CHINA ASSET BUBBLES: ARE THEY HERE, WILL THEY POP?

C O N F I D E N T I A L SECTION 01 OF 03 BEIJING 000292

SIPDIS

STATE FOR E, EAP, EAP/CM
TREASURY FOR OASIA/DOHNER/WINSHIP AND LOEVINGER
NSC FOR LOI
STATE PASS USTR

E.O. 12958: DECL: 02/04/2035
TAGS: ECON EFIN ETRD EINV PREL PGOV CH
SUBJECT: CHINA ASSET BUBBLES: ARE THEY HERE, WILL THEY POP?

REF: A. SHANGHAI 34

B. 09 BEIJING 3191

C. SHANGHAI 22

D. 09 BEIJING 3421

Classified By: Deputy Economic Chief Robert Forden; Reasons 1.4 (b, d)



1. (C) Summary. China's massive 2009 monetary stimulus
program was instrumental in avoiding economic recession
during the global crisis, but the huge amount of new credit
flowing into the economy has prompted concerns that asset
bubbles could form -- and burst -- in the property and equity
markets. Since the start of 2010, China's monetary policy
agencies accordingly have begun to tighten credit
availability, raising the reserve ratio requirement and
announcing other regulatory measures. In the booming real
estate market, which played a key role in keeping the economy
booming in 2009, housing price increases accelerated late
last year, prompting Premier Wen Jiabao and the State Council
to announce a slew of new lending, taxation, credit, and land
policy measures to cool the market. Official concern
escalated when new lending reached RMB 1.1 trillion (USD 160
billion) in the first two weeks of January, well above the
government's desired pace. With demand for new housing for
various reasons likely to continue to expand in 2010 and
beyond, the possibility of bubble formation is likely to
increase by late-2010 or early-2011. For China's
historically volatile stock markets, price-earnings ratios
have climbed sharply over the past year, but officials appear
less concerned. End Summary.


2. (C) Comment: Analyst opinions about the likelihood of
bursting bubbles vary, but most believe that despite some
worrisome data, the government is monitoring the situation
closely and has the means to avert any catastrophic crashes
in 2010 (ref a). The stock exchanges will be volatile, with
sharp short-term changes, but the analysts believe the
underlying economic fundamentals largely remain sound and
will propel share prices on a bumpy yet upward ride. For
real estate, the bubble would be larger and the negative
consequences potentially greater, but the People's Bank of
China (PBOC) and other regulators are able to employ an array
of micro-control measures, including interest rate
adjustments and down payment requirements that can vary by
city, to cool off individual over-heating markets. End
Comment.

Background
--------------

3. (SBU) Economic bubbles, generally defined as trade in high
volumes at inflated values, or as too much money chasing too
few assets, have appeared in a variety of countries at
different developmental stages, often due to excessive
liquidity in the financial system. In China, concerns about
the potential impact of the global financial crisis prompted
the government in late-2008 to implement massive monetary and
fiscal stimulus programs, including removal of bank lending
quotas. As a result, in 2009 Chinese banks issued USD 1.5
trillion in new credit, roughly double the previous record
set in 2008. While most of this money apparently reached its
intended destinations -- infrastructure projects, industrial
investment, and to a lesser extent programs to encourage
consumption -- analysts estimate there was substantial (e.g.,
twenty percent) "leakage" into, among other places, the
equity and real estate markets.


4. (SBU) This "leakage" would not attract too much official
attention as long as it did not generate other significant
problems, such as inflation and/or asset bubbles, which could
in turn lead to the dreaded "social instability." Inflation
and asset bubbles would not necessarily appear together, but
policy measures to address them generally would overlap.
Inflation, because it has helped spark social instability in
the past (e.g., 1989) and presumably could do so again, is a
key concern of the Chinese Government. Senior leaders and
financial regulators monitor price indices closely for any
signs of imminent escalation. Through most of 2009, as the
banks -- at the government's behest -- pumped stimulus money
into the economy, consumer price changes hovered around zero,
only turning slightly positive in November. In early
January, unusually cold weather and heavy snowfalls in
northern China led to a sudden jump in food prices. Beyond
that temporary phenomenon, however, surging economic growth
and rebounding exports have led some forecasters recently to

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raise inflation predictions for 2010 to 3.0-3.5 percent
(versus 2-2.5 percent previously). While low by developed
country standards, this level of inflation in China is
sufficient to prompt official concern and monetary policy
tightening.

Government Intervenes
--------------

5. (SBU) Since the start of 2010, China's monetary policy
agencies have begun to tighten credit availability. On
January 12, the PBOC raised the reserve ratio requirement
(RRR) by fifty basis points, to 16 percent for large
commercial banks (accounting for more than half of total
deposits) and 14 percent for small banks, effective January
18 (rural credit cooperatives were exempted). Analysts
believe the move was triggered by the early-January surge in
bank lending, which the government's actions sharply slowed
over the last ten days of the month. The RRR increase -- the
first since June 2008 -- was welcomed by most economists, who
believe it signaled the beginning of monetary policy
"normalization" by removing excess liquidity and containing
the risk of asset inflation and bubble formation. Such a
small raise in itself would not have much affect, but the
action implies further tightening measures in the next few
months, including more RRR hikes, direct credit controls
through "window guidance" to slow bank lending, restrictions
on investment in sectors with excess capacity, and perhaps
even price controls if food prices continue to rise.

Real Estate
--------------

6. (SBU) 2009 was a boom year for China's real estate sector,
which played a major role in compensating for the export
slump. In addition to some specific stimulus measures for
real estate introduced in late-2008, two other macroeconomic
factors boosted prices in 2009. First, the enormous monetary
stimulus caused money supply to increase much faster than
GDP, with a considerable portion of the excess liquidity
flowing into the asset markets, including real estate.
Second, in the wake of a slow-down in new construction since
mid-2008, officials and consumers alike were concerned about
rising prices and a potential supply shortage. Beyond these
factors, low mortgage interest rates and low overall taxation
on property purchase and ownership make property investment
an attractive proposition for Chinese consumers. According
to the China Banking Regulatory Commission (CBRC),real
estate development loans and individual home mortgages now
constitute twenty percent of total bank loan balances. Also,
large volumes of overseas investment and "hot money" are
believed to have poured into real estate investment over the
past year.


7. (SBU) In late-2009, officials began to worry that bubble
trouble was imminent for the real estate sector. Controlling
inflation, including property prices, was a major topic of
the December Central Economic Work Conference in Beijing (ref
b). November data on housing starts and property sales,
presumably available to officials before that conference,
showed huge jumps over October and compared to one year ago.
Prices accelerated even more in December, rising at the
fastest pace in eighteen months, according to the National
Bureau of Statistics (NBS). Housing prices in seventy large
and medium cities surveyed increased 7.8 percent in December
(y-o-y),contributing to growing fears of a bubble in the
sector. The cities with the most rapid increases were
Guangzhou, Shenzhen, Haikou, and Beijing. NBS attributed the
December rise to record bank lending levels in 2009,
favorable policies, and speculation. For all of 2009,
residential housing sales rose 35 percent from 2008, while
average sales prices jumped 16-27 percent in major cities.

Cooling the Market
--------------

8. (SBU) In late-December, Premier Wen Jiabao said his
government would attempt to moderate rapid growth in the real
estate market through taxation, credit, and land policy
measures. Next, the State Council re-imposed a 5.5 percent
tax on transactions involving residential property held for
less than five years. On January 7, the State Council issued
new regulations and orders to cities with rapidly rising
housing prices. It directed the municipal governments to
take steps to increase housing supplies for low-income
residents, and to prevent developers from hoarding land or
withholding housing from the market to drive up prices (ref
c). On January 10, the State Council also instructed the

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PBOC and the CBRC to tighten oversight of bank lending for
real estate purchases.

2010: Will the Bubble Burst?
--------------

9. (C) According to UBS Chief Economist Wang Tao, for 2010
and beyond, the need for new housing likely will continue to
grow rapidly, due to rising incomes, substantial pent-up
demand, and the government's recently announced intention to
facilitate more rural-to-urban migration (ref d). The
Government apparently intends to increase the supply of mass
market housing, especially in smaller cities, while also
seeking to reduce property-related lending that fuels
speculation. While a strong increase in supply could slow
price rises, Wang believes "exuberant expectations" of price
rises together with still-plentiful liquidity and the other
incentives noted above could continue to push demand,
possibly leading to a bubble in late-2010 or early 2011.

Stock Markets
--------------

10. (SBU) Since their inauguration in the early 1990s,
China's stock markets have been highly volatile, in part due
to inexperienced investors eager to take quick profits.
China's equities markets rose eighty percent in 2009, with
considerable volatility at various times. Overall, China's
capital markets raised 447 billion RMB (USD 65 billion) in
2009, the second highest total on record (after 2007). For
stock markets, one indicator of bubble formation would be
share prices misaligned with company earnings. For shares
listed on the Shanghai Stock Exchange (SSE),the current
price-earnings ratio is around 28, somewhat high compared to
developed country markets but in line with the SSE's
historical levels. What prompts bubble worries, however, is
that in October 2008 the SSE P-E ratio was just 14, so it has
doubled in just over one year.

What About the RMB?
--------------

11. (SBU) Some analysts believe the January 12 RRR increase
announcement was prompted in part by December's sharp rise in
exports, which heightened speculation that RMB appreciation
-- on hold since August 2008 -- might resume sooner than
previously expected. Asset bubbles, however, further
complicate this policy decision: if many investors become
more concerned about bubble formation, they could seek other
investment alternatives. As such options are extremely
limited in China, those investors might seek to place their
funds outside China. Expectations of significant near-term
currency appreciation, however, will generate uncertainty and
confusion in the market.
HUNTSMAN