Many investors breathed a sigh of relief with China’s second-quarter GDP release, which reported that the economy expanded 7.5% from the prior-year period. That was up from 7.4% in the first quarter of 2014, itself a floor that China hadn’t breached since the global financial crisis.

The consensus interpretation is that China has emerged from a cyclical trough and is back on track to meet the government’s 7.5% full-year growth target. According to this view, Beijing’s “mini-stimulus” worked. Growing public outlays aimed at infrastructure and social housing (and aided by looser credit) offset a moribund real estate market and external headwinds.

The problems with the consensus narrative are twofold.

First, the consensus narrative conflates a rebound in growth with a recovery in fundamentals. While headline GDP has indeed improved, fundamentals, in our view, have worsened. The investment-led growth model remained firmly in place in the first half of 2014. Gross capital formation added more to GDP growth (3.6 percentage points) than did household consumption (about 2.9 percentage points), just as it has in every year since 2007.

This is not a sustainable growth model. With physical capital that largely exceeds the country’s needs across manufacturing, real estate, and infrastructure, China doesn’t suffer from a deficit of investment. Stimulus, in our view, solves little other than the problem of politically unpalatable GDP figures.

Meanwhile, stimulus exacerbates a far more serious problem: debt. Because China has been adding to its capital stock at a rate that far outstrips its needs, returns on capital have fallen considerably. As a consequence, debt has grown faster than GDP for the past several years.

From 2007 to 2013, China’s GDP expanded 68%. China’s total debt burden, including corporate, household, and government borrowings, expanded more than twice as fast over that period: 151%. By year-end 2013, China’s total debt/GDP had swelled to more than double that of fellow large emerging economies such as Brazil, India, and Russia.

The second problem with the consensus narrative is its portrayal of China’s deteriorating real estate market as a headwind for GDP in the first half of 2014. The Financial Times, summarizing the broker reaction to the GDP release, wrote:

“China’s economy grew by 7.5 per cent in the second quarter, topping expectations and suggesting stimulus efforts to stabilise growth have succeeded in offsetting the impact of a weak property market.”

Intuitively, the notion that real estate dragged on GDP makes sense. Starts, sales, and prices all declined versus the prior-year period, empirical evidence backing the numerous anecdotes of China’s real estate woes.

However, just the opposite was true. Real estate was a tailwind to Chinese GDP in the first half, and an ample tailwind at that. Based on our analysis of China’s fixed-asset investment figures for the first six months of the year, real estate added 3 times as much to GDP growth as spending on rails, roads, airports, water, and pipeline transport combined (CNY 671 billion in nominal growth versus CNY 306 billion).

The figures are in sharp contrast to the consensus narrative that identifies infrastructure spending as the key offset to real estate weakness. Even adding utility investments (electricity, gas, and water) to the transport infrastructure total results in a GDP growth contribution 35% smaller than that of real estate.

How might this be?

It isn’t the statistical shenanigans Beijing is often accused of. Rather, it’s a function of how GDP accounting works in China (or any other country, for that matter). Economic output isn’t recognized when a home is started or sold–it’s booked continuously throughout the building process. So even if starts and sales are down, real estate contributes to GDP growth so long as real estate under construction is higher than it was in the prior period.

That was exactly the case in China in the first half of 2014. Floor space started declined 16.4%; floor space sold fell 6.0%. But floor space under construction rose 11.3%. The last is the measure that matters when it comes to counting GDP, so real estate investment grew a nominal 14.1% in the first six months of the year.

The year-to-date August figures continued to show a positive contribution from real estate. Floor space under construction is 11.5% higher than it was at this point last year. Real estate investment is up 13.2% in the first eight months of the year.

But leading indicators, which have a lagged impact on GDP, continue to signal trouble ahead. Year-to-date August, floor space started declined 10.5% and floor space sold declined 8.3%. Worryingly, supply continues to grow despite falling sales: floor space completed increased 6.7% in the first eight months of the year.

If starts remain in negative territory, floor space under construction growth will continue to ebb and real estate’s contribution to GDP will wither. The impact would be material. On a direct basis, real estate accounts for 13% of China’s economic output. For the first half of 2014, we estimate real estate added 0.8 percentage point to GDP growth, equivalent to 10.3% of the total rate. Absent that boost (that is, assuming 0% growth in real estate investment) and holding all else equal, we estimate China’s GDP would have increased at 6.7% in the first half instead of 7.5%.

If the real estate market remains weak or worsens in 2015, growth in floor space under construction is likely to dip into negative territory by year-end. Only then would real estate would turn into a headwind for GDP. We estimate a 10% decline in floor space under construction would slash an additional 1.3 percentage points from China’s GDP from the “no growth” 6.7% figure. Holding all else equal, GDP growth would decelerate to 5.4%.

However, all else is not likely to be equal in such a scenario. A persistently weak real estate market would weigh on a host of related industries, from mining to mortgage banking. While real estate accounts for 13% of GDP on a direct basis, the sector’s share of total economic activity has been estimated at 20%-30% after including related goods and services. Deteriorating real estate conditions would also weigh on household spending, spreading the infection to seemingly unrelated corners of the economy.

The transmission to household spending would occur along two routes: first, by weighing on job growth in real estate and related industries; second, by deflating China’s heady home prices.

Price data across China’s 70 largest cities already signal trouble. For July, 2 of the cities surveyed saw home prices increase, 4 saw no change, and 64 saw prices fall. What’s particularly worrisome is the pace at which sentiment has deteriorated; as recently as March, the situation was reversed: 56 cities saw prices rise, 10 saw no change, and a mere 4 suffered decreases.

While further home price deflation would be good news for the millions locked out of homeownership by unaffordable prices, it would be bad news for the far larger category of existing homeowners. According to China’s Southwest University of Finance and Economics, 90% of the country’s households already own a home. Of this group, one third owns at least two, mainly for investment purposes.

Sharp and sustained home price weakness would deal a major setback to household wealth and spending behavior. Recent surveys suggest real estate now accounts for anywhere from two thirds to four fifths of Chinese household wealth. That’s a staggering sum. At the peak of the U.S. housing bubble, real estate accounted for 26% of household wealth.

Real estate’s appeal as an investment or a store of value is no surprise, given the unpalatable alternatives. Adjusted by the GDP deflator, government-set ceilings on bank deposit rates averaged less than 0% over the past decade, a pittance given the breakneck growth registered by the economy, not to mention an enormous transfer of wealth from householder savers to state-owned enterprises and local governments that do most of the borrowing. China’s casino-like stock market, meanwhile, has generated returns that have lagged the U.S. stock market, despite China’s far stronger economic growth.

By contrast, real estate has rapidly risen in value every year for more than a decade, generating a perception of relative safety and surety of returns. A reversal in the price trend would threaten to severely undermine this sentiment. Because investors account for such a large share of homebuyers, the implications of a turn in sentiment for overall real estate activity would be significant. Falling prices would beget selling, which would beget falling prices and more selling.

Local governments throughout China have taken steps to entice buyers back to the market in a bid to avert such a vicious cycle. Minimum down payment requirements have been loosened in many markets. Incentives are being rolled out, too. The Wall Street Journal reported that the province of Fujian (population 37.5 million)) has directed local governments, developers, and banks to rescue the faltering real estate market. Buyers of second homes in Fujian will also now enjoy the lower down payment requirements and mortgage rates that buyers of first homes do. The provincial government of Sichuan (population 80.8 million) said it will subsidize mortgage loans made at rates lower than the benchmark.

Local government eagerness to reinflate the property market partly reflects a heavy fiscal dependence on real estate. Land sales often account for as much as 40% of local government revenue. Land holdings are used as collateral for the loans governments take out to fund ambitious infrastructure projects.

Efforts to kick-start the faltering real estate market strike us as a dangerous proposition and illustrate the corner into which China’s government has been backed by riding the investment-led growth model too long and too hard. If looser buyer requirements and more generous incentives succeed in reviving the market, bubble conditions could worsen. If the measures fail, the fallout from lost faith in the real estate market is likely to be significant. China’s GDP figures don’t yet reflect real estate’s troubles, but are likely to soon.

By DANIEL ROHR September 19, 2014 in Morning Star News