Is Your China Glass Half Empty or Half Full?

The national average price of a new home rose by only 1.4%, a big drop from the 7.7% increase in 2013. Recent trends have been worse, however, with median new home prices falling on a month-on-month (MoM) basis for seven consecutive months. But the rate of decline has been shrinking, leading me to believe that the market has begun to stabilize. On a YoY-basis, median new home prices have fallen for four months, and were down 4.5% in December. Investors should be aware that because of the base effect (prices rose more 9% last January and were up more than 5% every month through May 2014), even if the MoM price fall continues to shrink, the YoY decline in prices will continue to worsen in the coming months, before improving in the second half of the year. This is why it is important to look at the MoM and YoY trends, and understand the base effect—something the media often neglects.

It is important to understand that if, for several months, new home prices are down by say 5% YoY, there are a few reasons why this may not precipitate a crisis. First, because prices rose at an average annual pace of 8.4% over the last nine years, very few homeowners ought to be in the red. Second, new home buyers must put down at least 30% cash, far from the 2% median cash down payment made by first-time homebuyers in the U.S. in 2006.

Moreover, the products that broke Lehman Brothers—and caused havoc through the U.S. financial system—do not exist in China. There are no subprime mortgages and there are very few mortgage-backed securities. There is no secondary securitization, so no collateralized debt or loan obligations (CDOs and CLOs). China's residential market is clearly soft, but I believe a housing crisis is very unlikely.

Rebalancing Progress

China continued to rebalance and restructure its economy last year. Consumption contributed more to GDP growth than did investments, as was the case in 2011 and 2012. The tertiary sector (services, retail and wholesale trade in addition to finance and real estate) was larger than the secondary sector (manufacturing and construction), as was the case in 2013.

The most important "rebalancing" is the shift toward an economy that is driven by private sector entrepreneurs, and away from the model of an economy led by state-owned enterprises. Last year, state firms accounted for 32% of total FAI, down from a 58% share in 2004. Investment by private companies has grown faster than that by state firms in 57 of the past 58 months, which should lead to far better investment decisions.

I expect this reform process to continue, in part because China's leaders have no choice. They must continue to improve the operating environment for private firms, which account for about 80% of all urban employment and almost all new job creation. I have modest expectations, however, for further progress on the reform of state firms, as the government remains concerned about job losses.

Get Used to Deceleration

Investors must become accustomed to steadily slower rates of growth in almost all parts of China's economy. Deceleration is inevitable for many reasons: the end of China's "catch up" phase; the urbanization rate has hit 55%, up from 36% in 2000, and that process is slowing; the end of the demographic dividend, as the young working age population is shrinking; basic reforms, which have the most dramatic impact, have been completed; construction activity has peaked as infrastructure and housing have matured; and productivity gains are increasingly harder to achieve. I expect to see GDP growth in the 6.5% to 7% range this year, and 5% to 6% by 2020.

We are now in an odd period of time in which China's Communist Party is comfortable with this deceleration, while many in the West are increasingly worried by that trend. One of the most positive economic developments last year was that the Party refrained from deploying significant stimulus. The growth rates of bank lending and total credit outstanding, as well as of fiscal spending all slowed as expected. The Party seems to understand that gradually slower growth is inevitable, and that as long as the job market remains steady and income growth rapid (faster than GDP in recent years), most Chinese will feel that their standard of living is rising despite slower GDP growth. Eventually, the market will come around to this perspective.