved: those who have created, in a greater or smaller way, this scheme, those who accepted in silence and all those who have become used to it subconsciously.”

About his decision to enter the fray as a politician, he said:

“You can’t spend your whole life criticizing something and then, when you have the chance to do it better, refuse to go near it.”

About himself, he wrote:

“Anyone who takes himself too seriously always runs the risk of looking ridiculous; anyone who can consistently laugh at himself does not. ”

One of the most famous and important things Havel wrote was about his guiding philosophy living under an oppressive regime.  He said that he had decided to live and write “as if” he were free, and accept whatever happened.  He refused to self-censor out of fear — that was true slavery.  Many times, living and writing in China, I have thought about his words, both as an inspiration and as a challenge.  It is, needless to say, not easy.

Thank you, Mr. Havel.  You will be remembered, and missed.

I actually thought the Bloomberg interview was going to focus on the tax cuts and/or reforms that Chinese policymakers have been discussing as part of their effort to (a) re-stimulate the economy, and (b) encourage a substantive economic adjustment toward greater domestic consumption.  But the conversation never turned in that direction.  So I’ll share the thoughts I would have shared here:

• Smart tax cuts can play a role in stimulating innovation and consumption in China, and hence growth.  But the key is cutting the right taxes, and stimulating the right things.  China’s current tax system is geared towards subsidizing production (particularly exports) and investment (particularly real estate) at the expense of savers and consumers.  This needs to change, but unfortunately many of the tax “reforms” officials are currently talking about go in the wrong direction.  Let me give three examples:

1. Lower and middle-income earners account for over half of all income tax revenue in China (compared to the U.S., where the top 10% of income earners pay 71% of federal income taxes, and the bottom half pay only 3%).  This places a huge burden on lower-income earners and suppresses consumption.  The solution, some Chinese policymakers believe, is simple:  make the tax code more progressive.  They even started to shift in this direction earlier this year.  The problem, though, isn’t the tax rate — China’s top marginal rate is 45%.  The problem is uneven enforcement and collection.  SOE employees — including top management – receive a lot of their compensation in-kind (free food, free housing, free car with driver, etc) and tax-free.  Business owners can classify their income in ways that avoid taxes.  Officials, we all know, receive much of their income under the table.  The only people who actually pay 45% of their real income are foreigners or Chinese nationals working for foreign companies.  Raising their tax rates — which are already high — will just drive people to Hong Kong.
2. One stimulus tax cut the Chinese government is talking about is increasing the VAT rebate for exports.  All that will do is reinforce the existing imbalances in the Chinese and global economies.
3. One way the Chinese can potentially boost consumption is by creating a social safety net (either public or private in nature) that might allow people to lock up less savings to provide against unemployment, medical bills, or old age.  But the new National Social Security Law requires foreigners working in China to contribute to the payroll tax, even though they have no way of collecting the benefits (for instance, if you lose your job in China, you lose your visa, so you can’t collect unemployment).  Worse, Dalian is considering plans to remove the cap on payroll tax liability (now limited to three times the local average wage), which would effectively impose a 30% tax on top of the 45% income tax, for a total effective tax rate of 75%.  This is supposed to stimulate the economy?

• As China does look at more meaningful ways to cut taxes, policymakers should keep in mind that China’s fiscal resources are not as limitless as they seem.  Officially, China’s public debt to GDP ratio is somewhere around 20-30% (depending on who’s doing the counting).  This ignores, however, the contingent liabilities that the Chinese government is on the hook for — bailouts for banks, local governments, ministries (like the Ministry of Railways), SOEs, the property sector (in the form of subsidized housing campaigns).  Relative optimists (like the folks at Dragonomics) put China’s actual debt to GDP ratio at 90%.  Pessimists (like Victor Shih, Michael Pettis, or the folks at Fitch) put it at 200% or higher — Greek levels.  Not to say that China shouldn’t be looking at ways to improve its tax system, and reorient its incentives — it should — but it does not have, as many seem to think, money to burn.

If you’re not thoroughly depressed already, you can check out an interview I did on CNN about a week ago (and only just located the link for) on latest summit held by EU leaders to resolve the Euro debt crisis.  A week later, I think my comments — I said that European leaders have no growth plan, and “are rearranging deck chairs on the Titanic” — have held up rather well.  At first, German Chancellor Angela Merkel was quite confident in describing the meeting as a success, producing a landmark agreement that would bind the Eurozone together.  Now, a growing number of countries aren’t so sure.  The Czechs say they want to see the details, the Irish say they might have to hold a referendum.  And so it goes . . . no wonder the Chinese are nervous.

On my better days, I figure this is what the American Founding Fathers must have looked like when they were foundering around under the Articles of Confederation, before they sat down and drafted the Constitution.  And maybe that’s precisely what Merkel and Sarkozy are driving at.  But I can’t help seeing a whole lot of Rhode Islands here (which didn’t ratify the Constitution until more than a year after President Washington was sworn into office) who have no intention of signing up for the French or German idea of “a more perfect union.”

Last, on a much-needed lighter note, check out this wonderful parody from The Onion on Facebook as a not-so-secret CIA program.  My favorite line, on Twitter as a failed CIA program: “Funding for that should be cut entirely … 400 billion tweets and not one useful bit of data was ever transmitted.”  Second best part:  “Operation Farmville”.