Macro Letter – No 18 – 29-08-2014
The second arrow of Likonomics and the Chinese property market
- The Chinese rebalancing towards domestic consumption continues
- The shadow banking system is being forced into the light
- But a slowdown in the property sector poses a potential risk to economic reform
The Japanese “Ship of Happiness” containing the seven lucky gods – originally of Chinese and Indian origin
Back in March I anticipated a stimulus package to avert too dramatic a slow-down in the Chinese economic rebalancing, process: –
By a number of conventional measures China has reached the Ponzi stage. Total debt has increased from $9trln in 2008 to $23trln in 2013 (250% of GDP). Private sector debt has increased from 115% of GDP in 2007 to 193% in 2013. Measures of the multiplier effect of debt to GDP suggest it now takes 4 RMB of debt to create 1 RMB of GDP growth. The Chinese authorities attempts to slow bank lending have led to a significant expansion of shadow bank credit. Much of this lending is to sub-prime borrowers.
Recent action by the PBOC suggests they are now targeting the illusive shadow banking sector. Last week they drained 50 bln RMB via reverse-repos…after strong growth in 2013 the PBOC may be inadvertently engineering a “Minsky Moment” – when asset prices collapse – but the Third Plenum focus on market based reform would suggest this is not the intention…
Since then the PBOC has been actively steering the Chinese “Ship of Happiness” towards more tranquil waters by, among other measures, reducing bank capital requirements. Highlights of China’s Monetary Policy in the Second Quarter of 2014 updates the recent timeline:-
On April 22, the PBC decided to cut the reserve requirement ratios for county-level rural commercial banks and county-level rural cooperative banks by 200 and 50 basis points respectively, effective from April 25, 2014.
On June 9, the PBC decided to cut, effective from June 16, 2014, the deposit reserve requirement ratio by 0.5 percentage points for commercial banks (excluding those that were subject to the deposit reserve ratio reduction on April 25, 2014) that have complied with prudential requirements and have reached the required ratios in their lending to the agricultural sector, rural areas, and farmers, and to small and micro enterprises. In addition, the RMB deposit reserve requirement ratio of finance companies, financial leasing companies and auto financial companies was cut by 0.5 percentage points.
This change in reserve requirements has dampened the extreme volatility of short term repo rates. Lower volatility and lower rates fuel risk-taking; bank credit surged in June by RMB1970bln – up 90% on June 2013.
Meanwhile, the government, in pursuit of President Xi’s “Chinese Dream”, embarked on a mini-stimulus package – estimated in the local media at around RMB10tln. This has reignited the stock market but begs the question “How can further stimulus solve the problem of excessive liquidity?” The Business Insider – China Unveils ‘Mini Stimulus’ To Boost Its Slowing Economy described it thus: –
“The State Council is responding to the growth slowdown by announcing tax breaks for SMEs (small and medium enterprises), speeding up investment in railways and rebuilding urban shantytowns,” HSBC economists Qu Hongbin and Sun Junwei said in a report Thursday.
“This time the package is small in scale, but it is more targeted and involves reforms on financing to secure funding,” they said. “So this should help China to smooth growth without exacerbating financial stability risks.”
The tax breaks for “small and micro” companies will be extended until the end of 2016, the State Council said in a statement on the central government website.
It also said 6,600 kilometres (4,100 miles) of new railway lines will come into operation this year, 1,000 kilometres more than in 2013.
The plan will also see the creation of a railway fund that will receive between 200-300 billion yuan ($32-$48 billion) each year, the statement said.
… “These measures show that Premier Li’s government aims to stabilise short-term growth with policies which can enhance efficiency while avoiding future financial troubles,” Bank of America Merrill Lynch economists Lu Ting and Sylvia Sheng said in a report Wednesday.
“We believe these measures are the right policy responses to the ‘fiscal cliff’ as a consequence of the anti-corruption campaign, and we think markets will overall welcome them.”
There have been nine reported cases of Trust Fund defaults in the five months to May which matches the total during the whole of 2013, however, several shadow banks are being merged and acquired by licensed banking institutions. Meanwhile, the China Banking Regulatory Commission (CBRC) is helping to ease the pain of rebalancing for the banking system. Caixin – Banks Start Using New Loan-To-Deposit Ratio on July 1 – looks at the detail: –
Starting July 1 banks in China are using a new method of calculating the loan-to-deposit ratio, a change that the regulator and analysts say will allow for more loans to be extended.
The China Banking Regulatory Commission (CBRC) announced on June 30 the new set of rules for figuring the ratio, which is capped by law at 75 percent, meaning that banks cannot lend out more than three-quarters of the deposits they accept.
A CBRC official has said the regulator will consider adjusting the way the ratio is calculated to allow for more lending. That includes broadening the range of deposits to include “relatively stable” funds.
The new rules differ from the old ones in both loan and deposit calculations, the announcement shows.
Six types of loans can now be excluded from the formula. They include loans linked to the central bank’s re-lending program and proceeds from the sales of a special financial bond that raises money to support small and micro businesses. Loans made using money raised from bonds that investors cannot redeem for at least one year are also excluded under the new rules.
These loans all have clear and stable sources of funding and thus do not need to be matched with general deposits, the regulator said.
Why ease conditions when M2 is growing at 14.7%, M1 at 8.9% and M0 at 5.3% (June 2014)? I believe the easing of conditions is due to official concern that risk in the financial system is substantially understated. This article from the Wall Street Journal – Risky Business in China’s Financial System – highlights some of the issues: –
Is China heading for a financial crisis? Some risk indicators have risen markedly over the past twelve months: Interbank rates are more volatile, with liquidity shortages increasingly common; there have been a few minor bank runs; and the country experienced its first corporate default in recent history earlier this year.
Source: Oxford Economics, Haver Analytics and Wall Street Journal
Moreover, though official figures suggest that just 1% of loans are non-performing, bank balance sheets likely aren’t as healthy as they seem.
Evidence from a range of countries suggests that credit booms – as China experienced from 2009-‘13 – result in substantially higher levels of non-performing loans (NPLs). A more realistic assumption that 10%-20% of total loans might go bad implies total NPLs of RMB6-12 trillion (US$1-1.9 trillion). The higher end of the range would suggest a bad-asset problem comparable in scale to the one that followed the U.S. subprime loan crisis.
The author goes on to discuss the importance of the shadow banking system. Then he asks: –
What might trigger a crisis in China? The drift downward in property prices could accelerate as the economy cools, leaving substantial oversupply. Property and land are often used in China as collateral for loans, so a sharp fall in house prices would damage bank balance sheets; liquidity would dry up; and institutions with high rollover needs might struggle to find funding.
Higher interest rates also would increase debt-service payments, and banks could see their deposit bases erode as corporate deposits shrink. The growing importance of the shadow-banking system would likely exacerbate these effects.
Such a crisis would have major economic implications not only for China but — through financial and trade linkages – for the whole world. The Oxford Economics Global Economic Model estimates that, in such a scenario, Chinese gross domestic product would grow less than 2% in 2015, and world growth would drop as low as 1%.
Of course, that’s a worst-case scenario, and odds of it happening are only about 10%. With China’s overall government debt relatively low and foreign exchange reserves at an all-time high, authorities have the means to intervene on a large scale if necessary.
Still, as long as interest on deposits is capped by the government, Chinese savings will continue to be invested in riskier and higher-yielding products, adding to distortions in the financial system.
That means the risk of a financial crisis will remain until the government introduces reforms to the financial sector, and manages its way out of the credit boom in an organized fashion.
The deleveraging of the credit boom and reform of the financial sector are the second and third arrows of Likonomics – named after the economic policies of Premier Li Keqiang. Even getting to the second arrow will be difficult given a housing bubble which shows signs of bursting.
Housing, the Achilles heel
Recent official data shows house price declines in 55 out of 70 cities in June vs May and 35 out of 70 cities in May vs April. Sales volumes as measured by floor space are down 9.4% in the first seven months of 2014 vs the same period last year.
The FT – Property bubble is ‘major risk to China’ puts the Chinese government’s dilemma in perspective: –
The government itself has an enormous incentive to keep pumping the bubble up, since all land is technically owned by the state and land sales made up 60 per cent of local government’s budgetary revenues last year, according to estimates from JPMorgan.
Since 2008 land prices have increased fivefold, triggering corresponding asset price rises, but even as prices soared and supply mushroomed, demand for housing and office space pretty much kept up – until this year. More than 90 per cent of households already own at least one home and, for those urban households that own apartments, nearly 76 per cent of their assets are in real estate, according to Gan Li, director of the Survey and Research Center for China Household Finance.
At 90% Chinese home ownership is ranked sixth highest in the world (2012 data). It is slightly lower than Singapore but well above the levels in UK (66.7%) and USA (65.2%). Here is a table from Wikipedia . However, it has been estimated by the China Household Finance Survey that empty homes make up more than 20% of the housing stock. Of these, the vast majority are investment properties.
Meanwhile the first arrow of Likonomics – a tempering of monetary stimulus – put in place since the great recession, has been accompanied by a swath of anti-corruption policies. President Xi reaffirmed his commitment to anti-corruption measures in a speech on 29th June on the eve of the 93rd anniversary of the founding of the Chinese Communist Party.
Michael Pettis – The Four Stages of Chinese Growth describes the overall reform process being undertaken by the Xi government. The entire essay is a brilliant insight into the economic development of China since 1978 and looks closely at the “social capital” deficit which, if left unaddressed, might undermine the Chinese economic miracle of the last 30 years :-
The second liberalizing period. What China needs now is another set of liberalizing reforms that cause a surge in social capital such that Chinese individuals and businesses have incentives to change their behavior in ways that generate greater productive activity from the same set of assets. These must include changing the legal structure, predictably enforcing business law, changing the way capital is priced and allocated, and other factors that determined the incentives, so that Chinese are more heavily rewarded for activity that increases productivity and penalized, or at least less heavily rewarded, for rent seeking.
But because this means almost by definition undermining the very policies that allow elite rent capturing (preferential access to cheap credit, most importantly), it was always likely to be strongly resisted until debt levels got high enough to create a sense of urgency. This resistance to reform over the past 7-10 years was the origin of the “vested interests” debate.
Most of the reforms proposed during the Third Plenum and championed by President Xi Jinping and Premier Li Keqiang are liberalizing reforms aimed implicitly and even sometimes very explicitly at increasing social capital. In nearly every case – land reform, hukou reform, environmental repair, interest rate liberalization, governance reform in the process of allocating capital, market pricing and elimination of subsidies, privatization, etc – these reforms effectively transfer wealth from the state and the elites to the household sector and to small and medium enterprises. By doing so, they eliminate frictions that constrain productive behavior, but of course this comes at the cost of elite rent-seeking behavior.
Many of the Third Plenum measures are focussed on a root and branch reform of the property development industry. This post from Investing in Chinese Stocks – RMB 8.7 Trillion in Land Finance At Risk – provides some fascinating insights, into the dangers these reforms pose to the property development industry: –
A strict audit of ￥15 trillion in land sales is going to uncover dirt in many Chinese cities. Already, according to the article below, 9 cities have been found to have violated regulations governing land finance, including Shangluo, Hengyang, Neijiang, Xingtai, Huzhou and Suqian. Recall how land finance works:
Chinese local governments sell land to developers who build homes and commercial centers. The revenue from land sales pays for development of supporting infrastructure, everything from roads and subways to schools and parks. Land sales also finance local government debt which exploded after 2008. In the post-2008 economy, developers rushed to build property amidst a real estate bubble and when the government moved to restrict activity in first- and second-tier cities, developers poured into third- and fourth-tier cities and repeated the model. However, developers have run ahead of many local governments. In areas where there are true ghost cities, support infrastructure such as schools and hospitals have not been built. If the real estate bubble bursts and land sales fall, local governments will need to find another revenue source or they may be unable to finance the infrastructure that generates GDP growth and supports the local real estate market, and they may even face a debt crisis in some of the worst hit areas. This ignores all the potential issues with indebted developers, plus overproduction and bad debts in other sectors of the economy.
84 major Chinese cities have borrowed ￥8.7 trillion, backed by revenue from land sales. If cities have violated regulations or violated the law in their use of land finance, things could quickly come to a head in areas where the governments are borrowing to survive, which is already the case in some cities. The conclusion to the article is a good summary:
“Mortgage financing using state-owned land, borrowing money to promote urban development and stimulating economic growth, this economic growth model is not sustainable, it can very easily bring about hidden volatility in the capital markets and macroeconomic development.” Wang Jianwu told reporters, the key to solving the problem is for the local government to gradually adapt to the “new normal,” get rid of “land hormone” stimulus, while local governments also need to shift from the dominant role of economic development to servicing economic development.
Yet again, the anti-corruption probe lines up with the leaderships vision of economic reform. By squeezing local governments’ ability to borrow through land sales, the shift towards a rebalanced, market-based economy can proceed more quickly.
Concern about the Chinese housing market has even attracted the attention of the Kansas City Fed – China’s slowing housing market and GDP growth – they cover many of the issues already discussed but also look at the longer term impact of demographics: –
Looking further ahead, the real-estate sector will need to adapt to the inevitable decline in demand caused by demographic change. The share of China’s population from 24 to 30 years old, the age group needing to purchase their first home, has declined from 13.4 percent in 2000 to 10.7 percent in 2010. The share of the working age population (15 to 59 year olds) has declined to 68.7 percent in 2013 after peaking at 70.1 percent in 2010, reversing the upward trend of the prior two decades.
…Taking both the short- and long-term factors into account, the real estate sector’s recent slowdown is likely to continue as housing activity stabilizes at a lower growth path. While this adjustment could provide certain long-term benefits, it will generate significant downward pressure on China’s near-term growth.
For a rather more sanguine view of the current situation this policy brief from The Peterson Institute – Is China’s Property Market Heading toward Collapse? Provides a broader historical context, highlighting the fundamental differences between China today and USA in 2008 or Japan during the 1990’s: –
The fears about China’s property market are likely overblown. First, China’s private housing market is young. It did not exist until 1998. Over the last 16 years, the property sector has seen large swings in both prices and levels of investment. Cyclical downturns have resulted from macroeconomic conditions, credit restrictions, and the government’s attempts to curb either the overheating or overcooling of the sector. This cyclicality is a good thing to the extent that investors tend to avoid making one-way bets on either price appreciation or depreciation, and thereby it works to prevent excessive speculation. Largely owing to limited financial innovations, market developments, and punishing taxes, China’s property market is still less leveraged than is typical in more developed economies. Developers have lowered their debt-to-asset ratios since 2009 and Chinese buyers must offer down payments of at least 30 percent before they can apply for mortgages.
Second imposed more than four years ago to discourage property purchases for investment purposes. Indeed, at the time of this writing, some 30 Chinese cities have started to ease these property curb policies, which were designed to prevent excessive speculation. In addition, the government could also liberalize its urban household registration system, or hukou, to allow migrants to purchase houses and thereby encourage them to settle in their cities permanently.
In the medium term, the government can take a number of other steps, such as reintroducing an urban public housing program in large cities, funded by a property tax, to address income inequality and encourage an increase in rental properties. To reduce banking sector risk, the government could encourage banks to issue covered bonds to reduce the risk of maturity mismatch of their mortgage assets. Furthermore, diversifying property developers’ sources for finance through real estate investment trusts, or REITs, would also reduce their reliance on bank financing. China should also improve its data collection to take into account the quality, location, and other important features of property transactions.
More important, demand for urban properties is expected to remain high over the next decade. It is estimated that another 200 million people could join China’s urban areas by 2023. In this sense, China’s property market bears no resemblance to Japan in the early 1990s or the United States in 2008. As long as urbanization continues and appropriate policies are adopted, this property market downturn should prove to be merely cyclical, and a major correction is unlikely to take place.
The authors expand on the positive long-term factors which support the Chinese property market but remain cognisant of the risks of a near-term bursting of the property bubble. Chinese property has risen 64% since 2010, eclipsed only by Hong Kong where prices are up 94%. Rental yields are 2.66%, higher than Singapore at 2.41% but well below Japan at 5.53%. However, some comfort may be drawn from indications of the rise of zero down payment mortgages – if these become widespread the property bust may be deferred.
Private capital flight
This brings me to another issue which affects the global economy. If 76% of the net worth of Chinese city dwellers is tied up in real-estate, how will they diversify their investment risk? Many of the wealthiest Chinese families have already moved a substantial portion of their net worth abroad. This trend is likely to continue unless the government imposes capital controls. What is the likely impact on domestic asset prices?
A recent article from The Diplomat – Chinese Investors Fuel California Housing Bubble gives an interesting perspective to the debate. Chinese nationals only account for 11% of the foreign buyers of real-estate in the San Francisco area but their marginal impact is significant. Chinese demand is being fueled by uncertainty over domestic Chinese housing policy and fears about the stalling of economic growth:-
As Mark McLaughlin, CEO of Pacific Union, a prominent San Francisco real estate firm, told local CBS affiliate KPIX, “it’s added a demographic of buyers who, generally, take a long-term view. They’re not sellers in the next five to seven years.” Chinese buyers are sitting on much of this property as housing in the Bay Area becomes increasingly scarce, causing its value to skyrocket. The Case-Shiller home price index, released in May, saw Bay Area home prices jump by 23 percent compared with a year ago.
That may be just the beginning. On average, San Francisco real estate cycles take about five to seven years to run their course from recovery to collapse. The current surge in prices began in early 2012. Home values have shot up 50 percent since then; during the last surge, the prices peaked at 54 percent. Chinese money is likely to add pressure to the current bubble.
Of course Chinese buyers have been evident in many prime real-estate locations including Manhattan, London and Sydney. Earlier this month Wang Jianlin, China’s richest man, invested $HK12.5 bln in Australian real estate including a AUD900 mln resort on the Gold Coast.
A recent article from the Wall Street Journal – The Great Chinese Exodus looks into the migration trends of wealthy Chinese: –
…A survey by the Shanghai research firm Hurun Report shows that 64% of China’s rich—defined as those with assets of more than $1.6 million—are either emigrating or planning to. …The elite are discovering that they can buy a comfortable lifestyle at surprisingly affordable prices in places such as California and the Australian Gold Coast, while no amount of money can purchase an escape in China from the immense problems afflicting its urban society: pollution, food safety, a broken education system. The new political era of President Xi Jinping, meanwhile, has created as much anxiety as hope.
…Last year, the U.S. issued 6,895 visas to Chinese nationals under the EB-5 program, which allows foreigners to live in America if they invest a minimum of $500,000. South Koreans, the next largest group, got only 364 such visas. Canada this year closed down a similar program that had been swamped by Chinese demand. …Beijing makes a crucial distinction between ethnic Chinese who have acquired foreign nationality and those who remain Chinese citizens. The latter category is officially called huaqiao—sojourners. Together, they are viewed as an immensely valuable asset: the students as ambassadors for China, the scientists, engineers, researchers and others as conduits for technology and industrial know-how from the West to propel China’s economic modernization.
…Still, the sheer volume of China’s outbound travel these days, and its massive economic impact, gives it new leverage. In the global market for high-end real estate, Chinese buying has become a key driver of prices. According to the U.S. National Association of Realtors, Chinese buyers snapped up homes worth $22 billion in the year ending in March. Australia called a parliamentary inquiry to find out whether local households were being priced out of the market by Chinese money. (The conclusion: not yet.)
Without fee-paying Chinese students, many colleges in the postrecession Western world simply wouldn’t be able to pay the bills. Chinese students are by far the largest group of foreign students on U.S. campuses, and their numbers jumped 21% last year from the year before—to 235,597, according to the Institute of International Education. Their numbers are increasing at a similar pace in Australia. In England, there are now almost as many Chinese students as British ones studying full-time for postgraduate master’s degrees. …The Chinese government has no desire to slow the flow of students. Its attitude is simple: Why not have the Americans or Europeans train our brightest minds if they want to? President Xi’s own daughter went to Harvard.
Provided the domestic housing market doesn’t collapse and the Chinese authorities resist the temptation to impose capital controls, Chinese buyers will continue to support prime real-estate markets globally. However, this is a risk which needs to be monitored closely.
Conclusion and investment outlook
In order to understand China you need to study its history, this recent essay by The Economist – What China Wants – is an excellent introduction. China has witnessed several long-term “Cycles of Empire” over the past three millennia as this Moneyweb interview with David Murrin – China’s fifth reincarnation as an empire system and its link to Africa. Explains:-
It’s unique in that it is the fifth, could be sixth if you go back far enough, incarnation of a 500 year empire cycle. They’re now 120 years into that cycle so they’re really about the stage where they burst forth onto the world. Every one of China’s cycles has been bigger than the one before, so when people say it didn’t actually ever have influence outside its borders, look at the last incarnation at the peak of the 14th century. Their trading system reached the shores of Africa, they controlled the Indian Ocean, they controlled the whole or parts of the Pacific.
The opportunity to rebalance the Chinese economy has come at an opportune time, with the US in a slow, but steady recovery from the great recession. Moderate US growth is helping Chinese exports to rebound as this article from the China-United States Exchange Foundation- China-US Trade Boosted by Moderate Growth in the US Economy explains: –
The United States’ economic recovery, albeit moderate, is good for overseas exporters. During the first seven months of the year, Chinese exports of good to the US increased by 6.3% over a year ago, while its global export growth was 3.0%. The US market performed twice as good as the global market. In July alone, exports to the US shot up by 12.3%, contributing 2.1% to China’s global export growth.
However they recognise the need to maintain good trade relations with the US:-
According to China Customs statistics, Chinese imports worldwide increased by 1.0% during the first seven months of the year. Imports from the US, however, increased by 5.0%, far outperforming its global imports.
Perhaps the greatest risk to the Chinese administration, as it seeks to rebalance the economy, is a collapse in the housing market. So far, the rebalancing has proceeded without a major catastrophe. Chinese stocks remain cheap on a P/E basis (SSE current P/E 10.59) and forecasts for 2015 factor in little earnings growth. The chart below shows the Shanghai Composite vs the S&P500 since August 2010.
Source: Yahoo finance
The S&P 500 has risen close to 100% whilst the Shanghai Composite has fallen by 30%. By comparison, the Chinese real-estate index is up 64% over the same period. This chart from the Peterson Institute shows the under-performance of stocks relative to housing:-
Source: CEIC, Peterson Institute
A dramatic slow-down in European growth may justify the low valuation for the Shanghai Composite, as may a reversal in the fortunes of the US stock market, nonetheless, on a relative value basis, Chinese stocks look attractive. I believe the US economy will continue to perform, though not so strongly as of late. The ECB will avert an implosion of the major European economies “whatever it takes”. In this environment China will find, quantitatively fuelled, export markets to cushion the pain of domestic reform. Chinese stocks will outperform Europe, and may well outperform the US, over the next couple of years.
The second arrow of Likonomics – a deleveraging of the credit bubble – looks likely to be postponed.