Too Large To Grow So Fast

Falling property prices will further discourage consumption, which was weakening anyway. Many Chinese are feeling decidedly less rich because the local stock market has fallen by two thirds from its peak in October 2007. And historically, as consumer confidence wanes, so too do both the real-estate and auto sectors. In a telling sign, passenger-car sales fell in August, down 10 percent from the same month last year.

Until late 2007, China had in fact been relatively immune to the travails of the U.S. economy, which began to slow dramatically from the middle of 2006. But then inflation started to pick up speed in China, and policymakers responded last November by getting tough, with a strict directive to banks to clamp down on excess lending. The aggressive tightening of monetary policy laid the seeds of the current housing slump in China and dashed hopes of any economic decoupling.

Shakeouts are always necessary to cleanse the system of excesses in prices and spending that accumulate during any bubble. But China's housing excesses are less dangerous than those in the United States and Britain. For one, China's urbanization process is in its early stages, so housing demand is likely to rebound strongly in the long term, and help to swiftly clear unsold inventory. With Chinese household income rising at 10 percent a year, housing will become increasingly affordable if home prices remain flat, even for a year. And unlike Americans, the Chinese are not deep in personal debt; mortgage loans equal 12 percent of China's economy, compared with more than 100 percent of the United States' economy. Banks in China also have relatively small exposure to real-estate developers, who hold just 7 percent of outstanding banks loans. The comparable figure in the United States is 53 percent. The Chinese housing-market-led slowdown poses no systemic risk to its financial system.

The more important questions are how long will the downturn last and where will China emerge at the end of this phase? Some policy help is already on the way. The People's Bank of China recently reduced its benchmark rate by 27 basis points, its first softening in six years. With consumer price inflation slowing, there is further scope for an easing of monetary policy. The government also has ample room to stimulate the economy by raising spending, since its fiscal accounts are almost balanced, and its total debt-to-GDP ratio is very low at 16 percent.

But there is growing disappointment in the Chinese investment community as to why the government is not stepping in more decisively to stabilize growth, particularly in the property sector. The government's reaction reveals a lot about the shifting priorities of the leadership. Following the rapid rise in property prices over the past few years, there was a general feeling in policymaking circles that the average buyer was being priced out of the market and that developers were raking in money like bandits. The government would consequently be happy to see a fall in property prices, possibly a part of its larger objective of achieving a "harmonious society" by dampening the widening income gap.

The government is also wary of turning on the monetary spigots too quickly. It wants to anchor inflationary expectations after the painful experience of the past year, when inflation stayed well above the tolerance limit of 5 percent. The danger with such a strategy is that once a deflationary psychology sets in, it's difficult to turn things around. Consumer price inflation has fallen sharply from a high of 8.7 percent in February to 4.9 percent in August. While the merits of slowly lowering interest rates are debatable, this incrementalist policy does suggest a nuanced shift in the government's growth-at-any-cost approach to a greater emphasis on balanced economic development.