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NPR: What’s Going Wrong With China’s Solar Industry?

October 10, 2012

Yesterday, I was on National Public Radio (NPR) talking about the meltdown in China’s heavily subsidized solar industry, as a follow up to my Wall Street Journal op-ed on that topic last month.  You can read the transcript below, or listen to the interview here.

Steve Inskeep talks to Beijing-based economist Patrick Chovanec about too many subsidies in China’s solar energy industry. It is resulting in money-losing companies. One company, Suntech, could soon be delisted from the New York Stock Exchange because it is performing poorly.

STEVE INSKEEP, HOST:  Which brings us to our next story. As Americans try again to heat up the solar industry, let’s get an update on the competition. We reported last week on the West Coast solar power company that is trying to succeed where companies like Solyndra famously failed. American companies have struggled because they’ve been undermined by cheap imports from China. So it is meaningful to note that China’s solar power industry is a mess.

We’re going to talk about that with Beijing-based economist Patrick Chovanec. Welcome back to the program.

PATRICK CHOVANEC: Oh, it’s good to be with you.

INSKEEP: What’s going wrong with the Chinese solar industry?

CHOVANEC: Well, they have a dozen Solyndras. They basically have tried to build up an industry by pouring subsidies into trying to pick winners in that industry and right now those companies are failing badly because there’s a massive amount of overcapacity that’s been created.

INSKEEP: Well, let’s remember, because you say a dozen Solyndras. The company received hundreds of millions of dollars in U.S. government assistance and went bankrupt anyway. And one of the reasons we were given was that the price of solar power equipment has just been going down and down and down because the Chinese were producing it so cheaply, is that right so far?

CHOVANEC: Right. Prices have gone down so much that even the Chinese are not necessarily breaking even. So what you’ve got in China is a massive amount of overcapacity because all these subsidies have attracted so much investment. And you’ve got a number of very large companies, LDK Solar, which is the second-largest solar module company in the world; Suntech, which is the largest solar panel maker in the world, that are on the edge of bankruptcy right now and are really either being bailed out or there’s talk about bailing out to the tune of hundreds and millions of dollars.

INSKEEP: What are the public signs of their distress? Do they report losses? Do they fire workers?

CHOVANEC: Yes. LDK Solar has been reporting losses and they have been shedding about 10,000 jobs. And the local government, in its home province, has pledged about $315 million to try to keep it in business because they’re afraid that if LDK Solar goes down then hundreds of local companies could go under.

And Suntech, Suntech’s in kind of a unique situation. They guaranteed a loan to what is essentially a subsidiary that bought huge amounts of product from them, allowed them to report very high sales. It turns out that the collateral that was pledged, which was supposed to be German bonds to back that loan, doesn’t exist.

INSKEEP: OK. Now wait a minute. That was such a crazy story I want to make sure I understand it. You’re saying there’s a major Chinese solar company that set up another company and used borrowed money to buy solar panels – solar equipment – from itself and now is having a little trouble paying back the loan?

CHOVANEC: Yes. Not as unusual as you might think it in China – these kind of manufactured sales. Essentially what happened was there was a fund that they set up in Europe. Suntech owned about 90 percent of it, so effectively controlled it – it was essentially a subsidiary. That company bought solar panels to use in various projects in Europe. They borrowed money from China Development Bank. The parent company, Suntech guaranteed it. The total amount of the loan was $689 million, and it turns out that the collateral backing that loan just doesn’t exist. And a lot of analysts looking at that company basically say that that’s enough to push Suntech into bankruptcy.

Of course, since the Chinese government can’t allow that to happen, they’re going to have to step in and bail that company out as well.

INSKEEP: If all these cheap solar panels are being made why aren’t people just buying a lot more of them, which would save the companies?

CHOVANEC: Well, one thing that’s happening right now is the eurozone crisis and you have a lot of European countries that were giving very generous subsidies for people to buy and use solar panels. Those subsidies are now being cut severely.

INSKEEP: So what do the Chinese do now?


CHOVANEC: Well, what they probably do is they dig deep dig into their pockets – the pockets of the central government – and bail out these companies. Because what they’re really afraid of is, you know, we’ve seen this over the past couple of months, that even relatively small companies, when they fail in China they’re so intertwined in terms of their credit relationships and the local economy that essentially everything’s too big to fail.

INSKEEP: Patrick Chovanec is professor at Tsinghua University’s School of Economics and Management in Beijing.

Thanks as always.

CHOVANEC: You’re welcome.

[P.S. — This interview was recorded a week ago, before the New York Times published a very good article on the crisis in China’s solar sector.  In particular, the article sheds some additional light on my answer to the very last question — what will China do now?  It quoted one top Chinese official — the head of energy policy for the NDRC, China’s powerful economic planning agency — saying over-capacity is so severe that as many as 2/3 of China’s solar firms might have to die off  for the industry to survive.  In fact, it said, “he wanted banks to cut off loans to all but the strongest solar panel companies and let the rest go bankrupt.”  However, banks and local governments are resisting such strong medicine and want to keep failing companies afloat by any means necessary:

But banks — which were encouraged by Beijing to make the loans — are not eager to acknowledge that the loans are bad and take large write-offs, preferring to lend more money to allow the repayment of previous loans. Many local and provincial governments also are determined to keep their hometown favorites afloat to avoid job losses and to avoid making payments on loan guarantees, he said.

Central government authorities worry, though, that trying to prop up too many companies could doom the entire industry:

“For the leading companies in the sector, if they’re not careful, the whole sector will disappear,” said Chen Huiqing, the deputy director for solar products at the China Chamber of Commerce for Import and Export of Machinery and Electronic Products.

The article also notes that China’s wind energy sector is experiencing similar problems.]


Interviews on CNN and NPR

September 16, 2012

Here are links to two interviews I did recently with major U.S. media outlets:

The first is a 5-minute interview on CNN last Monday about the mounting bad debt problem in China’s banking system and its implications for the country’s slowing economy.  You can watch it by clicking here.

The second is 5-minute radio discussion on NPR about the economic transition China faces and whether its “landing” will be hard or soft.  You can listen by clicking here.

WSJ: China’s Solyndra Economy

September 13, 2012

I had a new op-ed in yesterday’s Wall Street Journal, which you can read below or view the original here.  At the very last moment, one paragraph was cut from the final version, presumably due to space limitations.  I have restored it here in italics, because the crisis facing Suntech (the world’s largest solar panel maker) make it clearer that what we’re seeing here is an industry-wide problem and not something restricted to a single troubled competitor.

China’s Solyndra Economy

Government subsidies to green energy and high-speed rail have led to mounting losses and costly bailouts. This is not a road the U.S. should travel.


On Aug. 3, the owner of Chengxing Solar Company leapt from the sixth floor of his office building in Jinhua, China. Li Fei killed himself after his company was unable to repay a $3 million bank loan it had guaranteed for another Chinese solar company that defaulted. One local financial newspaper called Li’s suicide “a sign of the imminent collapse facing the Chinese photovoltaic industry” due to overcapacity and mounting debts.

President Barack Obama has held up China’s investments in green energy and high-speed rail as examples of the kind of state-led industrial policy that America should be emulating. The real lesson is precisely the opposite. State subsidies have spawned dozens of Chinese Solyndras that are now on the verge of collapse.

Unveiled in 2010, Beijing’s 12th Five-Year Plan identified solar and wind power and electric automobiles as “strategic emerging industries” that would receive substantial state support. Investors piled into the favored sectors, confident the government’s backing would guarantee success. Barely two years later, all three industries are in dire straits.

This summer, the NYSE-listed LDK Solar, the world’s second largest polysilicon solar wafer producer, defaulted on $95 million owed to over 20 suppliers. The company lost $589 million in the fourth quarter of 2011 and another $185 million in the first quarter of 2012, and has shed nearly 10,000 jobs. The government in LDK’s home province of Jiangxi scrambled to pledge $315 million in public bailout funds, terrified that any further defaults could pull down hundreds of local companies.

Meanwhile another NYSE-listed Chinese solar company, Suntech, revealed on July 30 that the German government bonds an affiliate pledged as security for a $689 million bank loan it guaranteed never existed. Suntech, the world’s largest producer of solar panels, claims it was the victim of fraud. Considering Suntech already owed $3.6 billion (for a debt-asset ratio of 82%), and lost $149 million in the fourth quarter of 2011 and $133 million in the first quarter of 2012, many analysts believe the company could go bankrupt without a sizable government bailout.

Chinese solar companies blame many of their woes on the antidumping tariffs recently imposed by the U.S. and Europe. The real problem, however, is rampant overinvestment driven largely by subsidies. Since 2010, the price of polysilicon wafers used to make solar cells has dropped 73%, according to Maxim Group, while the price of solar cells has fallen 68% and the price of solar modules 57%. At these prices, even low-cost Chinese producers are finding it impossible to break even.

Wind power is seeing similar overcapacity. China’s top wind turbine manufacturers, Goldwind and Sinovel, saw their earnings plummet by 83% and 96% respectively in the first half of 2012, year-on-year. Domestic wind farm operators Huaneng and Datang saw profits plunge 63% and 76%, respectively, due to low capacity utilization. China’s national electricity regulator, SERC, reported that 53% of the wind power generated in Inner Mongolia province in the first half of this year was wasted. One analyst told China Securities Journal that “40-50% of wind power projects are left idle,” with many not even connected to the grid.

A few years ago, Shenzhen-based BYD (short for “Build Your Dreams”) was a media darling that brought in Warren Buffett as an investor. It was going to make China the dominant player in electric automobiles. Despite gorging on green energy subsidies, BYD sold barely 8,000 hybrids and 400 fully electric cars last year, while hemorrhaging cash on an ill-fated solar venture. Company profits for the first half of 2012 plunged 94% year-on-year.

China’s high-speed rail ambitions put the Ministry of Railways so deeply in debt that by the end of last year it was forced to halt all construction and ask Beijing for a $126 billion bailout. Central authorities agreed to give it $31.5 billion to pay its state-owned suppliers and avoid an outright default, and had to issue a blanket guarantee on its bonds to help it raise more. While a handful of high-traffic lines, such as the Shanghai-Beijing route, have some prospect of breaking even, Prof. Zhao Jian of Beijing Jiaotong University compared the rest of the network to “a 160-story luxury hotel where only 11 stories are used and the occupancy rate of those floors is below 50%.”

China’s Railway Ministry racked up $1.4 billion in losses for the first six months of this year, and an internal audit has uncovered dangerous defects due to lax construction on 12 new lines, which will have to be repaired at the cost of billions more. Minister Liu Zhijun, the architect of China’s high-speed rail system, was fired in February 2011 and will soon be prosecuted on corruption charges that reportedly include embezzling some $120 million. One of his lieutenants, the deputy chief engineer, is alleged to have funneled $2.8 billion into an offshore bank account.

Many in Washington have developed a serious case of China-envy, seeing it as an exemplar of how to run an economy. In fact, Beijing’s mandarins are no better at picking winners, and just as prone to blow money on boondoggles, as their Beltway counterparts.

In his State of the Union address earlier this year, President Obama declared, “I will not cede the wind or solar or battery industry to China . . . because we refuse to make the same commitment here.” Given what’s really happening in China, he may want to think again.

Speaking Events in Shanghai and Beijing

August 25, 2012

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 or  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

August 19, 2012

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

August 4, 2012

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

July 31, 2012

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