‘What else can I do? My factories are not making money. I have to put money into property’, an entrepreneur in Ningbo responded to my doubts on his capital deployment.

In property speculation, the most I can lose is 30%. When push comes to shove, I can walk away and give the properties to banks. In stock market I can easily lose 70 or 80% like two last year ago’, he justified his position further.

When I queried why not cash, he responded: ‘My friend bought properties last year at ten thousand yuan per square meter. It is now twenty thousand. Bank deposit doesn’t appreciate like before. I must catch up with my friend.’

The above is not an isolated story. In my last few trips to Zhejiang Province-the epicenter of China’s export machine, entrepreneurs are telling the same story to me again and again. Factories are not profitable anymore. (1) Workers are hard to find. Monthly salary of yuan 2,000/month plus lodging and food isn’t enough to attract workers. Only five years ago the salary half as much could attract numerous workers. (2) The prices of raw materials, though significantly lower than in 2007, are still very high, twice as much as five years ago. (3) Foreigners are not buying as much as before and are demanding price cuts. There are still too many eager factories for the fewer buy orders.

A major force behind China’s property bubble is the capital exiting out of the manufacturing sector. The stock market crashed in 2008. The A-share market dropped three fourths in one year from the peak in November 2007. The revival since is a bear market rally, not a new bull market. The stock market is no longer the main sure. The bullish noises about the stock market are really desperate cries for bringing back the losses in the big crash. The desperation could be viewed in all its colors on the websites that specialize in talking up the market minute by minute. Some of the websites seem like mental hospitals without doctors.

The main show is definitely the property market. The sales in the primary market are likely to exceed yuan 4 trillion this year, more than half of the country’s total government revenue. Most of the proceeds end up in the government’s pocket. Land and tax account for over half of the sales proceeds. The developers may take one quarter in gross profit. But, that money goes back into purchasing land and probably leveraged up with sub debt. Even though government revenues are classified into many categories, one could possibly trace half back to the property sector. China’s fiscal situation seems quite similar to Hong Kong’s before 1997. This is why it is so difficult to deal with the property bubble.

The current property upturn started in 2002 when the dollar began its bear market. The initial driver was overseas Chinese who wanted to cut their dollar holdings and thought Chinese properties were a safe haven. The beneficiaries of the first wave were the coastal cities with strong linkages to overseas Chinese like Shanghai. It ended in 2005 when the Fed raised interest rate above 4%. Chinese bank lending drove the second wave, in particular, the rapid growth of mortgage lending. The capital raisings by property developers in Hong Kong and the inflows from foreign property funds played an important role in the second wave. The beneficiaries were most provincial capitals.

As the stock market clamored for big land banks and geographical diversification, the listed property companies and the aspiring ones aided by foreign property funds went on land acquisition sprees among provincial capitals. Their money inflows played an important role in supporting their economic growth and creating property demand. In a way, financial guys were paying for their own property dreams. But, they were hoping to offload their stocks in Hong Kong to someone else. To them, China’s property market was merely a sellable story in the Hong Kong stock market. They all expected to cash out before the day of reckoning.

The current wave began in March of the current year. It is mainly a Chinese affair. The weak dollar story mainly helps by blocking capital outflow, bottling surplus capital within for cooking the asset bubble. To a lesser extent it drove some hot money into China by swelling its foreign exchange reserves and banking liquidity. But foreign residents, burnt in the 2008 crash, didn’t surf the property bubble this time. Indeed, foreign residents have been net sellers in this upturn.

I see three types of buyers in this cycle:

1) The government won’t let property price fall

Most buyers fall into this category. These people are middle or up middle class with income two times the national average or above. They never felt comfortable with the high prices and were waiting for a correction to buy. They welcomed the global crisis as a great opportunity for property prices to adjust, which would increase the purchasing power of their hard-earned savings. Instead, the prices didn’t fall much. It convinced them that the government wouldn’t let the prices fall. The logical thing to them was to borrow to buy at high prices because the prices would go even higher.

They have been the main driver behind the massive increase in mortgage lending. Most of their purchases happened between March and August this year. As land prices have been making new highs despite cooling sales volume in the secondary market, their bets have worked so far; they have paper profits for now.

2) The Party loves property developers most

During the crisis a friend remarked to me that the Party loved the property industry most. At the time most developers were on the ropes. They had high leverage and their main asset, land, was depreciating. In a normal market economy, bankruptcy would follow quickly. Instead, the state-owned banks extended their credit lines and sustained their liquidity regardless of their net asset positions. Then, a massive lending boom in favor of property purchase triggered massive increase in property sales. The developers, small or large, bad or good, have all been saved.

Other industries, from steel, media, to retail, all faced unprecedented hardship and are yet to regain their 2007 glory. Most export businesses, of course, have suffered disproportionately. The lessons that other industries have learnt is that the property business always makes profit. Hence, everyone wants to become a property developer. But, as the property development is a capital intensive business, many who don’t have sufficient capital have become property speculators, hoping that the profit would allow them to be developers one day.

3) Money will become worthless

Inflation is a hot topic. Most people expect inflation to rise. The inflation expectation tends to rise with one’sbank deposit size. This is consistent with the inflation trends: the prices for products and services that high income groups purchase seem to increase fastest. Recently I have heard from many people who have discovered that the prices for goods and services are lower in Europe or Hong Kong, even for products made in China. This is why the rich fear inflation most.

‘No matter how much property price falls, I will always have the property. But money’s value could go to zero.’ One participant in my Hangzhou seminar remarked to me on why he wouldn’t hold cash.

Regardless of one’s justification for adding and holding onto one’s property holdings the rising price expectation is the ultimate driver. And the rising price momentum seems to justify this expectation. Nothing attracts people like a train about to leave the station. In previous asset cycles I observed the same phenomenon: nothing makes people more optimistic like rising asset prices. Most bearish people couldn’t hold onto their views for two weeks in a rising market. In efficient market rising prices would tell use something about the future. But, is the rising property price in China a market phenomenon, let alone an efficient market phenomenon?

China is not short of land. The annual production is sufficient to meet urbanization growth. While there are no government statistics on vacant properties, casual observations suggest that possibly one third of the properties that have been delivered in the past four years are vacant. The low rental yield, about 3%, supports this story. The current rental yield is probably similar to the damage cost of what a tenant may incur, i.e., property owners are indifferent between renting their properties out and leaving them vacant.

What can explain the rising price trend is the speculative demand. The issue is why the speculative demand is so massive and lasting. The main reason is the local government support. Whenever the market cools, local government support has allowed developers to delay sales without worrying about the pressure from banks. Hence, sales volume vanishes in a down market. The market behaves like there is one seller who doesn’t face liquidity constraint and is determined to maintain minimum selling price. And the minimum price is steadily increased to punish people who wait. This market behavior has convinced speculators that they should buy as early as possible and with as much leverage as possible.

The local governments are sort of ‘dealers’-a term describing stock speculators with deep pockets who support share prices to attract small time speculators; it gives little guys the confidence to speculate when a big guy promises to cap the downside. I still remember that in 1997 one rich guy in Hong Kong bought many flats in a famous development and, to stop others from selling, offered to buy all the flats at a certain price, i.e., he was giving everyone in the development a put option. He went bankrupt when the market crashed in 1998. The local governments are not giving put options to speculators but have been cutting supplies when prices fall. It is a proxy for the put option. The issue is if the local governments have the wherewithal to sustain their past behavior.

The speculative dynamic can last if the funding for speculators remains cheap and plentiful and if the local governments can continue to cut off supplies whenever the market turns down. As the local governments can borrow money from banks through multiple channels, their staying power against market forces depends on banking liquidity too. Thus, the property bubble lasts as long as money supply continues to grow rapidly, which ensures the banking liquidity plentiful.

A country can print as much money as it wants if it doesn’t face pressure from inflation or exchange rate devaluation. For developing countries, when dollar is weak, inflation tends to be a problem. When dollar is strong, devaluation pressure is the constraint on monetary policy.

For example, India and Russia are experiencing double digit inflation, while their currencies have been strong against the dollar. Both are raising interest rate but slowly. The currency stability gives them time to deal with inflation.

When the dollar is strong, developing countries often experience currency crisis. Latin America did twenty years ago. Asia and Russia did ten years ago. When a developing country faces devaluation pressure, usually following an asset bubble during a weak dollar period, it has to tighten monetary policy despite a weakening economy. The pain is often unbearable. It remains to be seen how this game ends in China.

One common mistake that investors make is to believe that fast economic growth means rising asset prices. There are two problems with this view. First, fast economic growth, even if done efficiently, doesn’t support infinite asset prices. Hence, economic growth can only justify asset price appreciation to certain level. That level can be determined by valuation metrics. When prices rise above what these metrics can justify, they will fall back even though the promise of economic development is fully realized.

Second, rapid economic growth is often associated with inefficient capital allocation. Even though economic development may be successful, investors don’t do well. Their money has gone into subsidizing capital formation. Take Japan as an example. Its stock and property market are lower than three decades ago. But the Japanese economy is much bigger today. Korean and Taiwanese asset markets have behaved similarly.

I think that inflation will end China’s property bubble. Inflation is ultimately a monetary phenomenon. For example, China’s money supply is rising at about 30% and nominal GDP probably 5%. The difference will show up as inflation one day. The delay between monetary growth and inflation depends on the environment. When the factors for production like labor and raw materials are plentiful and production capacity is in surplus, the lag tends to be long. China’s situation in the past decade was like that. But, things have changed.

China’s labor market is quite tight now. This is quite in contrast with the perception of endless supply due to the vast rural surplus labor reserve. The story is quite complicated. I’ll write about it another time. You have to take my words now that the wages, especially for unskilled manual labor, are on the way up.

Natural resources like oil and copper are up two to three times from their averages in the 1990s. Even though their prices have been stable in the past three months, their full inflationary impact from the past price increase is yet to be fully absorbed. Further, their prices are likely to rise in the coming two years, adding to inflationary pressure.

Overcapacity is still a barrier to inflation, but not as powerful as before, because the inflation of raw materials has decreased the share of value added from manufacturing in final products. For example, iron ore and coking coal account for three quarters of steep production cost. The steel industry overcapacity doesn’t have much impact on steel prices. They follow the prices of raw materials.

The exit of capital out of manufacturing into property is the final nail in the inflation coffin. As low profitability and surging property price are enticing manufacturing companies to de-invest, overcapacity becomes less a barrier to inflation overtime.

I think that inflation has already taken hold in China. The government’s administrative policies to stem the price increase could slow its momentum. But high inflation, like in the early 1990s, will arrive in China again. I believe that inflation will become a serious problem in 2012. The property bubble will burst then for two reasons. As inflation is global, the Fed would be forced to raise interest rate to above 5%, which would cause hot money to leave China. Second, China would have to raise interest rate above the Fed funds rate to fight inflation and to keep money from leaving China.

The property bubble will burst in 2012.