The Bubble made of Mortar - Another Chinese Wonder?

Well nobody can deny that "Made in China" has found its way all around the

world in almost all segments of industry, trade, and commerce. Be it mobile

phones, televisions, or prayer wheels - the Chinese products are everywhere.

Well it may get just get bigger as China appears to be successfully

developing the biggest bubble of Chinese origin. This may be the largest

development by China if we keep aside the Chinese Wall and it is so big that

when it bursts, the sound will be heard all over the world.

Bubbles do not form suddenly they are usually the final leg of a successful

reform and consequent growth story. When the stimulants of the growth run

dry and we still blow harder, the bubble a growth without sustainability,

starts growing. Dot Com bubble followed great breakthroughs in information

and communication technology, the crisis in South East Asia followed a

series of economic liberalisation policies adopted by countries in the region,

and the story holds true here too. In 1978 China, led by Deng Xiaoping,

embraced ground breaking reforms, which was commendable given the

theological legacy it inherited. The process of liberalisation focused on

economic freedom as well as modernisation was supported by affirmative

actions like farm privatisation, introduction of free enterprise and welcoming

foreign investments. Trade barriers were lowered, tariffs bought down,

regulations relaxed, and China joined World Trade Organisation in 1990.

Number of state owned enterprises went down by 48% between 2001 and

2004. One of the focuses was creating multiple urban centres which will

house people who migrate from farm sector to industrial sector. This focus

lead to a wild growth in real estate fuelled by ambition, dream, avarice, and

speculation. Success of economic liberalisation and urbanisation to provide

low cost industrial worker paid dividend as China clocked 9.5% annual

growth in GDP. After 2010 China became the second largest economy of the

world behind USA.

Global recession of 2008 had a detrimental impact on Chinese export and

China responded with an economic stimulus program of over USD 580 billion.

The money was used to generally build urban facilities and specifically

rebuild earthquake devastated Sichuan province. This money thwarted

recession and was available in the hands of few a situation potent to fuel
short term economic growth and speculation. If investments made using this

stimulus money fails to generate income, that will have a potential to cause

devaluation lot of money will be vying for limited useful economic assets.

The hypnotic focus on real estate has seen ambitious projects being

undertaken. In 2014, the Peoples Bank of China started easing lending

requirements and cutting interest rates. The China Securities Regulatory

Commission also permitted real estate developers to raise funds from market

by lifting restrictions on bond and stock sales by developers. According to

Bloomberg, in the first eight months of 2016, average prices for new homes

rose 28 percent in Tier 1 cities and 10 percent in Tier 2 cities. The housing

prices in China grew by 140% between 2007 and 2011. Beijing property

prices have a 27:1 price to income ratio. Property prices continued their

dream run and these were selling for ever-larger sums in government land

auctions, a bounty for the Government. By June 2016, 196 listed developers

of China had secured a debt of 3 trillion yuan, which was about 1.3 trillion

only three years earlier. Chinese have also made investments in real estate

in USA, Canada, and Australia, pushing up property prices in select locations

in those countries. This growth does not appear to driven by demand for real

estate to be out to use but as an investment. Chinese construction materials

manufacturers benefitted immensely from all these developments.

Economist magazine noted that Chinese spend more money on luxury goods

than Europe and US combined thanks to the enhanced supply of money.

Let us now enter the other side of the moon somebody must be financing

this growth story. These were done by local Government, thanks to the

stimulant money, and the amount is a staggering USD 1.2 Trillion which
many reckon as sub-prime lending. The banking segment has also wanted to

ride the economic growth and took high exposures in real estate. IMF has

been warning for some time on vulnerability of Chinese banking system.

Banking sector is usually among the first casualty of bubble burst. This

excludes the underground banking system. The money lenders, a very

common phenomenon in China.

Not that the Chinese authorities did not recognise these signs and interest
rates were raised in 2011. In some regions buyers with more than one
mortgages were declared ineligible to have any further mortgages. In some
cases, down payment requirement to buy property were raised to 80%. Even
bid prices were capped in some regions. The real estate market came down
responding to these measures along with downgrading of US and sovereign
debt crisis in Eurozone. The market witnessed on an average 20% reduction
in real estate prices. Another long-term factor could be the demographic
feature of China. Deutsche bank made a study which related recession with
demographic profile and claimed China may become old before they become
rich.
Government remains the biggest source of funding for the state funded

companies and the public private partnership projects. Tier 3 cities also rely

of property sales to support their budget and they have not seen much

activity in real estate sector unlike what was witnessed in Tier 1 and Tier 2

cities. Slowing down of this sector will have serious impact and experts feel

that it may bring down the representative Exchange Traded Fund at iShare

FTSE China (FXI). In fact, this year FXI grew by 0.4% trailing behind 9%

growth in MSCI Emerging market. It is not a nice situation where large cities
need restrictions while smaller cities need support. This week (Dec 21, 2016)

the Chinese Academy of Social Sciences have warned of a GDP growth of

6.5% in 2017, lowest in 25 years. The fact that real estate prices are

growing in large cities and falling in smaller ones is an ominous sign. Not all

completed projects were being commercially exploited as some of the

infrastructure project like sea bridge or high speed rail failed and urban

facilities remained unoccupied. Stories of Ghost Cities started gaining

publicity bringing out the ugly side of the growth story.

So, will the bubble made of mortar burst?

Deutsche bank is a September 2016 report suggested that a 10% decline is

housing prices may lead to loss of 243 billion Yuan for the developers. DBS
(Hong Kong) projects 4.1 trillion yuan of bad loans if real estate prices drop
by 30%. Commerzbank AG endorses the view. Pacific Investment
Management Co. projects a non-performing loan ratio of 6 % from current
1.75% in next few years should property prices tank. Both Deutsche Bank
and Goldman Sachs have raised their concern over an impending correction
in property prices. In this context, it is important to note that mortgages
accounted for more than 70% of new loans in July and August of 2016 and a
fall in value is likely to have a serious impact on overall economic
management. One saving grace is that despite the boom, household debts
account for about 45% of GDP, much less than that of Japan or South Korea,
though mortgage payment as a percentage of income stands almost at the
same level that USA had before the crisis broke out. On the other hand,
Chinas debt stands at 255 percent of its gross domestic product (GDP),
clearly an unsustainable position.

The Wall Street Journal in early November warned that similar bubbles are
forming in other sectors in China - there is too much of money available and
few sincere investment opportunities. Should these bubbles pop, banking
sector will be the worst hit. Bloomberg data shows that median total debt at
144 listed Chinese builders stands at 8.1 times earnings before interest,
taxes, depreciation and amortization. This marks a sharp rise from 4.9 times
five years earlier. Total debt stands at a record high of 2.8 trillion yuan.
Chinese exports benefit both from cheap labour and weak Yuan, which many
alleges, is kept weal artificially. If the labour cost advantages go away or
Yuan is revalued, the price advantage on export will be lost. Of course, there
is a talk on China devaluing Yuan as political tool against USA. So, if Trump
led USA enters a trade war with China, the Renminbi may see a drop
Barclays is talking about year-end value of 7 lowest in last 8 years. That will
end up making Chinese exports even cheaper.

There is a level of comfort that even if real estate market tanks, most
developers have a collateral against their loan and banks are not un-
protected as they were during sub-prime led crisis in USA. Goldman Sachs
have underplayed any foreclosure crisis as banks have recourse to property
and Chinese homebuyers needs 20-30% down payment. Though collateral
makes good banking sense, there remains a doubt that during an economic
crisis whether these collaterals will have any market. Lack of derivatives also
make the crisis lot less toxic than what happened in USA during the sub-
prime crisis. However, exposure of Chinese bank to real estate is around
27%. Top five banks have almost 40% of their exposure in this sector. Fitch
Ratings estimates this exposure, including off-balance-sheet lending and
corporate loans using real estate collateral, to be around 60 percent of total
credit.

The question is can the bubble hold? In the long run, it cannot - question is
whether the regulator will deflate it or it will burst? If it bursts, we will
witness collapse of the second largest economy of the world. Even a ripple
effect will be strong enough to wash out few small economies of the world.

(With data sourced from Bloomberg, Forbes, Wall Street Journal, Fortune, Moodys,
and Fitch)