Speaking Events in Shanghai and Beijing

I’m going to be speaking at several events over the next week, to which readers are welcome to register and attend.

On Thursday, August 30, I will giving two talks in Shanghai.  Starting at 4:00pm, I’ll be participating in a panel discussion sponsored by the European Union Chamber of Commerce on “China’s Consumption Challenge: Rebalancing China’s Growth.”  My fellow panelists will be Fred Hu, former head of Goldman Sachs in China and the founder and chairman of Primavera Capital, and Arthur Kroeber, founder of Dragonomics.  The event will take place at the Grand Ballroom of the Le Royal Meridien Hotel, Shanghai, and there is a charge of RMB 400 for members and RMB 500 for non-members.  You can find further details and register to attend by clicking here.

Starting at 7:30pm that same evening (Thursday, August 30), I will give a separate talk hosted by the Hopkins China Forum and Young China Watchers, on the topic “Is the China Growth Story Finished?”  The event will take place at The Wooden Box, 9 Qinghai Lu (just to the south of Nanjing West Road) 青海路 9 号, 近南京西路, 地铁二号线南京西路站.  For details and to RSVP, please email editor@shanghai-review.org or youngchinawatchers@gmail.com.  I’ll try to cover somewhat different ground than the EU panel.

On Saturday, September 1, I’ll be back in Beijing where at 4:00pm I’ll be talking to the Wharton Club of Beijing in what is being called a “Fireside Chat” on “The Future of China’s Economy in Uncertain Times.”  The event will take place at the Fairmont Hotel, 8 Yong An Dong Li, Jian Guo Men Wai Avenue, Chaoyang District, Beijing (tel: +86 10 8511 7777), and is open to non-Wharton alumni.  There is a charge of RMB 150 for club members and RMB 300 for non-members.  You can register by clicking here.

What US Candidates Need to Know About China

This weekend, I was quoted in The Weekly Standard about what Mitt Romney and Paul Ryan need to know about what is happening in China.  It begins by noting that Paul Ryan, Romney’s surprise VP pick, came out swinging the other day on President Obama’s handling of China:

“Free trade is a powerful tool for peace and prosperity, but our trading partners need to play by the rules,” Ryan said. “This challenge focuses on China. They steal our intellectual property rights, they block access to their markets, they manipulate their currency. President Obama promised he would stop these practices. He said he’d go to the mat with China. Instead, they’re treating him like a doormat. We’re not going to let that happen. Mitt Romney and I are going to crack down on China cheating and we’re going to make sure that trade works for America.”

Soon after the Ryan pick was announced, I had an email exchange with my old boss Bill Kristol, editor of the Weekly Standard and one of the most prominent voices to urge Ryan’s selection.  In it, I outlined a few key points that are likely to shape the discussion about China in the months ahead and in the next president’s first year in office:

1) China’s economy is not just slowing, it is entering a serious correction.  The investment bubble that has been driving Chinese growth has popped, and there are no quick “stimulus” fixes left.  There is the very real possibility of some form of financial crisis in China before year’s end.

2) China is in the midst of a once-in-a-decade leadership transition that has not been going smoothly.  The transition will take place, but it has paralyzed the Chinese leadership’s ability to respond to the country’s growing economic troubles.  China’s leaders believe time is on their side; they do not “get” how serious and urgent the situation is, and that what has always “worked” is no longer working.

3) China’s economic problems spell trouble for the U.S. on several fronts.

• First, China is flirting with devaluing its currency to boost exports—a move that will put it in direct conflict with Mitt Romney’s commitments on this issue.
• Second, China is already dumping excess capacity in steel and other products onto the export market, a tactic that is likely to inflame trade tensions and reinforce imbalances in the global economy.
• Third, in a worst case scenario, China may be tempted to provoke a conflict in the South China Sea to redirect popular discontent onto an external enemy.

My advice is not really partisan in nature.  The points I outline are equally relevant for any other candidate, Republican or Democrat, to take into account.  Nor are they meant to inflame China-bashing rhetoric.  In fact, they reveal that fears of an unstoppable Chinese juggernaut are misplaced or outdated.  What we really should be worried about is a China that is stumbling badly and doesn’t know what to do next.

There’s an interesting personal history here as well.  Back when I worked for Bill Kristol in the early ’90s, Paul Ryan — who is my age and, like me, was fresh out of college — was my counterpart working for Bill Bennett and Jack Kemp at Empower America.  We were colleagues, and I always thought he had a bright future ahead of him.

At the time, it occurred to me that there were really two issues that would define America’s future in the 21st Century, which were worth devoting oneself to.  The first was entitlements.  The second was China.  The former poses the greatest internal challenge to America’s potential and its place in the world, the rise of the latter poses — for better and for worse — the greatest external challenge.  Paul’s mastery of the entitlements debate has taken him far.  My path led me to China — “far” in a more literal sense.  It certainly is interesting, where life’s paths lead.

Apologies to readers who have been waiting patiently for the next installment(s) of my in-depth analysis of China’s summer real estate “rebound.”  I have been busy writing several articles for publication and — I admit it — enjoying summer with my family.  It is coming, and (I hope) will be worth the wait.

CFR Interview

Earlier this week, I was interviewed by the Council on Foreign Relations (CFR) for their website, about the current state of the Chinese economy.  You can read what I had to say below, or check out the original post by clicking here.

Silver Linings in China’s Slowdown

China’s gross domestic product for the second quarter declined to 7.6 percent (WSJ) in July, its lowest level since the height of the global financial crisis in 2009. At the same time, the International Monetary Fund reduced its 2012 growth forecast (CBS) for China by 0.2 percentage points to 8 percent. While China has been adversely affected by external factors like the eurozone crisis, its current slowdown is mainly the result of internal structural issues, including a suppression of domestic consumption, says Tsinghua University’s Patrick Chovanec. “The main growth driver of the past several years has been an investment boom that was engineered in response to the global financial crisis,” explains Chovanec, “and this investment boom is buckling under its own weight.”

What are the main causes–internal and external–of China’s worsening economic slowdown?

A lot of people compare this slowdown to what happened in late 2008, early 2009. The main difference is that what happened in 2008 was primarily due to external causes–a fall-off in exports caused by the economic crisis in the United States. What’s happening now in China is mainly due to internal reasons. The main growth driver of the past several years has been an investment boom that was engineered in response to the global financial crisis, the last slowdown, and this investment boom is buckling under its own weight. It’s not sustainable, and it has given rise to inflation and now to bad debt, and that bad debt is dragging down Chinese growth. And, of course, people pay attention to whether Chinese exports are rising or falling. It’s relevant because if Chinese exports are very vibrant, that creates something of a cushion for the Chinese economy.

If the causes of the slowdown are more internal, and not just a response to outside factors like the eurozone crisis, should we expect a more long-term slowdown?

It really depends on what the Chinese leadership chooses to do. China is due for correction. That correction will be good for China in the sense that a lot of the growth we’ve been seeing over the past several years is not sustainable and in many ways does more harm than good. So in some ways, slower growth, if it’s part of an adjustment toward a more sustainable growth path, is actually good. That doesn’t mean it’s painless, so there is a lot of resistance, even though in principle China’s leaders know that China needs to make this economic adjustment away from dependence on exports and investment-driven growth toward more domestic consumption-driven growth. If they resist a meaningful adjustment and if they try to pump up the economy even more–try to push this growth model to its limits and beyond–then the repercussions could be more damaging and painful than embracing any economic adjustment, painful as that might be.

I would add that there are lots of areas of potential growth in the Chinese economy–in agriculture, in services, in healthcare, in retail, in logistics. The problem is that that growth is not as easily achieved as pumping money and boosting investment. Unfortunately, that more sustainable growth is not where the focus has been these past few years. But there is nothing to say that the Chinese economy has to be doomed to slow growth.

What are some policy responses China should take to boost domestic consumption and diversify sources of growth?

They have to realize that it is a structural issue. Part of China’s export-led growth model was to suppress consumption in order to maximize investment and then make up the difference through selling abroad. The Chinese economy is geared toward channeling resources away from the household sector –Chinese savers and consumers–toward investors and producers to boost production and basically turbo-charge GDP growth. To re-balance the Chinese economy, you have to channel those resources back to the household sector through changing exchange rate policy, interest rate policy, the tax policy.

The problem is that if you channel resources back to the household sector, you knock the legs out from under the growth that you’ve got, and nobody wants to do that. That’s the biggest challenge–that these are deep reforms that change the way the Chinese economy works, and it takes some foresight and some vision to pursue that.

What of the short-term measures the Chinese central bank has taken by cutting interest rates twice since the beginning of June? Should we expect further measures along this line?

Unfortunately, the short-term response we have seen is to fixate on GDP growth. Even though they talk about the need for quality GDP growth over quantity, whenever GDP starts to look like it’s falling–even slightly–the immediate response is, “We have to shore it up.” The easiest way to shore it up is through more lending, more investment. You get a situation where any movement toward meaningful reform or meaningful re-balancing is put on a shelf. A lot of people have been critical of the efforts to re-stimulate the Chinese economy for precisely that reason. There is a broader recognition that what the Chinese economy needs is not more stimulus, but reform. I don’t think there is a full appreciation for just how constrained the Chinese government really is, even if it chooses to go down that path of re-stimulating the economy. They are actually quite limited in their ability, in the tools they have available to continue pushing down this path.

The conventional view is that China has a debt-to-GDP ratio of about 30 percent and that they have all kinds of resources to throw at boosting growth. I would draw a comparison to Japan in 1990. Japan had many of the same qualities that would lead you to think they could stimulate their way out of any dilemma. They had a high savings rate, almost no foreign debt, and they had a strong fiscal position because of all the taxes raised during the boom of the 1980s. But when the Japanese turned on the fiscal tap, the money went primarily to socialized losses and to counteract a contraction in private investment. They were able to prevent GDP from collapsing, but they were not able to sustain high levels of GDP growth in the 1990s; the fiscal resources that Japan had went to fill a hole, to pay for the growth of the 1980s.

With the lending boom that took place in China in the last three or four years, it was fiscal spending in disguise, and now the bill is coming due. Once the fiscal taps are open, the money released will go to pay for the growth of the past four years, not the next quarter, not the next year, not the next decade. You start to see that already, with the bailouts starting to take place in China–local governments, even the national government, devoting resources to bailing out property developers, bailing out state-owned enterprises, bailing out companies that have run into trouble, bailing out local governments.

What are the implications of the economic slowdown for the Chinese political situation, particularly given a once-a-decade leadership transition this year?

There’s been little political capital for anyone to spend on meaningful reform or any kind of resolute action on the economy, because if people did have political capital to spend, it was going to be devoted to ensuring their seat at the [leadership] table. What happens after the leadership transition [is] hard to say. The slowdown we are seeing, and particularly the pressures that it has created in the financial system and the credit system in China–the danger of default and the danger of a domino effect rippling through the Chinese economy–has pressed some difficult choices on [the] leadership at a point where they are least prepared to make decisions. The economic situation is not waiting for the leadership transition to work itself out before demanding some kind of response.

What are the potential repercussions of China’s economic situation on the U.S. and global economies?

It depends where you sit relative to the Chinese economy. There are countries and companies that have been riding this investment boom that has been driving Chinese growth, but I would argue that is not sustainable and is now collapsing under its own weight. And for those countries–like Australia selling iron ore, Chile selling copper, Brazil selling iron ore, Germany selling machinery–they’re very exposed to this economic adjustment that’s taking place, this correction.

But if your goal over the long term is to sell to the Chinese consumer, and if you have an economy positioned to do that–if you’re a producer of finished goods or a producer of food–then this economic adjustment could be a good thing if it unlocks the buying power of the Chinese consumer. For any economy around the world that wants to sell more to China, that wants to have a more balanced trade relationship with China, a meaningful economic adjustment that resulted in a more balanced domestic economy in China would be a very positive thing.

If you have lower GDP in China, that doesn’t necessarily mean that China’s consumption has to fall. In fact, China has $3 trillion in reserve; that’s buying power. China has produced more than it has consumed for many years; China could afford to consume more than it produced. That would be a major growth driver for the rest of the world. It would provide a cushion for China to undertake this kind of economic adjustment that otherwise could be extremely painful.

What’s Driving China’s Real Estate Rally? Part 3

In the preceding posts, I examined the first two out of five basic theories that might explain the latest bump in China’s property sales numbers, and whether they portend a genuine turn-around in the nation’s real estate market:

1. Lower Prices are Bringing Buyers Back
2. Looser Restrictions are Unleashing Pent-Up Demand
3. Optimistic Buyers are Misreading the Market
4. Government Intervention is Boosting the Numbers
5. Developers are Fudging Numbers to Stay Afloat

Now I’ll turn my attention to the third:

3. Optimistic buyers are misreading the market.  Up till now, I’ve been taking demand for property in China, whether from residents or investors, as a given.  Buyers know what they want — the only question is how much they’re willing to pay, or whether the government will somehow get in their way.  But as the words of the young buyer quoted earlier suggest — “I can’t see [prices] falling by much more” — expectations about the future play a vital role in shaping present demand.

When we invest in stocks and bonds, the supply of these “goods” is relatively fixed.  There are only so many shares of Microsoft out there, and that number doesn’t change very frequently.  Yet the price of Microsoft shares changes every day, because demand for those shares keeps hopping up and down, based on constantly changing investor beliefs about what the company’s future performance will look like and — perhaps just as crucially — what they think other investors are thinking and would be willing to pay.  For other, more functional products like hamburgers, socks, or refrigerators, demand arises mainly from our own practical needs and varies only gradually over time, based on evolving consumer preferences, perhaps, or how the economy affects people’s incomes.  Swings in supply — a sudden shortage of a critical raw material, for instance — can also affect markets, but by and large, prices tend to be a lot less volatile than for stocks.

Certain kinds of products — commodities like oil or copper, as well as real estate — are hybrids: they have an immediate practical use, but are also widely used as speculative investments, bought in the hope that someone else will be willing to pay more for it in the future.  (For many people, their home is both).  As a result, both supply and demand tend to move around and interact in complex ways, as buyers and sellers try to meet current needs and anticipate what the future may hold.  Guess wrong, and the deal that made perfect sense today could be the cause of much regret tomorrow.

The typical homebuyer assumes the future will look much like the past.  Usually, they’re just preoccupied with finding a decent place to live at a price they can at least stretch to afford.  Even if they’re purchasing an investment property, they rarely have the time or the training to step back and assess the larger forces of supply and demand that could potentially reshape the market.  As we have seen, one theory that could explain the latest reported rebound in China property sales is that developers are offering lower prices, which are succeeding in attracting more buyers.  Alternatively, I discussed the possibility that even the perceived loosening of government “cooling measures” has led investors to shift their focus away from peripheral markets back to more prominent cities they had temporarily shied away from.  In either instance, Chinese buyers believe they are getting a relatively attractive deal, based on their past impressions and experience.

The critical question is whether they are correct, or are they misjudging the true state of the market?  If they are right, what we are seeing may be the market “bottoming out” and starting to recover.  If they are wrong, the rally will burn out and China’s property market will resume its downward slide.

This phenomenon, called a “dead cat bounce” (or, less colorfully, a “bear market rally”) is a common feature of bubbles when they burst.  Investors long accustomed to consistently rising prices see any substantial price decline as a buying opportunity.  Unfortunately for them, their confidence proves ill-founded, either because their view is discredited or simply because not enough potential buyers share their enthusiasm.

The chart below shows the Dow Jones Industrial Average before and after the 1929 stock market crash.  In the first two weeks after Black Monday and Tuesday (October 29-30) the market lost 48% of its value.  Then it began a striking recovery in which it regained 52% of the ground it had lost, before peaking on April 17, 1930.  It fell, then temporarily stabilized again in mid-1930 before beginning a long, steady decline — still punctuated, however, by numerous smaller rallies.  By the time the market truly reached bottom on July 8, 1932, it had lost 89% of its value.  The late-1929 rally, which looked for several months like a real turnaround, proved to be a false dawn.

A similar “dead cat bounce” is evident in the chart below, which shows the Nikkei Index after the Japanese bubble burst in the final days of 1989.  Again, the market showed a substantial recovery for several months in mid-1990 before sliding to new lows.

Finally, we can see the same pattern in the Nasdaq index after the Dot-com bubble burst in March 2000.  The market recovered roughly half of its value later that year, peaking twice before commencing a steep collapse.

Of course, such trends are only evident after the fact.  If you look at the left-hand side of each chart — before the crash — you can find numerous examples of price drops that were buying opportunities.  There is no way to prove conclusively that what we’ve been seeing in Chinese property is a dip in an upwards trend or a bump in a downwards one.  But we can try to come to a reasonable judgment by examining what is driving supply and demand.

On the supply side, we know that over the past two years, many Chinese real estate developers have accumulated very large unsold inventories, averaging in the range of 1-2 years worth of sales.  We know that they have heavily leveraged themselves, by a ratio of at least 70%, in order to carry these inventories, and that as credit availability has tightened, the interest rates many developers have had to pay shadow banking sources such as trusts, private wealth management vehicles, and even loan sharks to remain liquid have spiraled upwards, often into the double digits.   We also know, as I mentioned in my introduction to Part 1, that many of these debts will come due in the 2nd half of this year.  All of these factors place immense pressure on developers to sell property in order to raise cash, or risk bankruptcy.

According to CLSA, the official statistics for top Chinese cities show “for sale” property inventories peaking in January or February and falling steadily since.  In Beijing, for instance, declared stockpiles have fallen from ~30 months in February to ~12 months in March and ~7 in June.  Shenzhen fell from ~15 months in February to ~9 months in June.  Xiamen has fallen steadily from ~25 months in January to ~6 months in June.  Shanghai has fallen more modestly from ~11 months at the start of the year to ~9 months in June.  I find it hard to accept these numbers at face value, however, considering that even the cities which reported the greatest sales rebounds this summer were seeing falling sales alongside rapid growth in completions until May at the earliest.  How that translates into falling inventories throughout the spring is beyond me.  (One eyebrow-raising contribution: on March 26, Beijing authorities slashed the city’s  “for sale” inventory tally by 32% overnight due, when they suddenly discovered that 5 million square meters of unsold properties had in fact been sold — although how that squared with previous trend lines was not clarified.)

As I mentioned in a previous post, “for sale” inventory is an easily manipulated number because developers and local governments get to define (or redefine) what completed or semi-completed units are “for sale.”  Nationwide, the official “for sale” inventory tally amounts to little more than 3 1/2 months worth of sales, based on average monthly sales over the last 12 months, with residential inventories barely exceeding 2 1/2 months.  In contrast, total floor area under construction, nationally, has risen to 4.5x the last 12 months sales, up from 3.1x in June 2010 and 3.7x in June 2011.  For residential floor space, the ratio is 3.9x, for office it’s 7.7x, for retail it’s 6.7x.  Assuming a three-year construction cycle, that suggests about a year’s worth of excess housing inventory, five years’ worth of excess office space, and four years’ worth of excess retail space lurking within the pipeline.  And all of those numbers are growing, not shrinking.

One could debate endlessly what portion of this construction pipeline is at what stage of completion, and how much is actually available for sale.  Some argue that many projects are “a nail away from completion” in order to hide the true extent of developers’ unsold inventory.  Others point out that the “under construction” figure includes projects where only a cursory amount of work has been done to avoid surrendering idle land, as well as other projects that have been suspended or abandoned.  In fact, this debate is really beside the point.  Every single square meter under construction — whatever its stage of completion — represents capital that is locked up and not generating any cash return until a sale takes place.  Most of that capital is borrowed, some of it at very high interest rates, placing a heavy financial burden on developers.  The four largest developers in Xinyi, in eastern China, recently found out what happens when you borrow lots of money and pour it into assets that don’t produce cash quickly enough:  they went bankrupt.  One of them funded its land purchases by borrowing at monthly interest rates as high at 6% (>100%/year).  Even at more reasonable rates, property development is always a race against time.

With time running against them, Chinese developers hard-pressed to sell.  The thing that could save them is if enough Chinese are equally hard-pressed to buy.  The question is whether there is enough underlying demand to absorb all the supply developers have built up, at an investment growth rate exceeding 30% per year.

The main drivers of growth in demand for housing, which accounts for roughly 80% of property sales, are urbanization and rising incomes.  (The main drivers for office and commercial demand, which make up the other 20%, are business expansion and performance, for which GDP growth provides a decent proxy).  The Economist Intelligence Unit (EIU) in Beijing predicts that China’s urban population will expand by 26% or 160 million people by 2020, at a compounded rate of 2% per annum.  I don’t think this ongoing rural-urban migration can be taken as a demographic given — it depends on continued productivity gains in China’s urban and rural economies — but based on historical trends, it certainly appears likely.  The larger point is, I agree there is no physical overstock of housing in China.  In Dubai, if you built it and they do not come, you have a desert with nobody there.  In China, there are 1.3 billion people who would be happy to move into as nice a place as possible — if the price is right.

Saying that there is great need for housing is not the same thing as saying there is strong demand for the kind of housing that is being built, at the price that is being asked.  The crucial element, then, is rising incomes.  How much is the typical Chinese household willing and able to afford?  A national price-to-income ratio of 7.4 in 2011 — calculated by E-House based on official statistics — suggests that current housing prices pose a bit of a stretch for the average Chinese buyer, a view confirmed by the latest Q2 PBOC survey, in which 68.5% of respondents said they considered current house prices unacceptably high.  That stretch is even more challenging in top-tier cities sporting price-to-income ratios in the low to mid teens:  Beijing at 11.6, Shanghai at 12.4, Shenzhen at 15.6.  Nevertheless, it’s possible to envision that rapidly rising incomes could make prevailing prices — if they don’t keep rising — more affordable in years to come.

According to China’s National Statistics Bureau (NBS), in the first half of this year, per capita disposal income of urban households grew by 13.3% in nominal terms, 9.7% in real terms, compared to the same period last year.  EIU expects it to continue rising, in real terms, by 9.8% a year, expanding 2.6-fold by 2020.  I would question whether at 3.6% deflator is sufficient to adjust for the rapid rise in cost of living most Chinese have experienced these past few years, particularly in housing and food.  I would argue that much of the wage gains we’ve seen at the lower end of China’s income spectrum have been inflationary in nature, driven by money creation channeled largely into construction (of infrastructure as well as property) which bid up the price of low-skill labor in competition with export industries.  Others would argue that the official statistics understate a large amount of “hidden” income concentrated mainly among high-income earners.  As we shall see, both of these factors — below average real income gains on the low end and unrecognized gains on the high end — contribute to a potentially hazardous imbalance in China’s property market.

Even if we simply could take 9.8% real income growth per year, and compound it with 2.0% urban population growth, it would give us a market growing at 12.0% per annum in real terms (15.7% in nominal terms).  The thing is, China’s real estate market has been growing a lot faster than that.  Sales grew by 75% (nominal) in 2009, 18.3% in 2010, and 24.1% YoY in the first half of 2011, before the market went into contraction.

The explanation for this additional demand is simple:  investment.  In recent years, Chinese investors — some wealthy, some not-so-wealthy — have purchased a great deal of vacant property as a form of savings, partly due to a lack of good alternatives, partly in anticipation of future growth in real homebuying demand due to urbanization and rising incomes.  CLSA, based on regular surveys of project sales managers, says that investors have never accounted for more than 22% of sales, and accounted for just 9% in June (with 37% upgrading and 54% first-time buyers).  I think these salesmen either don’t know what they’re talking about, or are pretending not to know.  A recent government-sponsored research report, which I obtained courtesy of Nick Lardy of the Peterson Institute, calculates that Chinese households own an average of 1.2 homes.  Assuming a home-ownership rate of 88% (according to EIU), that implies 1/3 of all home-owning families in China have invested in a second property.  Recently, the Public Security Bureau (PSB) in Beijing disclosed that it counted 3.8 million empty residential units in the capital, which given there are 20 million people in Beijing, lines up rather well.  The PSB later rescinded the number, saying it was all a mistake, but it was widely believed because (a) everyone in China knows plenty of people who have bought up several apartments as an investment, and (b) all it takes is eyes to see whole developments standing sold but empty, not just in “ghost cities” like Ordos, but any city in China.

By anticipating future demand growth, investors effectively front-load that growth into the present.  That’s great for developers, who get to sell more today, but it means that a great deal of future demand has already been provided for and priced into the market.  We see this phenomenon in other markets as well.  In the West, many investors want to buy into high-growth companies like Apple or Facebook.  What they don’t realize is that, to the extent they’re paying a high price-to-earning (P/E) ratio, they’re paying for that growth up-front, with the benefit accruing to the present-day seller, not the new investor.  Even a genuinely promising company can have an overpriced stock.

The imbalance in real income growth I mentioned earlier exacerbates this phenomenon.  The proceeds of inflationary money creation are channeled to favored recipients, often in the form of “hidden” income.  These high income earners, in need of a place to stash their cash, pour it into property, in anticipation of future demand.  The more money is created through expansive credit, the more cash they have to stash.  In the meantime, the inflation that is generated boosts the nominal wages of low-skill workers, but erodes their real income growth, which is the basis for growth in future housing demand.  Excessive money growth inflates the price that investors are willing to pay today, and lengthens the amount of time it will take actual homebuyers to come to afford that price.  In other words, it creates a bubble.

As I noted before, rising incomes mean that current housing prices will become gradually more affordable — but only if they stop rising.  If the market has to depend solely on end-user demand, there is a catch-up period ahead, in which incomes gradually rise to meet anticipatory prices, and investors gradually sell their stockpiled apartments to actual residents.  The only way to avoid this catch-up period would be for investors to continue fronting for future demand by expanding their holdings even further.  Many believe this will happen.  In fact, if you think about it, this is really the main rationale behind calls for the government to lift restrictions on multiple home purchases: only investment demand, in the form of renewed stockpiling, can save the day.

But how realistic is this hope?  According to figures gathered by Wang Tao at UBS (and again passed along to me by Nick Lardy), urban housing stock as a percentage of Chinese household wealth has risen from 18% in 1997 to 39.5% in 2010 (Lardy’s team ran their own analysis for 2011 and come up with 41%).  The share in the U.S. in 2011, by comparison, was 26.2%.  (Both graphs below are courtesy of Nick Lardy and the Peterson Institute).

In Lardy’s eyes, and mine, these figures raise serious questions as to how much more of their wealth Chinese households will be able and willing to pour into real estate.  50%?  60%?  The current trends may be reaching their limits.  In a recent CLSA survey (dated June 12), only 19% of middle-class Chinese families surveyed expected real estate prices to rise over the next six months, with 42% saying they would fall (an improvement over January, when only 13% expected prices to rise and 56% expected them to fall, but still a pretty negative outlook).  Perhaps as a result, only 14% of consumers asked named property as their “best investment option in China” over the next 12 months, compared to 18% who said gold, 18% who said wealth management products issued by banks, and 24% who said bank deposits.

In summary, there is genuine growth in demand for housing — as well as office and commercial space — in China, but there is also evidence that both developers and investors have gotten ahead of the market.  Developers have built up large stocks of unsold inventories that they are now under great pressure to liquidate in order to pay mounting debts.  The capacity and willingness of Chinese investors to front for future demand may be reaching its limits.  All of this raises the real possibility that people who are buying into the latest rally, in the belief that “prices can’t fall any further,” may be misjudging the market, and the rebound we are saying may be a classic “dead cat bounce.”

Next installment:  Theory #4, Government Intervention is Boosting the Numbers

What’s Driving China’s Real Estate Rally? Part 2

Yesterday, I began an investigation into the potential causes behind the latest bump in China’s property sales numbers, and whether they portend a genuine turn-around in the nation’s real estate market.  I noted that five basic theories to account for what has been happening, and promised to examine them each in turn:

1. Lower Prices are Bringing Buyers Back
2. Looser Restrictions are Unleashing Pent-Up Demand
3. Optimistic Buyers are Misreading the Market
4. Government Intervention is Boosting the Numbers
5. Developers are Fudging Numbers to Stay Afloat

In my last post, I concluded that it was certainly possible that a fall in both real and nominal property prices could explain a recovery in sales, as properties become more affordable to buyers.  However, this theory cannot explain the rebound in property prices reportedly taking place, nor should it offer much comfort to hard-pressed developers, who would may have to endure steep losses to clear their inventories at reduced prices.  Chinese developers and bullish real estate investors much prefer a second theory that promises a return to both higher sales and higher prices.

2. Looser restrictions are unleashing pent-up demand.  The conventional explanation that you will hear for China’s real estate slowdown, from developers and from most of the media, is that it’s a direct result of government policies designed to “cool” the property market, including tightened rules on mortgages, residency requirements for buying, and — more than anything else — restrictions on multiple home purchases.  As a result, many who wish to buy are not allowed to do so.  If the government would only relax these restrictions, the argument goes, all that pent-up demand would come back onto the market.  As the chart below illustrates, in contrast to the first theory we examined, introducing new demand (shifting the entire demand curve to the right) would boost sales for any given price, and cause both quantity and price to rise to a higher equilibrium point.

This is a dream scenario both for developers and for local governments that depend in various ways on a booming property sector, which is why both have been baying for months if not years about the need to relax the restrictions. Some local governments have succeeded in loosening or circumventing the central government’s tightening measures when Beijing wasn’t looking, and May brought a surge of rumors that the central government itself would have no choice but to reverse course as part of its effort to re-stimulate a slowing economy, a belief that prompted one Beijing developer to quip, “Ducks first know when the Spring river water begins to warm” — in other words, “Happy days are here again!”

But is the conventional story — that China’s government drove down the real estate market, and can just as easily resuscitate it — really correct?  The evidence, I believe, demonstrates it is not.

Most of the government’s measures aimed at “cooling” the property market were adopted in April 2010 — over two years ago.  I remember it well, because I argued at the time that such top-down restrictions would do little to change the dynamics that drove so many Chinese to pour so much money into vacant, unproductive real estate as a form of savings.  I also distinctly remember the government ordering developers in key cities to take their most expensive units temporarily off the market, in order to (statistically) reduce the average market price and thereby show that the policies were producing immediate results.  “Mission accomplished” was quickly declared.

The chart below, courtesy of Joanna Dong, the chief China economist at the mining firm Anglo American, shows the number of Chinese cities (out of 70 tracked in the official statistics) where property prices rose (blue) , fell (yellow), or remained the same (orange) each month.  It is not weighted by market size, but it offers a good “heat map” of rising and falling prices by geography.  And along with the national statistics on property sales and investment, it tells a very interesting story.

After the government’s cooling measures were adopted in April 2010, nationwide property sales did not decline, as one might expect.   They rose by 18.3% YoY in 2010 and 24.1% YoY in the 1st half of 2011.  Nor did real estate investment, which rose by 33.2% YoY in 2010 and 32.9% in the 1st half of 2011.  In other words, the government’s cooling measures had little appreciable effect on a booming property market for the first 16 months they were applied, at least when measured on a nationwide basis.

The 70-city price map tells a bit more nuanced story.  First you see a drop in about 20 key cities, which corresponds to the politically-engineered withdrawal of high-end units I mentioned.  Then you see — strangely enough — a big surge in the number of cities reporting price increases which lasts until the summer of 2011, when the bottom falls out of the whole market.  Again, for the first 16 months or so that “cooling measures” were in place, property prices continued rising in a large majority of Chinese cities, instead of stabilizing or falling.  What happened?

The fact is, the government’s “cooling measures” were not terribly effective.  Premier Wen Jiabao admitted as much at the end of 2010.  They were only enforced in a few key cities, and even then, if you really wanted to purchase  multiple apartments in Beijing, you could probably figure out a way to do it (through relatives, nominees, false documents, etc).  What the “cooling measures” did do, however, was send investors a signal that, if they wanted to see outsized returns, they’d do best to look for them outside high-profile cities like Beijing and Shanghai, when China’s leaders were at least trying to rain on their parade.

Government-imposed restrictions didn’t rein in Chinese demand for real estate, as the national numbers indicate.  But they did shift buyers’ attention away from a handful of 1st-tier cities — where prices stabilized or fell — towards 2nd and 3rd-tier cities in the provinces — where, as the chart shows, they surged.  In other words, the party didn’t end when the cops showed up, it just moved down the street.  In the summer and fall of 2010, I visited a number of provincial cities and asked developers there how the central government’s “cooling” policies were affecting their business.  Every single one of them reported that they had experienced no effective restrictions; to the contrary, investors from other cities were showing up  literally holding sackfuls of cash, looking to buy.  When “cooling measures” were gradually extended to more cities, developers responded by building luxury condos and villas out in the countryside, whose sole selling point was that they lay outside the restricted zone, permitting investors to buy as many units as they desired.

China’s property market continued booming right through the summer of 2011, when — as the price chart shows — the wheels abruptly fell off.  Why the sudden implosion?  Because even as sales grew by 20% or so, investment in property development expanded at an even faster rate, higher than 30%.  The government’s ineffectual “cooling measures” had lulled developers into a false sense of security: believing that buying restrictions had artificially suppressed demand — which was not true, except on a very localized basis — many developers borrowed heavily to build far more than they could sell, reasoning that they would be in a winning position when the government ultimately relented and relaxed its controls, and all that pent-up demand came flowing back onto the market.  To support these rising unsold inventories, however, they needed to borrow more and more money — at the precisely the time China’s central bank was reining in credit expansion to combat inflation.  By the end of last summer, Chinese developers finally ran out of funding options and were forced to begin liquidating their inventories to generate desperately-needed cash.  The fire sale they initiated quickly undercut existing demand, as would-be buyers who had once rushed to beat rising prices now held back, now that every day brought larger discounts.

So if the government’s “cooling measures” were NOT the cause of China’s property downturn, is there any way the relaxation — or anticipated lifting — of those measures can possibly explain the rally we’ve seen over the past couple of months?  Surprisingly, the answer may be YES — but the implications are not what struggling developers or China property bulls might like to imagine.

As we’ve seen, the government’s restrictive measures did not suppress overall demand, as many imagined.  They merely redirected that demand away from 1st-tier cities, towards 2nd and 3rd-tier cities, as well as the countryside.  Undoing those measures would have the opposite effect: allowing demand to flow back to 1st-tier cities like Beijing and Shanghai, while cutting the legs out from under the lower-tier (and potentially much more vulnerable) markets that benefited from the earlier diversion.  Prime urban areas would see higher sales and higher prices, but the nationwide effect would be a wash.  That may help explain the apparent disconnect between the rather astonishing statistics we see coming out of Beijing, Shanghai, and other big cities, and the much less impressive results revealed in the national statistics for June.

It’s also interesting to note, as well, that the latest rebound in Beijing, for instance, took place in anticipation of a policy change, even though buying restrictions and other “cooling” measures remained largely in place.  That accords with my argument that it was the policy signal, rather than the practical effect of the restrictions themselves, that led buyers to shy away from Beijing and similar markets and channel their interest elsewhere.  When the signal was perceived to have changed — when people came to believe the government would welcome a rebound in the city’s property market — they rushed back in, revealing the restrictions themselves to be an inconvenience, at most.

Critics will respond that, in fact, it was the government’s restrictive policies — its efforts to rein in lending — that brought the real estate market down.  But it’s important to note that China’s leaders had little choice, given the need to combat rapidly rising inflation.  More relevant to my argument, the constraints imposed by credit “tightening” (relative to developers’ spiraling credit needs) fell mainly on developers, not buyers — it did not create any reservoir of “pent-up demand” that later could be “unleashed” to boost the market.

This concept is worth clarifying.  Developers, investors, and analysts often talk about there being “pent-up demand” in China for buying homes.  But as I hope these last two discussions have illustrated, “pent-up demand” can mean very different things.  In Theory #1, it means that if prices fall, the quantity demanded increases, although the calculus for demand does not change.  In Theory #2, it means that a change in policy could shift the entire demand curve outwards, increasing the amount demanded at any given price.  I have just argued that, in fact, it could mean demand increases in one location only at the expense of another, with overall demand remaining the same.  All of these are very different dynamics, with different implications for developers, investors, and the Chinese economy.  Very often, people conflate them under the broad and appealing notion that 1.3 billion people in China would really like to buy as nice a home as possible, if only they could.  Of course they would.  The essential question is under what conditions this general desire gets translated into actual purchases and at what price.

Next Installment:  Theory #3, Optimistic buyers are misreading the market. 

What’s Driving China’s Real Estate Rally? Part 1

The buzz is that China real estate is back.  After nearly a year of steep discounting, with both land and housing sales in April looking like they were falling of a cliff, the market was electrified in late May by stories of would-be home-buyers lining up around the block and entire luxury developments selling out on the days sales opened.  China Securities Journal reported that Beijing housing sales were up 46.5% YoY in May, Xinhua reported they were up 50.6% YoY in June, and property agency Centaline says they’ve continue to surge at 37% YoY in the first half of July. Over Dragon Boat Festival weekend, in late June, China’s Housing Ministry said sales volume for Beijing residential property soared 289% YoY (nearly 4x), and Centaline said six other cities saw sales growth greater than 100% YoY that same weekend. In Shanghai, housing sales surge 65% WoW in late June and, according to China Business News, primary market sales that month rebounded close to their five-year average.  Securities Times reported that, even in 2nd-tier Wuhan, primary market sales were up 18.7% YoY in June.

Word is that property developers, encouraged by the turn-around in sales, have begun ditching discounts and raising their prices again.  Official statistics for June showed property prices rising in more cities (25) than falling (21) for the first time since last September, with Dow Jones calculating average nationwide prices increasing by a modest 0.02% after eight straight months of decline.  Online property site Soufun said nationwide home prices rose 0.1% MoM in May, the first gain in 10 months, while the China Real Estate Index System (CREIS) showed the national average rising 0.05% MoM in June (with Beijing prices bounding ahead by 2.3% MoM in June).  Just this week, Tiahe Group put a new batch of luxury villas on the eastern outskirts of Beijing onto the market for the eye-popping price of US$47.5 million each, which works out to RMB 200,000/sq. meter or $2,925/sq. ft. (for reference, the average price on Manhattan’s pricey Upper East Side is $1,426/sq. ft.).  Perhaps encouraged by such trends, Longfor Properties, Agile Property Holdings and Evergrande Real Estate Group all made big land purchases in recent months, with Evergrande paying a record-setting RMB 33,000/sq. meter for plot in Guangzhou.  This month, developer SinoBo easily topped them by paying more than RMB 41,000/sq. meters in a Beijing land auction.

However, other numbers tell a very different story.  According to data from China’s National Bureau of Statistics, total floor space sold was down -9.3% YoY in May, and -3.3% YoY in June.   Total sales in June rebounded to +6.9% YoY, the first gain this year, but hardly makes a dent compared to the 33% YoY increase in units for sale.  Meanwhile, land sales resumed their downward slide to -22.4% YoY in June, and new starts were down -16.3% YoY that month, the worst this year.  As a result, growth in total floor space under construction has steadily declined, from 35.5% YoY at the beginning of the year to 17.2% YoY in June.  I’ve been hearing more and more stories about that construction being put on hold, a storyline that appears to be validated by the fact that completions, which were up 45.2% YoY in January, have fallen to 0.3% YoY in June — basically flat compared to last year, and heading into decline.  No surprise, then, that growth in real estate investment has fallen from 27.9% YoY for 2011 to 16.6% for 1H12 and 11.8% YoY in June — numbers that will feed directly into lower GDP growth.

In the meantime, China’s property developers are facing intense financial pressure just to stay afloat.  As the Wall Street Journal reports:

Standard & Poor’s Ratings Services says China’s more than 80,000 developers could face a battle for survival as a wave of short-term property loans fall due this year. The risk is that these businesses could become so desperate they will either default, leaving behind half-finished projects at a time economic growth already is slowing, or start offering steep discounts, triggering a price war.

It’s not just the small-fry who are sweating it, either.  China Daily reports that, among A-share listed developers (some of China’s largest) 17 expect losses for 1H12, 22 forecast profit growth, while 13 expect lower profits than in the first half of 2011.  Developers tell the paper that losses are mainly due to the rising burden of carrying huge unsold inventories, and that many continue to feel pressure to offer big discounts to raise cash.  The Wall Street Journal notes that much of this pressure comes from a tidal wave of trust loans coming due:

Securities brokerage China International Capital Corp. estimates that about 223 billion yuan ($35 billion) of trust loans are due to mature this year, almost half of which reach maturity between July and September, with a further 282 billion yuan due next year. Combined, that represents almost 75% of all outstanding trust financing to the property sector at the end of 2011.

With developers under this much pressure, it’s hard to imagine the market suddenly turning into a seller’s paradise.

So what’s really going on with China’s property market?  Is the rebound in sales real, and if so, can it last?  Is the market bottoming out, surging back, or seeing one of those false rallies that precedes an ever steeper decline?  Since the decline in China’s property market since the end of last summer has been something of a leading indicator of the nation’s broader economic slowdown, and since the assumption of ever-rising property prices underwrites a large part of China’s lending, it’s important to get to the bottom of this question.  If China’s property market is on truly on the mend, it bodes well for a much-anticipated recovery in the 2nd half of this year.  If it’s still broken, things may get worse before they get better.

I’ve spoken to as many people as possible over the past two months — buyers and sellers, bankers and developers, economists and officials, bulls and bears — and I’ve heard five basic theories to account for the latest bump in China property sales numbers:

1. Lower Prices are Bringing Buyers Back
2. Looser Restrictions are Unleashing Pent-Up Demand
3. Optimistic Buyers are Misreading the Market
4. Government Intervention is Boosting the Numbers
5. Developers are Fudging Numbers to Stay Afloat

I’m going to walk through each of these theories in turn, and try to determine which of them — if any — offers the most credible explanation for what’s happening in the market.

1. Lower prices are bringing buyers back.  For a while now, one of the main concerns about China’s property market is that prices have spiraled so high that most potential homebuyers find them unaffordable.  But with prices dropping, and wages rapidly rising, maybe that equation is changing, with more buyers willing to snap up what are starting to look like good deals.  The chart below depicts how an economist would see the process: the supply curve shifts outward as overzealous developers build more than they can sell at prevailing high prices, leading them to cut prices and moving the market equilibrium point down and right along the existing demand curve.  The behavior of buyers hasn’t changed, but offering them lower prices translates into greater quantity sold.

Based on anecdotal evidence, this certainly does appear to be the rationale many would-be homebuyers are giving for re-entering the market.  As one 29 year-old buyer recently told the Financial Times, “Everyone has been paying attention to this development, because it is a big one. I saw the prices go down and I thought they were now reasonable. I can’t see them falling by much more.”  In early June, a senior official with Beijing’s real estate industry association told Jinghua Times that the reason for strong May sales was aggressive price-cutting, and that when a few projects tried to raise prices, they saw sales fall off immediately.

The problem with this explanation is that — according to official statistics at least — prices haven’t fallen all that much and are starting to rise again.  Dow Jones calculates that prices in June were a modest 1.3% lower than a year before, while Reuters estimates 1.5% — not much to get excited about, if you’re a stretched Chinese homebuyer.  And if higher demand is the effect of lower prices, there’s absolutely nothing in that dynamic that would cause prices to go back up — which is what we’re told is now happening.

There are two possible answers to this objection.  The first would be to not put too much credence in the official price statistics.  When prices were rising, over the last few years, there was a noticeable disconnect between the rapid price increases people were seeing the ground — prices doubling in 2-3 years — and the modest rises reported in the official statistics.  Over the past year, there has been a similar disconnect between the 20-30% discounts regularly offered at point-of-sale and the 0.1-0.2% MoM price declines in the official and “independent” (CREIS, Soufun) indices that still get much of that get much of their data from the same industry and local government sources.  There’s plenty of reason to believe that actual prices rose a lot more — and have fallen a lot more — than the official data suggests.

Second, if rising incomes are indeed part of homebuyers’ calculations, then we need to understand the “Price” axis on the supply-demand chart as indicating real rather than nominal price.   If other prices, including wages, are rising due to inflation, then home prices actually don’t need to fall much (or at all) in nominal terms to become more affordable in real terms.  The Shanghai E-House real estate research institute, for instance, calculates that China’s price-to-income ratio for houses peaked at 8.1 in 2009, fell to 7.4 in 2011, and will decline further this year — in part due to rising wages, in part to falling (nominal) home prices.  What E-House’s affordability ratio doesn’t explain very well, however, is why the latest sales boom appears to be centered on cities that still have extremely high price-to-income ratios, like 12.4 in Shanghai, 11.6 in Beijing and 15.6 in Shenzhen.

If the recovery in sales volumes really is being driven by lower prices (either nominal or real) that’s hardly good news for developers.  It means that for the market to clear — for them to sell down the large inventories that are weighing so heavily on their finances — prices will have to drop even further, or at least not rise for some time.  That means a continued squeeze on their profits, which some may not be able to sustain.  That’s why most developers prefer an alternative explanation of what is happening, one based on a burst of pent-up buyer demand.

Next Installment:  Theory #2, Looser Restrictions are Unleashing Pent-Up Demand

Am I a China Bear?

There are two schools of thought on the Chinese economy right now.  The first says “It’s always darkest just before the dawn.”  The second says “It’s always darkest just before it goes pitch black.”  It’s clear that China’s economy is slowing.  But what happens next is far from clear, and the subject of much debate.

The conventional wisdom at the moment, among officials and economists, runs something like this:  China’s economy is slowing alright, perhaps a bit too much for comfort, but it’s mainly a self-induced slowdown driven by the government’s own cooling measures.  GDP growth is still above Premier Wen’s target of 7.5%, and is destined to improve in the 2nd half of the year as the government switches gears to re-stimulate the economy.  The slowing inflation rate gives them plenty of room to ease.  The real estate market has already bottomed out, and the banking system is stable.  Maybe stimulating more investment isn’t the best thing for China’s economy in the long run, but Chinese leaders have the ability to kick that can down the road for some time.  They have time.

No they don’t.  I disagree with virtually every single element of the conventional view I’ve just outlined.  Over the next few days, in a series of posts — on credit, real estate, inflation, and stimulus — I will describe how and why.  For the last two weeks, I’ve been on a bit of a hiatus from this blog, focusing on my Twitter feed @prchovanec — which if you haven’t checked out, you should.  Not only has Twitter been a wonderful way to introduce new readers to this blog, it has offered me an excellent perch for monitoring the data and news stream coming out of China, while trying to make sense of what it all means.  Several important story lines have emerged, and what I’m seeing really worries me.

Indeed I am worried — not thrilled, not vindicated — because contrary to stereotypes, I do not consider myself a “bear” on China.  In that respect, I would like to make a few points.  Because over the next few days I’m going to be saying some very negative, critical, and even scary things about China’s economy, these points are quite important.

1)  I don’t hate China.  I’m not “rooting” for China to “crash and burn.”  I realize that at least a few of my Chinese readers, when they hear me harshly criticize policy or make dire warnings, might conclude that — as an American — I’ve caught an acute case of China-envy and would love nothing better than to see China taken down a notch.  In fact, I am so critical not because I want the worst to happen, or believe it must happen, but because I hope and believe the worst can be avoided, if clear-sighted, courageous choices are made.  My wife is from Beijing, my son was born here, and we are all tied by blood and affection to a whole host of relatives in China whose struggles and aspirations we share.  On a less personal level, no matter what you think about China’s current form of government, or the implications of its rising global influence, the complex challenges and opportunities posed by a strong and prosperous China are infinitely preferable to the terrible dangers and uncertainties the world would face if China were to “collapse” or just lose its way in confusion.

2)  I’m not a “Perma-Bear”.  In other words, I’m not the kind of commentator who has been warning of China’s imminent crash for so long that eventually I’m bound to get it right, like the broken clock that tells the right time twice a day.  I’ve been traveling to China for 26 years, and living here for over a decade.  For most of that time, I would have described myself as a China “bull.”  I’ve seen an incredible transformation of an economy, an astonishing burst of wealth creation.  I’ve worked for private equity funds that invested in promising Chinese companies and helped them grow. In the past, the problems — bad debt, inefficient state industries, protected markets — were outweighed by even more positive developments: the wholesale privatization of small and medium state enterprises, China joining WTO and committing to more open markets, foreign investors taking an active stake in reforming state-run banks.  But something changed in the past few years, when China adopted state-managed stimulus and money-printing as a model for permanently boosting economic growth.  I don’t see myself as inherently a “bull” or a “bear” on China.  The fact is, I see plenty of promising areas where China can achieve huge productivity gains and realize meaningful growth — but I don’t see that happening as long as China keeps trying to insulate favored market sectors from economic reality.

3)  I’m not “talking my own book”.  Earlier this week, former Morgan Stanley strategist Stephen Roach warned CNBC viewers to ignore skeptical concerns about China’s economy.  “Beware of people who say things like this,” he told the anchor, “Oftentimes they’re just talking their own book.”   In other words, they’re talking down the Chinese economy because they have taken short positions that will pay off if it tanks, or merely if market sentiment turns negative enough.  I don’t know about other people, but I can assure you that when I express concern about the Chinese economy, I am NOT talking my own book.  I own (one) property in Beijing, which we bought at a reasonable price.  My wife’s career, with a global investment bank, rides on the health of the China market.  Virtually all of our income is in RMB, and there are barriers to moving it out of the country.  Because of my wife’s job, we are prohibited from taking any short positions in the market, at least actively — in fact, it’s very hard for us to move in or out of any China-related investment freely.  In our lives, careers, savings, and income,  we are exposed long on China — and like most people in China, can’t really do much about it.  But I’m still going to call things as I see them, when I see them heading for a cliff.

In short, I have no reason for talking down China, and plenty of reasons for wanting China  to get things right.  Keep that in mind as you read my “bearish” Tweets, or consider my negative outlook for China’s property market or my skepticism towards China’s renewed stimulus efforts.  I would much prefer to see a very different fact pattern and reach far different conclusions.

Of course, my worries may prove overblown, my facts incomplete, my vision faulty.  In which case, I’ve at least given everyone food for thought.  As Yogi Berra said (which I’ve stolen unapologetically from Fred Thompson’s latest blog post): “Predicting is tough. Especially about the future.”

Falling Dominoes

Last month, I called attention to an article in Caixin magazine about the implosion in Beijing of something called a “credit guarantee company,” and examined the potential risks such entities pose to China’s financial stability.  Today, Caixin published another must-read article about a new crisis in which credit guarantees — this time directly between borrowers — have triggered a mini financial meltdown in Hangzhou:

The Zhejiang government is scrambling to settle a credit crisis threatening banks and financial institutions that altogether issued about 6 billion yuan in loans to scores of companies.

Sources say 62 companies, from furniture makers to import-export traders, have been affected to varying extents by the collapse late last year of Hangzhou-based property developer Tianyu Construction Co. Ltd.

The companies were financially linked to Tianyu through a province-wide, reciprocal loan-guarantee network. Tianyu’s sudden failure raised the specter of a domino effect of defaults taking down every network participant and devastating their lenders.

“After Tianyu went bankrupt, banks in Hangzhou started calling in loans to other firms guaranteed by Tianyu,” said the owner of a company tied to the network. “That had a ripple effect and affected a number of other companies.”

The web of interlocking, often incestuous, and sometimes circular credit arrangements is reminiscent of Wall Street in the lead-up to the subprime crisis, in which a relatively small amount of mortgage losses, which most people believed could be contained, triggered a chain reaction that brought down major banks and froze credit across the entire global economy.  So how did Hangzhou’s banks allow this situation to develop?

One credit analyst said Zhejiang banks have been blindly trusting loan guarantors while failing to properly examine and screen loan candidates. An official at China Construction Bank’s Zhejiang branch said his bank should have better analyzed potential borrowers’ financial conditions, not just guarantees and promises.

We’ve seen this before with Zhongdan.  The banks, in turn, blame borrowers taking what now look like stupid speculative risks (but at the time looked like a sure thing):

“Zhejiang’s business owners were spoiled by easy access to credit, especially in 2008 and 2009,” said a credit manager at one bank. “Back then, they could always get loans using land as collateral and could always make money by investing in property.”

There’s probably enough blame to go around — as there always is when credit flows freely — but one thing is becoming clear:

The reciprocal nature of the guarantee network stripped real bank loan guarantees of any value, argued another banker. The system has made all its participants mutually vulnerable to an economic downturn, he said.

Now that property development can no longer guarantee profits, the banker said, borrowers and guarantors are in trouble together.

Cash flow at some enterprises has fallen to dangerously low levels, said a bank loan officer, so that they’ve been forced to survive on credit. Many ran out of cash after pouring money into speculative property investments, he said, which flopped after the central government imposed real estate development restrictions in 2010.

In other words, a lot of these firms are actually insolvent and are just borrowing from Peter to pay Paul, in order to postpone the day of reckoning.  Of course, the government could step in and bail everyone out.  As the article notes, that’s what happened in 2008 in the neighboring city of Shaoxin, when a local petrochemical company that had issued similar loan guarantees ran into trouble.

But before we take too much smug comfort in assurances that the Chinese nanny-state will surely “resolve” (i.e., foot the bill for) everyone’s losses, making them magically go away, here are a couple points worth noting:

• Even if everyone in Hangzhou is eventually bailed out, the interim effect on the real economy is chilling.  Companies that are hanging by a thread, with almost no access to working capital or investment funds, certainly aren’t going to be contributing to GDP growth.  Bailouts, when they do happen, don’t make losses go away, they just impose them on someone else — the drag on growth remains.
• The quotes cited above highlight the central role the property market plays in China’s financial system.  For the past several years, higher property prices led to more lending, which led to even higher property prices and onwards and upwards.  Now that the market has turned, lower property prices are undermining the basis for both past and future lending, and shutting down China’s engine of investment-led growth.  (If these words sound familiar, that’s because I warned exactly this on Bloomberg last year, when China’s real estate downturn had just begun).
• In my blog post last month, I wrote that I couldn’t really tell the scale and scope of the risks posed by credit guarantee companies like Zhongdan.  Just today, I came across some numbers from the China Banking Regulatory Commission (CBRC) — courtesy of the BoA-ML research team in Hong Kong — which say that, at the end of 2011, China had 8,402 credit guarantee companies, which had total assets of RMB 931 billion.  Notably, those assets had grown by 57.2% over the previous year.  Although the total assets figure adds up to just 1.7% of total loans outstanding in the Chinese banking system, the increase in 2011 equates to around 5% of net new loans issued that year.  More importantly, the inter-company guarantees at the heart of the Hangzhou Tianyu meltdown add a whole new dimension to the exposure of Chinese banks, beyond the professional guarantee companies themselves.
• Tianyu was one of a handful of relatively small real estate developers that were allowed to go bankrupt recently, presumably because they weren’t seen as worth rescuing.  Yet allowing even that small thread to be pulled unraveled a whole web of credit relationships that put numerous banks and businesses in danger.  Now think what could happen if a developer like Evergrande (one of China’s ten largest, which last week was accused of hiding the fact that it is actually insolvent via massive accounting fraud) went bust.  The domino effect would be orders of magnitude larger, and hard to preemptively anticipate.
• Finally, the Tianyu story, along with Zhongdan and others, should finally put to rest the argument that last year’s credit meltdown in Wenzhou (which is still going on, by the way) was a “unique” or “isolated” case.  Shadow banking, and the risks it hides, are pervasive across China’s economy.  If you’re still buying the line that what happened in Wenzhou has no relevance to the rest of China, I have a couple of high-speed rail lines I’d like to sell you.

Evergrande Allegations

I was quoted today by the BBC on today’s announcement that China will relax some of its restrictions on foreign investment in its domestic stock market.  You can read my comments here, and I’m also going to talk about it live on BBC TV at 6:30am Friday morning Beijing time (6:30pm Thursday NY time).

The big story today, in my opinion, is the report issued by Citron Research accusing Evergrande, one of China’s ten largest property developers, of massive fraud and arguing that the company is deeply insolvent and nearing the end of its rope.  I can’t vouch for any of the allegations, but the report is well worth reading.  Concerns about dodgy accounting practices have dogged Evergrande ever since its 2009 IPO, but Citron’s multi-barrelled shotgun blast takes them to an entirely new level, forcing the Hong Kong-listed company to issue an official denial today.

The allegations of rampant bribery and misuse of funds are certainly titillating, and do expose Evergrande to certain risks, but the really critical issue here is the company’s solvency and liquidity — whether it is a genuine going concern, or a house-of-cards Ponzi scheme.  Citron notes that Evergrande, which just this week shocked markets by paying a record-high RMB33k/sq meter auction bid for a plot of land in Guangzhou, has run a cumulative RM 26 billion operating (pre-Capex) cashflow deficit since 2006, sustaining itself by running up ever-rising levels of debt.  The report contends that Evergrande has hidden at least RMB 23 billion and possibly as much as RMB 56 billion in  trust loans and other debt off its balance sheet in Enron-style special purpose vehicles (SPVs).  It uses industry metrics to argue that Evergrande is overstating its cash balances by RMB 17 billion and overstating the value of its real estate holdings by RMB 10 billion.  Overall, its report argues that Evergrande is RMB 36 billion in the hole and fast running out of cash.

As I say, I’m not in a position to validate any of these specific allegations.  But they do resonate with me, because they resemble or are connected to many of the systemic risks I see building up across China’s property, trust, and banking sectors.  The big question I have been asking myself all Spring — with so much developer debt coming due, and with their cashflow so visibly impaired by the property downturn — is why we’ve hardly seen any Chinese developers (and the trusts that have fueled their building binge) go bust.  The hidden losses alleged by Citron may help answer that question, and the explanation is unlikely to be limited to one “bad actor.”  Like the losses that have been brushed under the rug in the Zhongdan Guarantee fiasco, they are just one piece in a much bigger and interconnected mosaic.

Here are some other data points and article links I’ve tweeted over the past few days @prchovanec:

• (Jun 21) oughta be interesting RT @MalcolmMoore PLA, in internal corruption investigation, asks officers to reveal assets http://is.gd/masI0X
• (Jun 21) HSBC new export orders PMI sub-index drops to 45.9, lowest since March 2009 http://reut.rs/L6Yp0J
• (Jun 21) Busnweek: In China’s Dating Scene, Women Get Pickier http://buswk.co/NlOYzf wow, tough market
• (Jun 21) RT @ProfGillis PCAOB Warns China Patience is Wearing Thin – Compliance Week http://www.complianceweek.com/pcaob-warns-china-patience-is-wearing-thin/article/246467/
• (Jun 21) HSBC flash PMI for China falls to 48.1, 8th straight month of contraction, 7-month low http://reut.rs/L6Yp0J
• (Jun 21) Alchemy: AMCs regard property NPLs as “low risk” and have been booking large profits on spread btw promised returns and own borrowing
• (Jun 21) Silent bailout? China’s AMCs have bought RMB 50b in troubled developer loans to keep real estate trusts from going bust
• (Jun 21) Xi Jinping urges stronger Party grip over China’s top universities http://bit.ly/Ll98cs wonder what that means for the likes of me?
• (Jun 21) Caixin: Rising alarms over food safety in China http://bit.ly/LDyPGE
• (Jun 21) RT @BrookingsInst: @JonHuntsman, former Gov of Utah and Amb to China, joins Brookings as a distinguished fellow: http://brookin.gs/Azwy
• (Jun 21) RT @michaelmccrae Sinopec considers bid for Chesapeake assets http://bit.ly/M5JMy6
• (Jun 21) @andrewserickson offers insight into China’s naval strategy and capabilities http://bit.ly/N9JhB7
• (Jun 21) RT @AdamMinter Why are Chinese investors buying up Toledo real estate? http://finance.fortune.cnn.com/2012/06/20/toledo-china-real-estate/?iid=SF_F_River
• (Jun 21) China defends rare earth restrictions http://on.wsj.com/Kl3Kle but they may be beside the point http://onforb.es/MrO1oi
• (Jun 20) RT @theanalyst_hk $$ Australia’s inverted yield curve points to recession http://dlvr.it/1l69QV
• (Jun 20) WSJ: Chinese gold imports skyrocketing http://on.wsj.com/M2UR2U
• (Jun 20) China Banking Assoc says outstanding loans to “social housing” projects up 66% yoy
• (Jun 20) PBOC survey: 15.1% of Chinese households plan to buy car in next 3 months, highest since survey began in 1999
• (Jun 20) PBOC survey: 68.5% find housing prices “high and hard to accept,” +0.8% QoQ, -5.8% YoY
• (Jun 20) PBOC survey: 20.4% expect housing prices to go up in Q3, +2.8% QoQ, -15.8% YoY
• (Jun 20) PBOC survey: 15.7% of Chinese households intend to buy house in next 3 months, up 1.6% from 12-year low in Q1
• (Jun 20) Is Germany looking bubbly, or just rebalancing? http://bit.ly/NfNR46
• (Jun 20) “Give us the dead body” – more on protest by African migrants in Guangzhou http://bit.ly/M4PuCr
• (Jun 20) Censorship at SCMP? http://bit.ly/N5QdiD Is it even remotely ethical for new editor-in-chief to be CPPCC member?
• (Jun 20) Cambodia arrests Frenchman linked to Bo Xilai, at Chinese request http://bit.ly/KxR8fi
• (Jun 19) Foreigners take to Guangzhou streets to protest after African man dies in Chinese police custody http://bit.ly/Pjchcw
• (Jun 19) Was China’s inflation imported from QE2? You decide: http://bit.ly/Ph0cok
• (Jun 19) China steel industry assoc says revenues down 1%, profits down 97%, taxes paid down 58% YTD April
• (Jun 19) 86% of South China factories saw orders fall or stay flat, but 90% are still struggling to hire enough workers http://on.ft.com/LB8MuV
• (Jun 19) WSJ: China turns to securitization to boost bank lending http://on.wsj.com/Nc3uK5
• (Jun 19) Official numbers show avg China home prices down 1.5%. This is discount everyone’s excited about? Either figures lie or buyers are nuts.
• (Jun 19) Economic Observer reports steel, iron ore, coal, cement, and paper pulp piling up to record levels at China ports http://bit.ly/KOZ4FH
• (Jun 19) MOFCOM says FDI inflow into China up (tiny) 0.05% yoy after six straight months in negative territory – basically flat
• (Jun 19) China Bsn News reports China’s domestic airlines lost RMB 1.4 billion in May
• (Jun 19) China’s Ministry of Finance says state sector profits down 10.4% YTD by May, revenues up 11.3%
• (Jun 19) China Securities Journal reports Beijing housing sales up 46.5% yoy in May

Data Points and Article Links 6/18/12

Here are some of the data points and article links I’ve been tweeting @prchovanec:

• (18 Jun) Overcapacity: China aluminum supply = 1.6m tons growing at 20%/year, demand = 1.3m tons growing at 4% http://bit.ly/Pbtx3f
• (18 Jun) FP: Popular novels offer glimpse into “hidden rules” of Chinese politics http://bit.ly/LwIMCo
• (18 Jun) RT @chinahearsay Telegraph: ‘Sexy Mandarin’ online language school uses models to help students learn http://bit.ly/KGNh0U
• (18 Jun) Inflation: Mercer survey says cost of living in 1st/2nd tier Chinese cities now exceeds US http://bit.ly/L7euKb
• (18 Jun) Zhejiang business owner flees owing RMB 1b debt after losing money on real estate, company goes bust http://bit.ly/LfsSOs
• (17 Jun) Interesting NYT profile of Wendi Murdoch http://nyti.ms/NzUKQl
• (17 Jun) RT @WantChinaTimes Beijing forbids ‘negative’ news ahead of leadership transition http://bit.ly/L50sJ0
• (17 Jun) RT @niubi Caixin has long piece on Chengdu & commercial real estate bubble. 30 buildings 200m+ tall under construction.
• (17 Jun) Do RVs (Winnebago-style recreation vehicles) have a bright future in China? http://natpo.st/MULTT6 Good luck finding a parking spot
• (17 Jun) WTO strikes down China tariffs on US-made specialty steel http://onforb.es/MUE1B4
• (17 Jun) China Times: China Overseas Land reported sales up 22% in May, actually sold less than half amt claimed http://bit.ly/LwzeFW
• (15 Jun) China aircon manuf to build world’s tallest bldg in 9 months … in Changsha. Changsha? http://on.wsj.com/Mbx0e5
• (15 Jun) Almost 90% of China shipyards have received no orders this year, 28% have secured none since end of 2009 http://bloom.bg/KGGL5x
• (15 Jun) China Bsn News reports long queues to buy property may be “faked” by developers to gin up sales – any thoughts?
• (15 Jun) China power consumption in May up 5.2% yoy, vs Apr +3.7% and May 2011 +11.7%
• (15 Jun) Further info from Reuters on alleged CIA mole in China’s State Security Ministry http://reut.rs/K7oNaW
• (14 Jun) New stimulus measure? RT @haohaoreport Guangdong TV Trots Out Girls In Bikinis To Deliver Weather Forecast http://bit.ly/OE4iq2
• (14 Jun) Here we go again! China Daily reports CBRC set to relax limits on lending to LGFVs and property http://bit.ly/KoD9Zo
• (14 Jun) Serious EU-China trade spat over airline CO2 charges: China threatens to seize European planes http://reut.rs/KnADm6
• (14 Jun) Reuters: May surge in China oil imports likely stockpiling to hedge US pressure to stop buying from Iran http://reut.rs/M3nppp
• (14 Jun) RT @JingDaily With E-Commerce Surging In China, Who Needs Brick-And-Mortar? http://is.gd/6B4peP
• (13 Jun) RT @WSJchina Chinese Banks to See Profit Squeeze http://on.wsj.com/Nf2pTM assumes profits were real to begin with
• (13 Jun) Bloomberg: Wenzhou’s financial crisis isn’t over, it’s still going on http://bloom.bg/L6KOvS
• (13 Jun) Watch what you Tweet: 2 arrested in Wuhan for “spreading rumors” re horrible air pollution http://bloom.bg/KsVUvR
• (13 Jun) Greentown boss: ignoring govt efforts to curb property market nearly ruined firm http://bit.ly/Ne3dZ2
• (13 Jun) Caixin: May recovery in property sales driven by price discounts, avg price down 12% yoy, set to fall further http://bit.ly/KBfth1
• (13 Jun) Caixin casts doubt on China effort to open banking and infrastructure to private investment http://bit.ly/LxJMrJ
• (13 Jun) SCMP: More on the crunch faced by China’s strugging car dealers http://bit.ly/M1S0DX, http://bit.ly/MrokE0
• (13 Jun) Very alarming: China authorities have arrested/harassed researchers into fraud by Chinese companies http://bit.ly/KBcLbn
• (13 Jun) WSJ: China is Hollywood’s fastest growing market for films http://on.wsj.com/KBce9g curious how will this affect content?
• (13 Jun) Caixin: loan demand remains weak despite boost in China’s May lending data http://bit.ly/KToXIS
• (13 Jun) NBS says China home appliance sales flat (+0.5% yoy) in May, compared to +7.7% in April
• (13 Jun) NDRC reports China’s car dealers are cutting prices due to mounting inventories, despite May rebound in sales
• (13 Jun) Beijing title transfers >600/day, due to surge in secondary property sales – investors are cashing out, to greater fools??
• (13 Jun) Chinese media reports Shanghai, Shenzhen, Hangzhou, Nanjing seeing thousands lining up to buy homes – the well of confidence is very deep
• (13 Jun) New Express (via BoA-ML) reports 30+ people killed in shadow banking dispute in Shandong, ppl borrowing at rates >20%
• (13 Jun) In Hunan, 26 of 35 power plants shut down, coal inventories at 50 days
• (13 Jun) Hunan power plant utilization at just 25%, Hubei at 62%, Jiangsu at 65% due to weak demand from steel, nonferrous, and cement prod
• (13 Jun) WSJ’s Orlik: Is Chinese govt caving to property developers? http://on.wsj.com/LPKyvC it’s more about credit access than buying restrictions
• (13 Jun) RT @AdamMinter air quality emergency in Wuhan. PM 2.5 at 589! Rumors of chlorine gas leak at a steel mill. Birds falling from the sky.
• (11 Jun) China regulators refusing to help SEC investigate fraud charges against US-listed Chinese companies http://bit.ly/Oh8tbj
• (11 Jun) Steady stream: head of Yantai Bank + 38 employees taken down for embezzlement http://bit.ly/MBcub7
• (11 Jun) Who’s next? Caixin reports head of China’s Postal Saving Bank under investigation for corruption http://bit.ly/MBbO5N

• (11 Jun) @chinamoneypod Famed China “bull” Jim Rogers offers nuanced, cautious outlook for Chinese economy http://bit.ly/LTXAuj