The growth trade-off gets harder

China’s better-than-expected economic data for the second quarter underscore just how effective a jolt of stimulus to housing and construction can be. The June quarter was likely even better than implied by the flat 6.7% year-on-year reading for headline real growth: nominal GDP growth actually accelerated to 8.4% in 2Q from 7.2% in 1Q. But housing is already cooling, as growth in sales and construction started turning down in May, and the rest of the Chinese economy will follow suit in coming months.

The increasingly frothy behaviour of housing prices made a pause in the stimulus seem prudent, and the fear of a housing bubble will continue to constrain the government’s ability to pump up growth to meet its targets.

The stabilisation in China’s growth this year has been a thoroughly “old economy” phenomenon: nominal growth in the industrial sector was basically zero in the second half of 2015, but picked up to 3.5% by 2Q16. Despite more rhetoric about the transition to a services-driven economy, growth in the service sector has continued gradually to slow, led by the expected downturn in the financial sector after last year’s unsustainable stock-market boom.

The acceleration in credit growth that began in late 2015 was so effective not just because it was larger than expected, but because so much of it was funneled into mortgages, which are now up about 30% YoY. The resulting bounce in housing sales and construction boosted output of steel and other construction materials—which also led, crucially, to a bounce in prices as producers struggled to adjust to the rapid change in conditions. That easing in industrial deflation lifted, at least temporarily, some of the gloom over Chinese heavy industry.

But the stimulus also had a big impact on another set of prices: housing prices in the four large “Tier 1” cities (Beijing, Shanghai, Guangzhou and Shenzhen). The surge in those top-tier prices easily exceeded that in the last housing upcycle in 2013: annualised increases neared 50% at the peak of the boom, and were starting to spill over into other cities (see the chart). The simultaneous surge in household leverage and housing prices posed obvious financial risks. But they also created a political problem, as high housing prices squeeze the urban bourgeoisie and generate discontent. Beijing has repeatedly shifted economic policy when housing price gains threatened to get out of control, and this time proved no exception: some cities imposed restrictive policies, and the central government allowed credit growth to slow.

With momentum from the construction rebound already sufficient to ensure 2016’s official target of 6.5% GDP growth is met, the government’s decision was perhaps not a difficult one. But this will not be the last time the government has to make a trade-off between two sets of political goals: meeting Xi Jinping’s implausibly-high growth targets, and avoiding a property bubble that would immiserate the urban middle classes.

Outside real estate, private-sector investment continues to be weak—a sign that most companies are looking beyond the bounce in housing and expect final demand to keep deteriorating. Notably, nominal fixed-asset investment by private-sector companies declined -0.5% YoY in June, the first negative reading since the data series began in 2004. So as the momentum of the housing rebound fades, there is little to take its place as a growth driver. Infrastructure spending by local state-owned enterprises is still growing by over 20%, but such spending has been fairly constant since 2012, and it seems to have few spill-over benefits. Therefore growth seems certain to soften in 2H16, and so calls for another round of stimulus are only a matter of time.

If meeting the GDP targets was the government’s only consideration, then another round of easing could come fairly quickly. But while the political importance of the growth target is clearly very high, so is the political importance of avoiding another bubble in housing prices. The difficulty of that trade-off could push the next easing cycle into 2017.

This constraint on policy, in my view, reflects a new structural reality for China: fundamental demand for housing is more or less already at its peak level.

Therefore increases in credit to the sector will be plowed less into building more housing and more into trading existing assets. Pumping credit into housing is, as this year has shown, still a pretty effective tool for stabilizing growth— but one whose costs are rising and whose benefits are diminishing.