China, Will The Bubble Burst?

This cycle has worked extremely well for the past 50 years, and has kept both countries from economic implosion since the current recession started.  However, when looking beyond the nation’s balance of trade, problems start to arise for China. One major point that needs to be taken into account is the growing real estate bubble in China..  The U.S. is currently experiencing the aftermath of our own real estate bubble, which was exacerbated by the issuance of Mortgage Backed Securities, followed by Credit Default Swaps.  China, which has seen record increases in both commercial and residential real estate construction, as well as prices, in the past several years, is developing its own bubble.  Since China’s securitization market is still in its infancy, significantly fewer consolidated securities have been issued but the Chinese banks hold a large number of construction and mortgage loans as a result of their real estate boom.  But to realize the potential fallout from this bubble, the problem needs to be seen from all sides.

 

China’s Stimulus

In a global context, China escaped the recession relatively unscathed.  Their housing market is still growing (some would say too quickly-which is the primary focus of this article), their national GDP grew by 8.7% in 2009, and the national unemployment rate is currently only at 9.3% (keep in mind this information is all courtesy of the Chinese Government, which is constantly under scrutiny).  The country received major help on November 9, 2008, when the government decided to issue a $586 Billion stimulus package.  Although received with skepticism at the time, it has proven itself to be incredibly efficient, and analysts praise its success, comparing it to the U.S. stimulus.  However, the two are far from comparable.  As of late 2008, China’s GDP was $3.3 Trillion (to put this in perspective, the U.S. had a GDP of $13.8 Trillion at the time). Working through the math, we see that China’s stimulus consisted of spending a whopping 17.8% of their GDP, while America’s was only 5.7%. Economists around the world would expect nothing but positive results from such massive government spending, and the Chinese had accomplished what they set out to do at the time.

DFI

Direct foreign investment (money invested in China by foreign non-institutions) in the last year has declined by 2.6%.  This number had been increasing for the last 4 years, until hitting a wall in 2009.  Fewer individuals- whether out of economic necessity, or speculation- invested less money in the Chinese economy.  Foreign-invested businesses account for roughly 30% of domestic industrial output, 11% of urban employment, and 55% of trade.  After China’s stimulus wears out, it is unclear whether foreign investment will be able to sustain, or at least stabilize the domestic economy.  This is just one small piece of the potential fallout.

Credit Crunch

As Chanos mentioned in his most recent remarks about China, “The Chinese banking system is the problem, it is loaded with bad debt.”  As of 2001, China was struggling with their bad debt- a result of significant numbers of underperforming loans.  The cumulative count of underperforming loans in 2000 was 29%, which the government claimed to have brought down to 7% by 2006, although this is also highly scrutinized by Western analysts- many suggest the number was decreased through the creation of questionable bond offerings, and specially established asset management companies. Regardless, the structure of the Chinese banking system, where the government essentially controls all domestic commercial banks, allows for massive lending on demand (such was the case when the stimulus package was announced).  The Chinese government said “lend”, and the banks followed. This, in turn, raised inflation rates, and allowed for increasing numbers of potentially underperforming loans. In response to these concerns, on January 20 the Chinese government demanded the largest national banks stop lending.  Not simply raise interest rates, but go cold turkey.  This is just the first step toward the Chinese recognizing they have a huge problem on their hands.

The Bubble

Following the massive stimulus, consumption has increased within China since late 2008.  Inflation has increased, and with it have home prices.  In 2009 alone, average home prices increased between 20-60% in various districts, and average incomes have far from caught up.  Following the Shanghai Stock Exchange dip in February of 2007 (during which the Shanghai Index fell by 9% in one day), Chinese investors were weary of investing in stocks.  They saw real estate as tangible alternatives, and thus decided to invest for long term growth –as opposed to risking inflation loss with low yield savings accounts.  This rapid increase in demand for real estate has driven prices to their current levels, even though much of the property (commercial and residential) may not even be occupied.  As the market continues to grow, house price to owner income ratios continue to widen.  They are currently 27:1, meaning that the average price of a house is 27x that of its owner’s income (at the peak of the U.S. boom, this ratio was roughly 6:1).  This means that any potential homeowner will need as large a loan as possible, to bridge the financial gap and buy real estate.  Because of this increasing ratio, the government recently put a policy in place which requires buyers who are purchasing their second homes present a 40% down payment, to insure they have the liquidity required to pay back the loan.  And many new homeowners are purchasing with the hopes of flipping the houses- making improvements, then reselling them for a profit- similar to what happened in the U.S. (Florida, CA, and Las Vegas).

A different problem becomes evident with commercial real estate.  As of year-end 2009, there is 30 billion square feet of commercial real estate currently under construction (“That’s a 5x5 cubicle for every man woman and child in China”-Chanos).  This provides a gross surplus, which has led to the average rental value to be 1/500th of a property’s value (this is referred to as a capitalization rate which in this case is 0.2%, compared to a current rate of 8% in the U.S.)- due to the lack of demand for rent because of a surplus of supply, and a desire to own instead of rent.  So anyone looking to invest in a property for its rental capabilities will only realize a loss.  With that being said, it is hard enough to find a rental tenant (current vacancy rates are 20-30%, although questionably higher).

So the only question that remains is, when will the real estate bubble burst? Although some argue that no bubble actually exists, we see that the current numbers and trends in China (rapidly increasing housing prices, high inflation, a significant increase in underperforming loans, and decreased occupancy) mirror the indicators of the U.S. market crash.  SOHO China, the country’s largest commercial developer is early to recognize the problems.  In a recent interview, the CEO Zhang XIN, in response to being asked how soon the developer was looking to sell their properties, his response was: “As soon as possible”.  If Jim Chanos and Zhang Xin are right, the Chinese economy is in for a massive reversal in the possibly near future, although the government will do everything in its power to stop that from happening.