A Real Estate Trip in China

I have wanted to discuss more on the real estate sector for a while even though I have to confess I am far from being an expert on the topic, and this in a market which even the experts find terribly confusing. What the real estate market is really telling us about underlying monetary conditions and the health of the economy is one of the most debated topics in China, and one on which there is the widest range of views – itself an indication of future expected volatility.

Fortunately one of the readers of this blog and a fund manger, Stephan van der Mersch, wrote me the following very interesting email (slightly edited) last week. It is not intended to be an overall picture of the Chinese real estate market but is, rather, notes generated during and after a visit through certain parts of China to gauge the investment climate. At the end of his notes he appended a few questions for me.

I don’t know how much you travel around China. Tom 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, Tom and I 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. We have a few questions we’d love to hear/read you chew on (all the hard questions of course):

1. What will determine whether China experiences a steady slowdown (possibly sub-par growth rates over next decade) vs. a crash of the economy. Is controlling credit and SOEs enough to prevent a collapse of the typically most volatile component of the GDP – fixed asset investment? If they can prevent a crash, then maybe it’s all worth it? (the premise for shorting rests on the place crashing)

2. How high can the debt go and for how long can they keep on rolling over dud loans, dud payables, defunct real estate projects, before it becomes truly unsustainable? Do we have any precedents to go by, what would be the clues to look for that it’s cracking? And which are the pieces of the chain that are most fragile and most difficult to control by the government? (inventory, evidence of flight capital)

3. Could the Chinese create a mess of monetary and fiscal policy and create a big inflationary push or are they paranoid enough inflation to resist it? Given the poor Chinese reporting how should we track these trends?

4. What’s the chance that the Chinese want to create a full blown economic bubble that they wish to ride on for like 5-10 years in hope of then miraculously diffusing it because the early excess would be taken care of by demand created by later bubble growth? All in their light “justified” by China still having a low base for most things

Yes, these are all very tough questions and I am not sure I can answer them, but here goes anyway.

What will determine whether China experiences a steady slowdown (possibly sub-par growth rates over next decade) vs. a crash of the economy. Is controlling credit and SOEs enough to prevent a collapse of the typically most volatile component of the GDP – fixed asset investment? If they can prevent a crash, then maybe it’s all worth it (the premise for shorting rests on the place crashing)?

In my opinion crashes are results almost exclusively of balance sheet instability, and there are broadly speaking two things that determine the stability of balance sheets, and to be technical these are really the same thing but we often think of them differently: the amount of debt and, more importantly, the structure of the debt.

It is easy to see why the amount of debt is an indicator of balance sheet instability, but we often ignore how much more powerful the structure of debt is. What I call “correlated” debt in my book (The Volatility Machine) is debt whose financing and refinancing costs move in the opposite direction of asset values (and by the way I consider NPLs as just a kind of financing cost). When the underlying economic conditions are good and asset values are rising, the financing cost is also rising, thereby eroding part of the benefits, but when asset values are falling so are financing costs> This provides some stability to the balance sheet.

“Inverted” debt does the opposite. It performs brilliantly when underlying conditions in the asset side of the balance sheet are strong, but abysmally when things go badly. The more inverted a capital structure is, the more intoxicating its performance is when times are good, but also the more prone it is to collapse. A very simple kind of inverted financing was, for example, the way prior to the 1997 crisis South Korean companies borrowed heavily in dollars to fund domestic activity. When the country was growing rapidly and domestic asset prices rising, the won strengthened in real terms so that the cost of financing actually declined. CEOs were able to see both sides of the balance sheet improve at the same time and their equity values soared.

But when the domestic economy collapsed, asset values and operating profits declined with it. Unfortunately because this led to capital outflows and downward pressure on the won, the financing cost of all that dollar debt soared, and CEOs got hit with collapsing asset values and soaring debt at exactly the same time, with the concomitant collapse in equity.

An important part of unstable debt structures is the possibility of self-reinforcing behavior and mechanisms that exacerbate volatility (I guess I can never talk about debt without revealing my membership in the Hyman Minsky cabal). There were at least two very obvious mechanisms in the South Korean case. First, declining equity ratios increase the probability of default, which forced asset sales and declining enterprise value. Both – the former mainly when everyone is doing it – are self-reinforcing. Second, when there is downward pressure on the won, companies who have large dollar liabilities must hedge by selling won and buying dollars, which puts more downward pressure on the won, forcing less leveraged companies to hedge, and so on.

I talk a lot about all of this elsewhere in this blog and in my book, so pardon the race through the topic, but this is all just a way of saying that the amount and structure of liabilities, as well as mechanisms for slowing or speeding up the liquidation process, will determine whether or not there is a crash or simply a long, slow landing. I think because of the tendency of NPLs to vary intensely with the speed of lending and, more importantly, with underlying economic conditions, they add a lot of inversion to the balance sheet. Many analysts will estimate an NPL ratio and input that into their projections, but I think this can be misleading. For example, we might think that on average 10% of the loans will go bad, so we will do our calculations of the total cost and use that cost however we see fit.

But that doesn’t really help us. If an average expectation of 10% loss is correct, for example, we can be certain that we will never actually see a 10% loss. What we will see instead is that if all goes well and the economy grows quickly, NPLs might actually hit only 3%, but if the economy goes badly NPLs will surge to 17%. In other words the rise in NPLs will be exactly what we don’t want – it will be minimal when we can afford it anyway and huge when we can’t. By the way I have several times mentioned the 2007 IADB book Living With Debt, which points out that nearly every recent Latin American debt crisis was “caused” by of a sudden surge in contingent liabilities – the two most important sources being external debt, whose value surges in a currency crisis, and non-performing loans, whose value surges in an economic slowdown or after collapsing asset prices.

So to get back to the original question, will we see a crash, or a steady slowdown? My guess is that there is significant and rising instability in the banking system’s liabilities, and far more government debt than we think, all of which should indicate a rising probability of a crash, but I think the ability of the government to control both the liquidity of liabilities (i.e. to slow them down, or to forcibly convert short-term obligations into longer-term ones) and the process of asset liquidation (at least within the formal banking system – I don’t know about the informal), suggests that if a serious problem emerges we will probably see more of a “Japanese-style” contraction: a long, drawn-out affair as bankrupt entities are merged into healthier ones, liquidations are stopped and selling pressure is taken off the market by providing cheap and easy financing, and so on.

This is a long way of saying what I have often argued – that what we should expect in China is not a financial collapse but rather a long period – maybe even a decade – of much slower growth rates than we have become used to. There are many reasons to expect a short, brutal collapse followed eventually by a healthy rebound, but government control of the banking system eliminates a lot of the inversion that in another country would force a rapid adjustment. This is not a note of optimism, by the way. As the case of Japan might suggest, the long, slow adjustment may be socially and politically more acceptable but it may also be economically more costly.

The second question was:

How high can the debt go and for how long can they keep on rolling over dud loans, dud payables, defunct real estate projects, before it becomes truly unsustainable? Do we have any precedents to go by, what would be the clues to look for that it’s cracking? And which are the pieces of the chain that are most fragile and most difficult to control by the government? (inventory, evidence of flight capital)

Debt levels can get quite high – look at Japan – if they are funded by fixed-rate, long-term, local currency-denominated bonds. Remember that in Japan, by controlling deposit rates and most other form of interest rates, the government was able to force most of the financing burden onto households. I think the Chinese government can do the same thing too, although massive deposit outflows in the mid 1990s inflation period and in the post-1998 period, and even many cases of bank runs, suggest that there are limits to that policy. The real danger is that by forcing the cost of cleaning up the banking system onto households, the government will implicitly constrain consumption growth, which seems to have happened in Japan too.

I would say that rising inventory levels and flight capital, as Stephan points out, are key indicators to watch closely. The third question:

Could the Chinese create a mess of monetary and fiscal policy and create a big inflationary push or are they paranoid enough inflation to resist it? Given the poor Chinese reporting how should we track these trends?

I think policymakers are more worried about inflation than they are about rising NPLs. I also think there may be structural impediments to creating inflation, although I need to read up a lot more about Japanese policy in the late 1980s and 1990s to get more than just an intuitive feel. The fourth question:

What’s the chance that the Chinese want to create a full blown economic bubble that they wish to ride on for like 5-10 years in hope of then miraculously diffusing it because the early excess would be taken care of by demand created by later bubble growth? All in their light “justified” by China still having a low base for most things.

I am not sure how that would work. If the bubble is inflated by pouring resources into production capacity, the problem becomes how to absorb that production. Until now the answer to that question was pretty easy – Chinese consumption was rising quickly and the US absorbed the huge increase in excess production generated by the Chinese development model. I am pretty sure that the US won’t be able to play that role any more, and I am also pretty sure that no other foreign country can step it to replace the US.

Finally, for reasons I have discussed often enough, I am also skeptical that Chinese consumption growth will rise sufficiently quickly to fill the gap. The consumption rate will certainly rise in China, and the savings rate decline, but it can easily do so with a slowdown in the rate of consumption growth and a much faster slowdown in the rate of GDP growth. Frankly this is the outcome I am expecting.

Since this posting was supposed to be about real estate, I want to quote from a subsequent email also sent to me by Stephan with additional notes from some meetings they had. It is very interesting reading the notes of seasoned real estate investors. I have done some very light editing but kept the flavor of the comments unchanged.

» “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.

I thought the last two points were especially interesting points to ponder.

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