China: Royal Flush or House of Cards?

The International Comparison Program, a loose coalition of the world’s leading statistical agencies, recently reported that China will become the world’s largest economy this year based on purchasing power parity. PPP measures what money can actually buy. For instance, a hair cut in China is much less expensive than one in the U.S. When you adjust for this you can better compare economies.

The United States has been the world’s largest economy since 1872 so in one sense the recent announcement is a big deal. But in another sense it is not. China is still a low income country. Its per capita income is only 10-20% of the U.S. and globally China ranks just above Turkmenistan but behind Libya and Suriname. 

Source: Financial Times

Source: Financial Times

It is interesting that China fought the release of the ICP data. One reason is that when you are the Number One economy you are expected to take on more global responsibilities. China wants to avoid this, leaving the tricky and expensive problems to the United States. It will not be so easy in the future.

As China gets ever wealthier it will be buying more of what the rest of us produce. This is good news. China today exports 14% more than the U.S but its imports are 30% smaller than the U.S. China’s appetite for imports will increase.

So what could go wrong with China? A big economic question mark is real estate. Apartments and commercial buildings are the investment of choice in China. Hands down. Constructing and outfitting apartments accounted for 23% of China’s GDP in 2013.  This is higher than housing’s share of GDP here in the U.S. prior to the housing bust. In addition, two- thirds of Chinese household wealth is tied up in real estate. At the peak of the U.S. housing boom only 30% or so of our household wealth was in real estate.

Source: Financial Times; ICD; IMF; World Bank

Source: Financial Times; ICD; IMF; World Bank

There are signs of over building in China now. The stories of brand new but empty apartment towers are increasing. Tier one cities such as Beijing, Shanghai, Guangzhou and Shenzhen will probably be fine but second tier and especially third and fourth tier cities could be vulnerable. The Chinese government has done an excellent job controlling the ups and downs of the economy the past thirty years. Whether they can deal with the big elephant in the room now -  real estate - is today’s big question.