David Griffith’s Note: I recently published the case for a Chinese ‘soft landing’ in this blog. There are many ‘China Bears’ that are now advocating that the Chinese economy is becoming the classic bubble; while I don’t necessarily agree with this belief, and hope for the sake of the global economy they’re wrong, here’s one excellent argument for the bearish side.
SEEKING ALPHA by: Williams Equity Analysis December 19, 2011
China’s growth curve has gone parabolic in recent years. For the last couple of decades, China has typically averaged 10% GDP growth, and it has maintained that growth even as a multi-trillion dollar economy. Of course, 10% growth in an economy already worth trillions is an astounding achievement, but it can also lead to severe economic tribulations, such as soaring housing and food prices. China has incurred both of these troubles. As a growing middle class emerges, demand for beef has far outstripped supply growth, and beef is typically making record highs every month. Additionally, the usage of real estate as collateral for local government loans, amongst other factors, has led to soaring housing prices.
China has a significant housing bubble on its hands. Growth in the real estate sector is important in all modern economies. Construction of homes and commercial office space is a huge driver for demand in the steel, cement, and construction sectors, and is an important part of demand in the commodities market. Construction requires the use of iron (in steel), copper, and fuel. Moreover, local governments depend wholly on rising land and real estate prices, since almost all of their collateral is in their properties. The famously investment driven Chinese also depend heavily on rising home prices to attain better rates of return than are possible in other markets.
A slowdown in the real estate market has appeared recently; prices in nine major Chinese cities fell 4.9% in April from a year earlier. Real estate prices in major cities had been on an absolute tear for the past several years, as a growing Chinese middle class desires to migrate from the countryside into major cities. A year ago, prices in these cities rose an astounding 21.5%. Now, as demand has significantly weakened, some analysts believe the supply glut in two of China’s largest markets (Dalian and Tianjin) could be as bad as twenty months of housing inventory. Furthermore, China’s official numbers need to be taken with a grain of salt, since the central government can twist the numbers a bit; the government can pressure developers to withhold or add high-value properties, contingent on the kind of statistics it wants to display. Therefore, China’s housing slowdown is potentially being understated.
Ordinary citizens are finding it nearly impossible to buy a reasonably priced home in Chinese cities, which is a classic sign of a housing bubble. When average, financially sound individuals can no longer buy homes, prices have typically deviated far away from their equilibriums. In 2006, it cost $100,000 to buy a decent apartment in Beijing. The average Chinese citizen would have had to save for 32 years based on the average disposable income. Five years later, in 2011, it cost $250,000. Of course, the actual price of housing is irrelevant if incomes are rising as much, if not more than housing prices are growing. Unfortunately for Chinese citizens, income growth came up short, and it now takes more than 57 years of saving to be able to cover the cost of buying said apartment. 57 years of saving is not a normal figure for average citizens in a healthy, economically balanced real estate market. Even the chairman of China Construction Bank, one of China’s largest banks (and who is heavily dependent on strong real estate growth) said, “In some ways, real-estate prices are really crazy.”
Housing prices got to this level mainly because the Chinese government wanted its citizens to save, but it has not offered them viable alternatives to the real estate market in which to invest. As previously mentioned, the stock market has been too volatile for most individual investors, capital markets are considered to be overwhelmingly underdeveloped, and the deposit rates that banks are paying their customers are much too low to provide reasonable rates of return after inflation is factored in. Thus, citizens have had no other practical investment vehicles in which to park their savings. China has, in recent years, attempted to cool the real estate market, most notably by requiring that prospective buyers put 40% down in cash on their purchases. Even more recently, that mandate was bumped up to 60% down. There will, at the very least, be an assuredly long-term trend of deflating construction activity and declining housing prices. This development will lead to lower GDP growth.
Fitch, another one of the “big three” rating agencies, also put out a terrifying note: “the process of bundling the debts into securities continues to grow, which is transferring the credit risk to a broad group of investors.” What this process essentially describes is securitization; any hint of the word should spook those familiar with the 2008 financial crisis. These banks are wrapping up bad loans and selling them to outside investors in return for a sum of cash. Investors can typically bet on different tranches of the security; the tranches with the highest probability have the lowest rate of return for the investor, and as you move into riskier tranches, the rate of return improves (providing that the default limit is not reached). Chinese regulators are considering allowing banks to further securitize more of their assets, in order to reduce liquidity and capital strains (by generating more cash flow). This should come as unwelcomed news, and it appears that the central government is becoming worried about the low-quality loans that are maturing in the short term.
Increased leverage in China is a dangerous development. Worldwide, overwhelming debt levels, particularly in developed economies, have been a major economic concern recently; China is typically (and mistakenly) not included in these discussions relating to over-leveraged economies. The ability of the Chinese economy to expand right on through the global recession at a torrid pace was baffling. The Chinese Gross Domestic Product grew at 9.6% in 2008, 9.2% in 2009, and 10.3% in 2010. This expansion, compared with the figures in the European Union and the United States, whose economies saw negligible growth in 2008, contraction in 2009, and about 2% growth in 2010, shows a stark contrast. The obvious question, of course, is how it is possible that China grew an incredible 9.2% in 2009, while two of its biggest customers were plummeting into their worst recessions in decades. The answer lies within massive, hidden government expenditures.
Chinese exports make up 30% of the nation’s GDP, so any decline in total annual exports should result in a subsequent decline in GDP growth, everything else equal. In 2009, China’s global exports fell 16% from 2008, yet its GDP mustered 9.2% growth. This kind of growth in a multi-trillion dollar economy is difficult enough, without the added hurdle of severe demand contraction in overseas markets. In order to pick up the slack, consumer spending (domestic consumption) had to have either surged, or the government must have had to sink hundreds of billions, or even trillions into the Chinese economy to achieve 9.2% growth. Total household consumption is typically used to measure domestic consumption. Chinese household consumption checked in at 35% of GDP in 2008 and 35.1% of GDP in 2009. This negligible growth is clearly not enough to make up for a $230 billion decline in exports; the only driver of growth left is government spending. Not surprisingly, the World Bank calculated that while fixed-asset investments (the definitive measure of social capital investments and government real estate projects) were only responsible for 4.6% of China’s GDP growth in 2008, they were responsible for 8.8% of GDP growth in 2009; this was good for a 91% year-over-year increase. This investment is now equal to 70% of China’s GDP. To put this figure in perspective, Japan’s fixed-asset investment was equivalent to approximately 35% in the 1980s (during its housing boom), and the United States’ measurement has typically hung around 20% for the last couple of decades.
Certainly, China needs to allocate significant capital toward infrastructure; China has a massive population, a furiously growing middle class, and a great deal of migration from rural areas into major cities. The issue, however, is that much of this investment is highly leveraged (little cash is put down as payment, while the rest is financed through bank loans), and a large proportion of these projects exist simply to sustain headline growth over 9%, despite deteriorating fundamentals. Because these projects are so leveraged, merely servicing the debt becomes a huge intermediate-term cost. Beijing’s public finance system is set up so that local governments are responsible for almost all social services, which include social capital and real estate investments, even though the central government collects 60% of all national taxes. Because of this, local governments have almost no equity to finance projects, even while Beijing is mandating increased investment to sustain rapid headline growth, as written in the 2008 national stimulus bill. Worse still, local governments aren’t even allowed to sell bonds to institutional or private investors to help pay for the projects; a typical solution is to create state-run corporations to whom private banks will then lend money to, thereby serving as the intermediary.
To make the system even risker and more confusing, the collateral that the local governments and their subsidiaries often use to attain the bank loans is lofty, and likely overvalued land prices. Finally, in confusing and illogical fashion, private banks aren’t even allowed to collect on bad loans, or any loan for that matter. Essentially, money lent to state enterprises is free. Of course, private banks have trillions in consumer deposit monies, so a growth in asset toxicity, or bad loans, would require huge recapitalizations from the Chinese federal government, or a financial crisis could ensue.
Furthermore, Beijing’s tight controls have resulted in a structure in which bank loans are the only way to finance public projects. Since local governments collect almost no tax revenue (the central government collects 60% of all taxes), they can’t use cash to fund capital ventures. Also, as previously discussed, since local governments can’t issue bonds, they must go to private banks to get the necessary principal; their only collateral for the loans is state-owned real estate. This has inexorably led to unquantifiable risk for banks, local governments, and the central government (since Beijing will have to bail-out involved parties if and when the loans go rotten). Land-grabs have become common in China (government authorities seizing private property in order to generate revenue), a sure sign of deteriorating conditions.
Moreover, Chinese officials have a destructive propensity for attempting to distort underlying demand by pumping up spending, and then hiding it in state-run investment corporations. To see figures that show severe exports contraction and stagnant domestic consumption, in conjunction with 9.2% GDP growth in 2009 screams falsification and distortion to me. I also believe that China’s tendency to re-stimulate its economy every time international demand weakens is a horrible way to try and achieve sustainable long-term growth.
Given these factors, it appears certain that most investors have yet to grasp a firm understanding of both how secretive and manipulative the Chinese Government is, and how much debt is hidden in the system. Additionally, a horrific financial structure will be a major factor in China’s eventual crash landing.
This shouldn’t be surprising to anyone. The idea that a few government officials can decide how an economy should function, and consequently set countless controls on markets is remarkably ignorant. Perhaps the most important thing to note is that the Chinese governemnt is desperate to keep GDP growing at a pace above at least 7% for the next several years, since China requires astonishing expansion to mitigate the effects of a rapid migration into cities. The political pressures alone will almost certainly lead to poor decision making (over-aggressive stimulus), and an eventual uprising from the Chinese people. There is simply no way that a wealthier, more educated China will remain quiet (they’ve already begun protesting) about a suppressive system.
While sheltered from discussions involving the failed Keynesian practices of incredibly over-leveraged developed economies, China is indeed the younger brother of countries like the U.S. and the European Union.
What Should Investors be Doing?
Investors need to understand that China’s days as “the driver of World growth” are numbered. No, that doesn’t mean China will fall off a cliff tomorrow, but it’s coming. All it takes is one serious catalyst; it could be Europe, angry Chinese banks, or a continued decline in real estate prices to the point where local governments become insolvent.
At the very least, investors should know how much prospective investments rely on Chinese growth. Companies like Intel (INTC) derive half of their revenue from the region. You can also play the short side of companies who are heavily reliant on Chinese growth, but this complicates the process a bit and may not provide the exposure you’re looking for.
Conclusion
As was the case in the years leading up to the 2008 global economic collapse, the so-called “China bears” are often brushed aside as doom and gloomers. General consensus is that China can engineer a soft-landing, so as to avoid to a rapid decline in economic activity.
Well, for those in that camp, let me ask you something. Why would you ever want to turn off good economic growth? Healthy, natural economic advances should never be thwarted by governments or central banks. The only reason growth would ever need to be turned off artificially, i.e. by a central authority, is because it has bubbled so much that further growth would cause a catastrophe.
Granted, as an economy surges, any free market should begin to inch interest rates higher anyway. The issue in Beijing is that the time to decrease speculative activity was before it saw housing prices reach epic levels, or before it saw food prices begin to cause street riots. At this point, any central action is too late. A horrificially constructed financial system, in conjunction with overly agressive central planning, has set China up for anything but a soft-landing.
