Reasons to fear a market correction in China
I haven’t been writing much about China as of late, so I intend to do so in this post to catch up on some recent developments in China.
There are signs of a real estate bubble in China. Sure, many people might think that fears of a real estate bubble might be overblown given that China’s young workforce has grown older to the point where most of them would be seeking to move out of their parents’ homes to their own. But consider this from Michael Pettis’ blog, a blog focused on financial and economic matters in China, where he discusses an email received from a reader:
I don’t know how much you travel around China. T and I do a fair bit, and most recently we were in Guiyang. I thought I’d seen insane excess in the past – 200 thousand square meter malls completely empty next to apartment complexes with 40 thousand units and 30% occupancy rates, etc. etc. But what we saw over there is rather hard to fathom. It seems the Guiyang city mayor had the same idea as the Shenzhen mayor – to move the old downtown to a piece of undeveloped land.
Of course Guiyang has a quarter the population and probably a quarter the per capita income of Shenzhen. They built sprawling new government buildings about a 20-minute drive north of town. And then the residential high rise projects started going up. From driving around the area, we figured well over 100 20+ storey buildings.
What was most distressing was that the development has been totally uncoordinated – a project with 15 buildings here, in another field two miles away a project with one building, another mile in another direction three buildings, sprawled over what was easily over 30 square kms. of farmland well north of town. Every building we got close enough to see was either incomplete/under construction, or empty. Our tone gradually went from “Haha, another one!” to “Oh my God, another one.” We conservatively guesstimated that we saw US$10bn of NPLs in one afternoon. The only buildings that were occupied were six-storey towers built to accommodate the peasants who had been displaced by the construction.
Back in the city proper, every neighborhood we saw was a convulsing mess of buildings being torn down, new ones being built, and unfinished high rises starting to crumble.
- “Real estate prices are up 70-80% in the last five years. Generally speaking, real estate prices in China are equal to or slightly greater than 2007. Land prices in Beijing and Shanghai are up 10x in the last 5 years. In 2004, I remember whole market sentiment was different. The amount of restrictions was much, much higher – for example completion schedules were controlled. From my impression, the increases in the property sector have been because of loosening of regulations.”
- “The buying sentiment is back to 2007”. X is bullish because the affordability ratio is down from 80% (e.g. requiring 80% of your monthly income to meet mortgage payments) to 50-60%.
- “When the real interest rate (on bank deposits) turned positive, the housing market went downhill. It was directly correlated with the property market.”
- Most of the developers are buying land again, and the price has skyrocketed.
- Gearing ratio for the industry hasn’t come down, but they’ve rolled over short-term loans for long-term loans.
- Q: What else can the government do to promote the sector other than liquidity?” A: Not much. They can introduce more land at a cheaper price.
- The government is outright lying about inventory overhang in major cities. X was laughing about the Beijing government’s claim that it’s only a 2 month inventory overhang in the city. He figured closer to a year from personal observation.
- No evidence of major consolidation in the market at this point. The listed developers haven’t been coming out with many acquisitions. X estimated that 5-10% of the small-time developers in Guangdong province can’t get their projects done.
- A freaky deduction of my own: Even at the darkest hour of the crunch, the real estate developers decided it was easier to go renegotiate loans with the banks than lower their prices! They never had to lower their prices even though they were making gross margins in the range of 30-40%!! That’s not a bailout from the banks, that’s a handout! Then again, such a huge portion of Chinese savings have been put into real estate that if prices came down the government would be worried about the wealth effect decreasing people’s consumption.
- It would be fair to say that a large majority of the residential real estate excess we see is in the outskirts of cities. Anecdotally we’ve observed and heard these projects often get sold even though occupancy rates remain dismal (0-30% dismal). Realistically speaking, lots of these projects will never be occupied. If a meaningful portion of Chinese household savings is in real estate that never will be occupied or won’t transact for the next decade (and then transacts at a potentially lower rate 10 years out given that the building has been rotting for ten years and the construction quality sucks), are those savings really there?
- Just to clarify, we do see plenty of excess inside cities. It’s a bit harder to spot (because it’s hidden by other buildings instead of popping out of a field). And you definitely observe blatant commercial/retail excess in prime locations, and those stocks haven’t recovered.
- Our analyst’s view is that “As long as the government provides the liquidity, it will support the market.” Why do Chinese like real estate so much? My view is there is an unusual cultural affinity for real estate ownership in China. Aside from that however, if your interest rate on your savings account is 2% or less, then real estate can look pretty attractive in comparison. That’s why you end up with so many sold and unoccupied units on the outskirts of cities in China. The “Well, we might as well buy an apartment instead of leaving it in the bank” thought process is probably pretty common in China. So keeping interest rates low enforces the property market in two ways: by making mortgages cheap, and by increasing the incentive for households to move their savings into real estate. Considering how many unoccupied units we see in China, it’s certainly remarkable that the secondary residential property market is as miniscule as it is. This all tells us that Chinese homeowners’ holding power is extraordinarily high. So in shorting Chinese real estate we’re competing against 1) the buyers drying up and 2) Chinese holding power staying strong. That’s kind of an ugly thing to bet against. The fundamentals could stay insane for quite a while longer? What makes the buyers dry up?
- China needs to increase domestic consumption for stable internally driven growth. You can’t increase domestic consumption if you’re buying real estate. So this is yet one other way that this whole liquidity injection is preventing a transition to a consumption-based economy. You really do wonder how long the Chinese will keep up this level of “pump priming”. If they realize how much they’re screwing themselves for the next decade, the central government might just tighten liquidity.
Now I understand how hard it is to identify bubbles in advance, and the market correction of the United States which precipitated a global financial crisis may have made people like myself more jittery than usual. But apart from the above observations, China’s banks, under pressure by the central government to report an 8% GDP growth this year (8 is a lucky number for the Chinese), has vastly over-extended loans, causing a flood of excess liquidity:
The result was an enormous leap in bank lending during the first six months of 2009. New yuan loans totaled CNY7.4 trillion ($1.08 trillion) in the first half of this year, equivalent to half of China’s gross domestic product for the period.
Last month, Gemdale Corp., a Chinese residential developer based in the southern city of Shenzhen, surprised the market by paying 3.05 billion yuan ($446.5 million) for a 210,000-square-meter plot in Shanghai’s Qingpu suburb, more than tripling the opening bid.
A few weeks earlier, Franshion Property (China) Ltd. paid 4.06 billion yuan at a public auction for a 156,000-square-meter site in Beijing’s main business district. The price of 14,500 yuan per square meter, when calculated using the total area that can be developed, was a record on that basis.
And it’s not just the property market which appears to be overheating. The Shanghai stock market main index gained 91% this year. Earlier, I posted an entry on how an econophysics paper predicted a market correction for the Shanghai market would occur between Jul 17th to 27th. As of today, that hasn’t happened. Whilst there was a 5% dip in the Shanghai Composite index near the end of July, the index has since recovered and is still advancing:
The Shanghai measure tumbled 5 percent yesterday amid concern the government will curb inflows into a market that had more than doubled from last year’s low.
Stocks on the Shanghai Composite index have a P/E ratio of 37.1 times or greater at the moment:
Gains on the Shanghai Composite Index have made Chinese stocks the most expensive based on PE multiples since January 2008, according to Bloomberg data. Shares in the index now trade at 37.1 times earnings, triple November’s low.
Recently, it seems that Chinese stocks are starting to moderate in the face of more explicit threats to rein in liquidity by the Chinese central bank. Here’s a graph illustrating the slight downward trend of the past week:
Now that’s for stocks. How about the fundamentals of the economy? Are they solid enough to withstand sudden market corrections? It turns out that the surprising answer may be “I don’t know”. Why so? Because China’s growth figures don’t add up properly. The Financial Times has an article dated Aug 4th with the ominous title China’s growth figures fails to add up :
GDP totalled Rmb15,376bn ($2,251bn) in the first half, according to data released individually by China’s 31 provinces and municipalities, 10 per cent higher than the official first-half GDP figure of Rmb13,986bn published by the National Bureau of Statistics.
All but seven of the regions reported GDP growth rates above the bureau’s first-half figure of 7.1 per cent. At the start of the year, Beijing set 8 per cent as China’s growth target for the year.
Add to this the fact that earlier this year Krugman linked an article from the WSJ about how Chinese power companies stopped publishing data on electricity consumption when people began questioning why reported power consumption declined while industrial output increased. Forbes published a recent report regarding this.
Now what happens when the euphoria finally ends and market corrections take place? Who gets hurt? I’m no economic analyst, but I’ll hazard a reasonable guess that the Chinese consumers and households would not be badly hit. Unlike their American counterparts who were heavily leveraged and indebted, urban Chinese households save about 28% of their disposable income:
… the saving rate of urban households has jumped from 20% to 28% of their disposable income over the past decade …
Contrast this with the typical American household, whom in May 2009 saved about 6.9% of disposable income. Even then, that 6.9% figure is considered a record saving rate in 15 years, spurred by economic uncertainty amidst the recession. In fact, not too long ago in May 2008, American households did virtually zero saving. In other words, most of Chinese household wealth are held in liquid cash deposits, compared to Americans who hold most of their wealth locked up in illiquid real estate property and which is subject to the volatility of housing prices as we saw fell drastically in 2006.
Furthermore, the consumer debt to GDP ratio in China is less than 20%, compared to 97% in the US at present. So it seems Chinese households would be in a much better position to ride out any bust related to the housing and stock markets. If that is so, whom would be the worst hit in such a scenario? Why the investors of course. And that includes the foreign investors.