As the Yuan declines in value, houses become increasing expensive to Chinese Nationals, prompting further erosion of new home sales to this large buyer group.

Last month I asked Will the slowdown in China hurt Irvine real estate? There is little doubt that stopping the flow of Chinese capital will impact new home sales in Irvine. Irvine homebuilders depend on Chinese buyers to purchase their overpriced houses, which becomes a problem if this flow of money dries up.

Last year I documented that Chinese real estate investors are less active in Irvine. For years, Chinese could export cash by setting up dummy foreign corporations that import goods into China. The dummy corporation sends a bill to the Chinese mainland for goods that are never shipped (or grossly overpriced), and the money is used by this dummy corporation to buy real estate, often in the US, and often in Irvine. The money leaves China through an export sham, but it leaves all the same.

As house prices rose and the value of the Yuan depreciated relative to the dollar, United States real estate became considerably more expensive for Chinese Nationals. As a result, new home sales suffered and inventory piled up in 2015. If the Yuan continues to devalue and Irvine house prices keep going up, the problem will only get worse.

Of course, for a short time, the opposite could happen. If everyone in China comes to believe the government and central bank will devalue the Yuan, wealthy Chinese will want to obtain US assets before this happens. There could easily be a last-minute flood of cash buying everything in sight.

The dynamic would be a lot like last call at a nightclub. Everyone buys a last drink, and those desperate for a hookup lower their standards. If wealthy Chinese sense devaluation is coming, they will desperately buy anything they can while they can still afford it. Homebuilders would be happy to use this frenzy to clear out some standing inventory.

So why would the Chinese government and central bank devalue the Yuan? Because if they don’t, they will run out of foreign reserves supporting an overvalued currency.

Money is pouring out of China as rapidly as it once poured in. That’s a dilemma for Xi Jinping.

One of the big questions for the global economy in 2016 is what Xi will do next to stop the flight of capital, which threatens to sap funds from China when growth is already weak. … Some China watchers say the question of Xi’s direction is already being answered. “China will become increasingly closed to the rest of the world,” predicts Alicia Garcia-Herrero, chief economist for Asia and the Pacific at Natixis Asia, a unit of Groupe BPCE, France’s second-largest banking company. “Xi Jinping’s mindset is one in which China is at the center of the world’s economy but not necessarily open to the rest of the world, or at least not vulnerable to it.” …

“Increasing closed” means a return to capital controls.

The problem now is that more money wants to get out of the country than wants to get in. Here’s the math: Last year, the IIF estimates, China had a little more than $250 billion coming in from the surplus on its current account, the broadest measure of trade. It got an additional $70 billion or so in net capital from nonresidents, including Chinese companies’ overseas affiliates. But those inflows were swamped by a record $550 billion in net outflows by individuals and companies inside China. …

“It really is a puzzle,” says Steven Wei Ho, a Columbia University economist. “We can only speculate,” he adds, which option the leadership will choose. To University of Macau economist Vinh Dang, the answer is obvious: Because flexible monetary policy is essential and China is too big to wall itself off from the world, “exchange rate control must be given up,” he wrote in an e-mail. Judging from China’s stop-and-go policies, its leaders haven’t completely wrapped their heads around the idea that they must make a choice. They still want all three parts of the impossible trinity. Calls for a large depreciation are “ridiculous,” Han Jun, the deputy director of China’s office of the central leading group on financial and economic affairs, said on Jan. 11 at a briefing in New York.

It can’t be easy for Xi to suffer the indignity of losing a fight against the world’s financial markets. That’s one reason to think he’ll try to escape the trilemma by restoring at least some controls on capital. Garcia-Herrero, the economist for Natixis, predicts that permission to send or keep money abroad will be doled out more stingily in the future. …

The real answer to China’s problems is to allow the Yuan to devalue, but it’s the one answer Xi doesn’t want to consider. Devaluing the currency would boost exports, stimulate their weakening economy, and re-balance trade. Unfortunately, in order to support powerful domestic interests and sustain local governments and zombie businesses, Xi needs to keep interest rates low, which doesn’t attract foreign investment.

The worst thing China’s leaders could do now would be to fall back on the tired old trick of supporting employment by building roads, bridges, and apartments. Gunther Schnabl, a professor at the University of Leipzig, says that lax lending merely keeps zombie enterprises on their feet: “If you do not have a hard budget constraint, you do not have an incentive to put forward dynamic, innovative investment.” Judging from the amount of capital flight that China is experiencing, a lot of people in the Middle Kingdom are worried about precisely that.

Given how overbuilt China is already, with 20% of it’s residential units empty and numerous shopping and business districts empty, building more unproductive assets isn’t the answer.

Realistically, China will fight devaluation with capital controls for as long as they can, and when that fails to solve their problems, they will devalue the currency. In either case, the influx of Chinese money into new homes in Irvine is going to decline. It’s only a matter of how quickly and how drastically this sales slowdown materializes.

I don’t believe this will cause house prices to come down as prices are still affordable by local residents, but it will hurt sales. The only thing that would make Irvine home prices go down is if the Chinese government starts demanding repatriation of the money Chinese Nationals parked in Irvine houses. If that happens, look out below.

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