China Data, Part 2: Slowing Growth
As China enters 2012, concerns that its economy may face a “hard landing” have entered the mainstream. In recent weeks, Paul Krugman (“Will China Break?” in the New York Times) and Robert Samuelson (“China’s Coming Slump?” in the Washington Post) both penned hand-wringing op-eds warning of an impending Chinese downturn. It’s interesting to see the rest of the world starting to wake up to the worrying trends we’ve been discussing on this blog for some time now.
When people talk about a “hard landing,” they’re usually talking about a sharp deceleration in GDP growth, which brings with it both business failures and unemployment. In two earlier posts (Parts 1 and 1A), I examined a variety of data points that suggest China’s real estate market is in the midst of a serious downturn. In this post, I want to take the next step beyond this and explore the impact of collapsing property prices on the pace of broader economic growth, and the prospects of a “hard landing”. (Originally, I promised to discuss the impact on China’s currency and inflation, but in thinking about it, I realized this places the cart before the horse. I’ll turn to this question in Part 3).
There are two ways that the drop in the property market translates into slower economic growth: direct and indirect. The direct impact is fairly obvious: to the extent that China’s real estate developers are overextended, and preoccupied with selling off their existing inventory in order to stave off bankruptcy, they won’t be commissioning any new projects — maybe not for quite a while. That means no work for construction companies, which in turn won’t be buying any new construction equipment. It also means less demand for steel (construction reportedly accounts for 40% of China’s steel demand), cement, glass, copper pipes and wiring, etc. It also means less furniture and fewer appliances to fill those new homes (although, as we know, many Chinese investors already leave the units they buy empty anyway). The estimates I’ve seen say these sectors dependent on property construction account for between 20% and 25% of China’s total GDP.
Frankly, you don’t need a real estate collapse in order to trigger a serious slowdown in these sectors. All you need is a pause in the hitherto frantic pace of construction. Let’s assume the bull argument that, due to urbanization and rising incomes, speculators are right: all the units they’re snapping up today, and holding as investments, will ultimately be filled with end users. That still assumes a catch-up period. If real estate investment, which according to monthly official figures has (even into November) been growing at >30% year-on-year, keeps outpacing urbanization and rising incomes, the gap will never close. At some point, the pace of construction has to moderate to give all that anticipated end user demand a chance to materialize, and start filling all those vacancies. If demand isn’t what speculators imagine it to be, at today’s sky-high prices, the adjustment — and resulting slowdown — will be even more severe.
So what evidence do we have that a construction slowdown may be occurring? Official data on housing starts does exist, but it’s not a reliable metric. Developers stand to lose their land back to the government if they don’t do anything with it after a few years. They are also under considerable pressure to show progress on “social housing” mandates that may be a condition of obtaining land. For both reasons, developers will often dig a hole in the ground and call it a “start,” even if they intend to delay further work indefinitely. Last month, China’s Ministry of Housing and Urban-Rural Development (MOHURD) estimated that as much as 1/3 of reported social housing starts were just “digging a hole” rather than actually building apartments.
A better approach is to look at the market for construction inputs. The clearest picture we have is for steel. According to a friend of mine who is an analyst in the steel and commodities sector, and recently completed a countrywide tour of talking to producers, sentiment in China’s steel industry is as gloomy as he has ever seen it. In November, Chinese steel output was down -8.8% month-on-month, down for the sixth month in row. More importantly, it was down -0.6% year-on-year, indicating this was more than just a seasonal or partial fall-off from the all-time highs it hit in the first half of 2011, which were driven in large part by demand for cheap rebar for construction. Apparently, the demand that drove that boom has almost entirely disappeared. Interestingly, according to one report by Shanghai Security News, steelmakers say that actual sales in 2011 failed to match official “social housing” construction data. Figures released by the China Iron and Steel Association last week indicate that steel output continued falling in December, by 3.87% month-on-month.
Not surprisingly, two things have happened. First, domestic iron ore prices have plummeted as unused stockpiles have accumulated. The China Iron and Steel Association recently announced that its iron ore price index has fallen 22% in the past four months, since the beginning of September, while iron ore inventories at Chinese ports rose to 96.8 million tons by the end of 2011, up 32% from the year before (Chinese iron ore imports were still up 10% y-on-y in December, but analysts expect buying to slow in coming months, due to flagging demand). Second, Chinese steelmakers are suffering. According to Caijing, more than 1/3 of them experienced losses in October and November, and the industry as a whole saw a net loss of RMB 920 million (US$ 146 million) excluding investment gains. The magazine said industry executives foresee an even tougher year in 2012.
Cement and glass also show a marked deceleration in growth. Cement output in November grew 11.2% y-on-y, but that represented a significant fall-off from 17.2% y-on-y expansion for the first 11 months as a whole, and the 17.3% y-on-y growth the industry saw in November 2010. Glass also saw a similar deceleration, growing 7.1% y-on-y in November, compared to 17.0% y-on-y from the first 11 months. Cement prices have been declining steadily over the past few months, a trend that Fitch projects will continue into 2012, due to overcapacity. It notes that, because of their high level of investment in building even more capacity, major Chinese cement producers are cash flow negative.
Copper presents a more unusual picture. China’s copper imports in December hit an all-time record high of 508,942 tons, up 47.7% y-on-y. However, there is little reason to believe this was driven by end user demand. Most analysts I’ve talked to believe it was primarily due to a resurgence in speculative arbitrage based on the gap between copper prices in Shanghai and London, and possibly renewed interest in using stockpiled copper as collateral for obtaining loans — both practices spurred by expectations of monetary easing. In short, the Chinese are buying copper, like homes, to trade not to use.
Of course, land is also a key construction input. I’ve already written about the dramatic fall-off in local government land sales to developers, here as well as here. Newly released year-end figures show that Beijing’s overall revenues from land sales in 2011 dropped 35.7% compared to 2010, despite robust sales in the first half of the year. Land sales revenues for residential projects plunged even more steeply, by 55.4%, while the average auction price for residential land dropped 30.5% (from RMB 7,317 per sq. meter to RMB 5,088). In Shanghai, total land sales revenues dropped 20.0% y-on-y, and average the average price of residential land plummeted 41.0%. On January 7, China’s Minister of Land and Resources stated that nationwide, land sales revenues in 2011 were up slightly over the previous year, but offered no details. A few days earlier, however, the 21st Century Business Herald reported that nationwide land sales may have dropped as much as 20% year-on-year.
All in all, it certainly appears that some kind of a slowdown, prompted by a correction in the real estate market, is taking place in China. What does this mean for the Chinese economy? Not much, argues Morgan Stanley’s Stephen Roach, in a recent syndicated op-ed:
Moreover, it is a serious exaggeration to claim, as many do today, that the Chinese economy is one massive real-estate bubble. Yes, total fixed investment is approaching an unprecedented 50% of GDP, but residential and nonresidential real estate, combined, accounts for only 15-20% of that – no more than 10% of the overall economy. In terms of floor space, residential construction accounts for half of China’s real-estate investment. Identifying the share of residential real estate that goes to private developers in the dozen or so first-tier cities (which account for most of the Chinese property market’s fizz) suggests that less than 1% of GDP would be at risk in the event of a housing-market collapse – not exactly a recipe for a hard landing.
I think Roach is underestimating the problem. First of all, 10% of GDP sounds a bit low to me. Reliable statistics forwarded to me by Bloomberg researchers put residential construction alone at 9.9% of China’s GDP in 2010 (compared to 6.1% at the U.S. housing peak in 2005, 9.3% at Spain’s peak in 2007, and 14.0% at Ireland’s peak in 2006). Roughly consistent with this figure, UBS economist Jonathan Anderson estimates that total real estate construction (including residential and commercial) accounted for 13% of GDP in 2010. Second, this number does not include sectors such as steel and cement that are directly and heavily dependent on construction demand. As I’ve noted, that raises the stakes to 20-25% of GDP. Third, I’ve argued vigorously for some time now that contrary to what Roach maintains, the overhangs in China’s property market are not at all limited to first-tier cities, based not only on the data I have seen but on copious news reports and the evidence of my own eyes. Far from being mere “fizz,” they are the pervasive outgrowth of deeply embedded structural issues in China’s economy.
Having said all that, let’s assume for a moment that Roach is right that real estate construction directly accounts for 10% of China’s GDP. Now let’s assume that the growth rate for real estate investment drops from roughly 30% last year to zero in 2012. That sounds catastrophic, but keep in mind, zero growth doesn’t mean a cessation of all construction. It means China will build the exactly same number of condos, villas, offices, and shopping malls this year that it did last year — an astonishing rate of construction, by any historical standard. If the property sector grew by 30% in 2010, and accounted for 10% of GDP, and GDP grew by 8.5% (roughly), that implies a growth rate for the rest of the economy of 6.1%. If you take real estate expansion down to zero, and assume the rest of the economy keeps humming along, that knocks overall GDP growth down to 5.5% — a “hard landing” in most people’s book. Again, that may sound extreme, but if we look to the U.S., Spain, or Ireland as an example of what happens when a bubble bursts, the most likely outcome isn’t a plateau in construction (zero growth) but a collapse (sharply negative contraction) followed by years in which hardly anything gets built. I’m already being generous here in assuming that China is somehow “different.”
More importantly, we’re only looking here at the direct impact of a real estate downturn on GDP: the homes and offices that aren’t built, the steel and other materials that aren’t ordered. In the lead-up to the U.S. subprime crisis, Ben Stein (who I generally have a high regard for) famously opined that subprime mortgages comprised such a tiny portion of the nation’s assets that they weren’t worth worrying about:
. . . the total loss may be about ½ of one percent of the mortgages made and probably less, and a lot of it is insured. This is an absolutely trivial number in the context of a $14 trillion economy with net wealth in the realm of $60 trillion.
Stein later penned a mea culpa, admitting that “where I missed the boat was not realizing how large were the CDS [credit default swaps] based on the junk mortgage bonds.” That insurance he was talking about actually turned to be a huge problem, not a solution. It was the indirect effects of the U.S. housing crash — the way it triggered reactions throughout the financial system and apparently unrelated parts of the economy — that turned it into a real crisis.
So in the next post in this series (Part 2B), I will take the next step and explore the far more serious indirect effects of China’s real estate downturn on growth. I’ll look at how the property market has been the lynchpin of a much broader investment boom that has been driving China’s rapid economic growth, and examine the concrete evidence that this boom is now starting to unravel.
UPDATE: I updated my calculations on the impact of zero property growth on overall GDP growth, based on more accurate numbers released by the National Bureau of Statistics on January 17. The revision also corrects an error I made in the mixing of nominal and real growth rates. The conclusion, however, is essentially the same. You can view the revised calculations here.