Demand for safe assets from emerging markets creates a headache for policymakers

This week’s Economist riff takes us to Canada. Are Canadian housing prices in a bubble? There’s little doubt the answer is yes. The article discusses some of the macro-prudential measures the government and Bank of Canada have taken, and their relative (lack of) effectiveness.

Tough to argue with that chart, when the price/rent ratio is materially outperforming peak prices from 2006 in the US, as well as Australia frothy prices. But is Canada on the precipice?

The article correctly points out the source of the bubble is capital flight from Asia, mainly China. This chart shows there has been an avalanche of capital leaving China looking for a safe destination with stable rule of law. Canada certainly fits the mold.

How has the Chinese government and the PBoC reacted to this capital flight? They have tightened capital controls in a variety of ways. This chart would argue they’ve actually been quite effective at it. Reserves have stabilized, and so has CNY. Similarly, front end rates in China have cranked higher as the authorities squeeze shorts. The combination of higher front end rates in China and tightening capital controls may not be completely uncorrelated to the recent slowdown in Vancouver and Toronto housing prices.

The international economics textbook would say this is unsustainable — Chinese authorities will be playing whack-a-mole trying to stop capital from leaving the country, and Canada will continue to be an attractive destination. So with money still seeking to leave China, are we near the end for the Canadian housing market?

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I believe the answer is again a resounding “no”, for a few reasons:

1. I would agree with the article here that Canadian banks are well regulated and capitalized. The shadow banking/zero down/ARM binge we saw in the US hasn’t gotten there (yet). There may be some bodies buried in the yard, but not system-wide.
2. It’s clear that it will be a reversal of the capital flows from China that finally pops the housing bubble, which will likely be because of a hard landing/financial crisis in China, coinciding with a cratering in commodity prices. As I discussed last week, there are clear signs of a Chinese credit boom. But I don’t see the signs that there is a bubble popping there. I recognize front end rates are inverted but I don’t see the spark that is going to ignite the tinder — maybe a dead whale beaches itself onshore tomorrow, but given the firepower and incentives of the Chinese government, I suspect that day is well in front of us.
3. The catalyst for an end, or a reversal, of the flows has to get back to value. The Chinese will repatriate their capital when and if there are cheap assets to buy domestically. But today there is huge value in exporting capital for your average Chinese citizen. And for these people, Canada still looks cheap. Not only do you gain a significant improvement in the rule of law, but CAD is near historically cheap levels on a REER basis, while CNY is still looks overvalued. Bubble economies tend to have overvalued currencies as the “story” behind capital flows overwhelm reality. The REER in Canada shows that is not the case, in fact, arguably the opposite. And it is worth noting that #2 in this measure is USD, which has been another huge beneficiary of foreign flows over the last several years.

Source: BIS

I’m not going out to buy a condo in Vancouver tomorrow morning. And I can see how foreign demand could make domestic assets expensive enough to price out local consumption and investment and submarine the economy. But I don’t see the evidence that we are there yet.