China and bust?

From Ed

…the private sector in the west is in a higher savings and slower growth mode. The only way that the government can net save at the same time is via an increase in net exports to the emerging economies. The FT’s Geoff Dyer is right when he writes the “G20 looks to Beijing to drive global growth.” For the global economy, it’s China or bust.

So China had better be growing healthily, hadn’t it?

There’s been a steady drumroll of comment about the burgeoning real-estate bubble in China for a year or ten now, from many quarters. Mike Shedlock is a handy source for the doomier end of the recent commentary spectrum; anyone with ideas about trustworthy specialist commentators is invited to put them up. Here, anyway, is Shedlock at the end of last year, rounding up his prior commentaries and showing us video of huge, completely empty property developments in China (some of these have been empty for five years, it seems), accounts of massive speculation in metals by Chinese private investors and balance sheet manipulations by Chinese banks. His summary:

China is in a Scylla or Charybdis scenario. If China continues to inflate it will overheat. If it doesn’t, unemployment and unrest will soar, and the economy will implode. Either way, there is no winning solution.

Rebuttals of this gloomy position by semi-insiders don’t look terribly convincing. From the FT in March, in an article by one of JPM’s local China specialists, Jing Ulrich, optimistically entitled “Debunking the myth of a China collapse”:

The worst-case fears concerning the property market are based on a layer of truth and we have previously highlighted the untenable nature of price increases in some big cities, as well as the possibility that last year’s boom was partly fuelled by misdirected bank loans. However, there are crucial differences between China’s property markets and those of the US or Dubai…

The combination of excessive leverage and mortgage securitisation were at the epicentre of the US sub-prime crisis. Both these factors are absent in the Chinese context.

…The crux of the problem with the Chinese real estate sector is that property is seen by the country’s investing class as a store of value, within an economy that offers its citizens limited investment options. I share many of the concerns about flawed incentives and overheating in the property market – but even if prices were to correct, this would not trigger the devastation that might arise in an over-leveraged economy.

Well, maybe securitisation is absent. But it’s perfectly possible to have a first rate banking crash without securitisation anyway, as the history of banking crashes from the dawn of time to July 2007 attests. You just need leverage; of the kind you can build up by the balance sheet manipulation that Mish describes, for instance.

Even the real insiders don’t necessarily seem that convinced that all is well in China. Yves commented on another sighting, FT in June, from the perspective of monetary policy; the interviewee, Li Daokui, is a member of Chinese central bank’s monetary policy committee. The glimpse of official concern about the state of the housing market is telling (FT via Yves):

“The housing market problem in China is actually much, much more fundamental, much bigger than the housing market problem in the US and UK before your financial crisis,” he said in an interview. “It is more than [just] a bubble problem.”…

Mr Li said the high cost of housing could hamper future growth by slowing urbanisation. Rising prices were also a potential political flashpoint, especially among younger people who felt locked out of the property market.

“When prices go up, many people, especially young people, become very anxious,” he said. “It is a social problem.”

In spite of the sharp slowdown in property sales and the troubles in Europe, he said economic activity was still too strong. “China is running the risk or is on the verge of overheating,” he said. Although he added: “I would say the situation is not out of control.”

Oh good. Now let’s see: you have Chinese who buy property as a store of value (according to Jung Ulrich; that’s what all those empty houses are: they’re owned, but not occupied), and other Chinese who can’t get into the market because of the price rises (according Li Daokui); those price rises are partly induced by the activities of the first group of Chinese, and partly inflationary (inflation which increases interest in value stores, feeding demand from the first group of Chinese again). All this despite breakneck building by Chinese developers and breakneck lending by Chinese banks. That really doesn’t sound like a situation that gets into balance without a smash-up of some kind.

Some more local colour from Mish suggests that the whole bubble may now at last be on the brink: some of it seems to be funded by Ponzis, and the retail investors have had enough. Some sort of confirmation of a turning point comes from this recent report that developers are now cutting prices. If Ponzis are a significant factor in Chinese RE finance, that turn in prices will expose them very quickly indeed, en masse. And that will make some small investors very angry, of course, as well as broke.

And a 15% price drop will expose any extreme leverage that exists, too, tucked away behind respectable looking LTVs.

On the more official end of the financing spectrum, we have the recentish surge in the bond yields of Chinese development companies; and from the FT, this week:

China’s banks are facing serious default risks on more than one-fifth of the Rmb7,700bn ($1,135bn) they have lent to local governments across the country, according to senior Chinese officials.

In a preliminary self-assessment carried out at the request of the country’s regulator, China’s commercial banks have identified about Rmb1,550bn in questionable loans to local government financing vehicles – which are mostly used to fund regional infrastructure projects.

This isn’t too bad by itself, if you believe S&P’s local analyst, as quoted in the FT again:

Rating agency Standard & Poor’s estimates that if 30 per cent of loans to local government vehicles become irrecoverable, it would add 4-6 percentage points to overall non-performing loan ratios at the banks. “The pain will be uneven across the sector; the major banks should be able to keep the impact to a manageable level because of their stronger credit risk controls but smaller institutions could struggle due to their proportionally heavier exposure to local government vehicles and lower profitability,” said Liao Qiang, an analyst with S&P.

But what about property, commercial or residential loans, rather than infrastructure? I’d like to hear from Chinese officials about those. Here’s a credit checking process to admire, plus a comparison that will be recognisable to Floridans, Californians or Brits, quoted in the Washington Post:

Wang Zhongwei, a 35-year-old stock market analyst who owns the apartment where he lives, bought two apartments in 2004 for investment purposes. He borrowed from family and friends to meet mortgage payments twice as big as his take-home pay. But in the middle of last year, he sold the apartments for twice what he paid and made $145,000, a fortune here.

“It’s much easier than working every day to make money,” Wang said. “I work very hard and compete for my so-called career every day, but I don’t make that much money from work.” In November, he bought two more apartments.

What about the balance sheet manipulation by banks, now spotted by the FT, too?

Headline growth in China slowed to 10.3 per cent in the second quarter from 11.9 per cent in the first quarter, and loans to property developers dropped 62 per cent from the first quarter to Rmb121.6bn in the second quarter, according to figures from the central bank.

But analysts say the apparent success of the clampdown on lending disguises a worrying new trend that involves banks co-operating with lightly regulated trust companies to keep loans off their books.

The regulator ordered a stop to this type of lending at the start of the month.

China’s banking system had a non-performing loan ratio of more than 50 per cent a decade ago. Today the country is a breeding ground for the world’s largest and most profitable banks with an average NPL ratio of just 1.3 per cent as of the end of last month.

That sounds like a banking system that is very unlikely to have remotely enough capital in it, with a crash to come sooner, rather than later (six months? 18? Come on, who knows?). And that won’t help growth much, within China, or outside it.

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  1. purple

    The main issue of the China-growth story is that China has no intention of letting Western MNC’s dominate its domestic landscape. In the short-term companies like GE and Siemens will be accommodated – just long enough for the technology to be stolen. Then they will be shut out or dramatically limited. China is moving up the value chain quickly, and for people who don’t believe it, recall what a joke Japanese cars were in the mid-1970’s. 10 years later they were wiping the floor.

    Whether China’s real estate market crashes or not really doesn’t affect the long-term arc of the story. Asian companies will eventually, or maybe even shortly, learn to do things every bit as well as the most advanced companies in the West. They will be geographically and culturally advantaged in reaping the rewards of the region where about 50% of the world’ population lives.I’m not sure where that lives Western MNC’s but to openly advocate militarism and destabilization to maintain dominance in non-domestic markets. Exxon for one isn’t too happy about being told to stand down by China in the South China Sea, an area of recent political ‘interest’.

  2. Hubert

    Thanks Richard,
    great summary.
    Makes me feel uneasy not having a clue about how long this Ponzi can keep going. And so much hangs on it. Greatly confused still, but on a higher level….

    1. Richard Smith Post author

      Either (obviously) a sudden surge in RE sales at lower prices, or (less obviously) a sudden cessation of RE sales altogether would be a dead giveaway that a crash is starting.

      For my part I’ve not been watching the market anything like closely enough to be able to distinguish routine blips from the genuine cliff fall.

      But bubbles typically don’t long survive a change in investor expectations of appreciating prices (hinted at above), or a tightening of funding (which we definitely have). So China RE might be at the brink right now.

      There even seems to be some sort of weird shadow funding system (via Ponzis, or relatives using up their savings just to fund the loan interest long enough for a profitable flip). I didn’t manage to find out fast whether those stories are outliers or whether everyone’s at it, but the anecdotes are out there, as you see above.

      The blowback to the economy comes not just via the banks; there may be a more direct link. I *think* businesses habitually use their commercial RE as security for working capital and expansion – will try to drag up some plausible data on this if I can find it.

      So the Chinese government is right on the hook and the political stakes are huge. Maybe they will try some intervention, for a while. It looks horrible to me.

  3. Bruce

    Per MMT, can’t the Chinese just recapitalize the banks over and over with interest-free perpetual debt? Are there any consequences of doing that? I think MMT says no, but I could be wrong.

  4. Mandarin

    Unlike the USA, UK, Japan or other dubious models of social equity, the Chinese investor is not at liberty to send his capital overseas or initiate an investment strike. Conversely when rates of return on domestic investment in China fall, their bankers do not have the God-given right to stuff their excess capital under the mattress.

    In the Chinese context the entire notion of economic crisis eludes economic analysis as such. Chinese Crisisnomics morphs into the realm of political speculation and Sinology, the relevant questions being “What’s the tolerance of the population for a given level of unemployment/inflation” or even better, “How much of the average family’s life savings will be blown if the housing bubble pops?”

    In the assessment and response to these questions, I have a lot more faith in the Chinese government’s seat-of-the pants management than I do in Mish Shedlock’s salivations over the demise of Communism.

  5. Nate

    Great summary – In my view the economic philosophy in China has not kept up with its growth. A centrally planned economy works great for mobilization of a country’s resources for wars, investment spending, and mass education, but not for domestic-demand based growth, which history has shown is the only sustainable long-term method.

    For the past 30 years, China has mandated 8% annual growth to its local government officials and when organic growth + exports fell short of that local governments simply borrowed to invest in infrastructure projects.

    These activities exploded during the global financial crisis because of the fall-off in exports. Local governments have been borrowing vast amounts of cash through off balance sheet special purpose vehicles (called LGFVs – “local government financing vehicles”) to invest in pet projects building ghost towns, empty malls, village skyscrapers, indoor ski slopes, unneeded factories, and expensive unused transportation systems. These loans are obviously not going to perform to expectations because there is no domestic demand to service them. Regulators fear a banking crisis so they are cracking down on banks with stricter capital requirements. The banks in turn know that the assets are probably junk, so they package the loans into wealth management products and sell them to investors to get them off of their books.

    If the central government cuts off this ponzi-like wealth recycling system then they will cut off the engine of China’s growth, since exports are unlikely to recover rapidly (US consumer deleveraging and Euro Zone in a sovereign debt crisis) and domestic demand is a long transition away from taking over. That means even more loans will go bust since China’s economy is so heavily geared toward exports and investment spending. This could be a serious systemic issue.

    I’ve written a fair amount on this topic on my blog in the “China” section:

  6. eightnine2718281828mu5

    Now let’s see: you have Chinese who buy property as a store of value (according to Jung Ulrich; that’s what all those empty houses are: they’re owned, but not occupied), and other Chinese who can’t get into the market because of the price rises (according Li Daokui); those price rises are partly induced by the activities of the first group of Chinese

    One of the side effects of income inequality; the wealthy have the wherewithal to speculate on housing which drives prices above what labor can afford or justify in terms of its underlying utility.

    And of course this has an impact on labor flexibility/mobility.

  7. Conor

    Chinese government attempts at trying to “cool down” its own economy right now seems like trying to turn off the Space Shuttle right after the thrusters have activated (a possibly not very good spur of the moment analogy) – it should be interesting to see if they can. After reading a couple of these blog posts regarding the current Chinese real estate market, surely it’s enough to chill the heart; and what affect this will have on the rest of the world’s economy, especially U.S.A.’s should also be really, really interesting.

    This certainly doesn’t seem to be on anybody’s radar. Have any of us seen much coverage of this in the MSM? I haven’t. Slightly analogous to the early days of the subprime mortgage meltdown when everyone thought Nouriel Roubini, Elisabeth Warren, et al were a bunch of doomy gloomy crazy people.

    THE NEXT DOMINO SHALL FALL…. *Moo-hoo-hoo-ha-ha-haaa-HAH!!!*

  8. lark

    Whatever I read about China and pay, emphasizes low pay. With all this low pay, I have been wondering how the Chinese manage to buy these expensive apartments (which they often keep empty). Car sales are soaring, etc. Now I think many Chinese are flipping, as in real estate. They can only really make money through leverage. Wages are insufficient.

    In that respect the Chinese are like Americans.

  9. GregG

    Also another side to China that doesn’t get as much press as it should is how controlled all the statistics are since so many come from hard-to-verify gov’t sources. So let’s say that everything from population numbers to employment to banking reserves, savings, energy usage, food safety, etc. etc., have a whopping fudge factor… I think the whole China things is very, very tippy.

  10. Noel Rado

    Fantastic post. I found it to be exceedingly instructive and gave me the information I was on the lookout for. Will come back – thanks for the recommendations.

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