Insight September 23, 2010, 11:14AM EST

The China Bears Are Wrong

Skeptics who contend that China is heading for a fall misunderstand what's happening in the world's second-largest economy, says columnist Shaun Rein

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China may have passed Japan as the world's second-largest economy in August, but that hasn't stopped bearish analysts from forecasting hard times for the Chinese economy. Such skeptics as short-seller Jim Chanos warned earlier this year that China's real estate bubble is a thousand times worse than Dubai's. Former Morgan Stanley economist Andy Xie has argued that China is in a real estate bubble because 25 percent to 30 percent of the country's homes are vacant and the typical consumer has to work a full year to be able to afford a closet. And Businessweek.com columnist John Lee argues that China has become ever-more reliant on an unsustainable economic model built on exports.

They're not the only ones who have been sounding off on China in pessimistic tones. The mantra of these China bears is that the world's second-largest economy is set for a massive slowdown, at best—and an explosion, at worst. Either way, the rest of the world had better watch out, the argument goes.

Most of the bears' logic simply does not hold up to even basic scrutiny. First, the argument made by Xie about high prices relative to average salaries and empty units does not make economic sense. Vacant units are not a problem if they have been sold to consumers who can afford them and are not held by developers who need to sell in order to pay back their loans. China's real estate developers are not sitting on empty units; they've sold to consumers who hold onto them as investments, much as many investors buy gold bars. Holding these units would be a problem if the investors were overleveraged, as in the U.S. before the crash, when even subprime borrowers could buy multiple houses at zero percent down. That's not what's going in China, where home buyers must pay 30 percent up front if they want to take out a mortgage on their first home, and 50 percent if it's their second. In Beijing, a full 60 percent of second homes are completely paid for up front.

In other words, the people buying homes can afford them. They are not overleveraged. Even if prices drop 20 percent, as they might, the fall won't threaten China's economic stability because there won't be panic selling. Mortgages won't go underwater and investors will still pay back their loans.

Soft landing is well under way

Moreover, it does not matter much from an economic risk standpoint if prices are too high for everyday Chinese. Certainly having adequate housing for low-income Chinese is important to preserve social stability, but that is a different problem altogether. As we think about the Chinese economy, what is important is whether the people who buy homes can afford them. Yes, they can.

Want proof that strict real estate policies implemented earlier this year are working to create a soft landing? Sales have plummeted—sales volumes last month dropped 70 percent year-on-year in the 15 biggest markets—but prices remained stable. That is hardly the sound of a bubble popping.

In commercial real estate, the bears are right: There is cause for concern. Last year many local governments established real estate arms that took out loans from big state-owned banks such as Bank of China and ICBC to get liquidity into the system because they cannot issue debt the way cities in the U.S. do. Nonperforming loans will definitely rise as a result. Investors should be wary.

Still, local debt as a percentage of gross domestic product is only about 12 percent to 14 percent. Add that to 22-percent-to-24-percent central government debt and China debt is only 34 percent to 38 percent of total GDP—far lower than the 65 percent to 70 percent proportion in the U.S. and Britain. The debt level is manageable and can be reduced by increasing taxes or simply reimplementing taxes that were temporarily rescinded last year as a result of the financial crisis.