Here comes the Chinese burn

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Over the last few days, a large selection of articles have appeared exposing cracks within the Chinese economy and suggesting that the China’s housing bubble might finally have burst.

Paul Krugman, has finally weighed-in to the China debate drawing eerie parallels with the 1980s Japanese economy:

Consider the following picture:
Recent growth has relied on a huge construction boom fueled by surging real estate prices, and exhibiting all the classic signs of a bubble. There was rapid growth in credit – with much of that growth taking place not through traditional banking but rather through unregulated “shadow banking” neither subject to government supervision nor backed by government guarantees. Now the bubble is bursting – and there are real reasons to fear financial and economic crisis.

Am I describing Japan at the end of the 1980s? Or am I describing America in 2007? I could be. But right now I’m talking about China, which is emerging as another danger spot in a world economy that really, really doesn’t need this right now…

The most striking thing about the Chinese economy over the past decade was the way household consumption, although rising, lagged behind overall growth. At this point consumer spending is only about 35 percent of GDP, about half the level in the United States.

So who’s buying the goods and services China produces? Part of the answer is, well, us: As the consumer share of the economy declined, China increasingly relied on trade surpluses to keep manufacturing afloat. But the bigger story from China’s point of view is investment spending, which has soared to almost half of GDP.

The obvious question is, with consumer demand relatively weak, what motivated all that investment? And the answer, to an important extent, is that it depended on an ever-inflating real estate bubble. Real estate investment has roughly doubled as a share of GDP since 2000, accounting directly for more than half of the overall rise in investment. And surely much of the rest of the increase was from firms expanding to sell to the burgeoning construction industry…

Now the bubble is visibly bursting. How much damage will it do to the Chinese economy – and the world?

Some commentators say not to worry, that China has strong, smart leaders who will do whatever is necessary to cope with a downturn. Implied though not often stated is the thought that China can do what it takes because it doesn’t have to worry about democratic niceties.

To me, however, these sound like famous last words. After all, I remember very well getting similar assurances about Japan in the 1980s, where the brilliant bureaucrats at the Finance Ministry supposedly had everything under control. And later, there were assurances that America would never, ever, repeat the mistakes that led to Japan’s lost decade – when we are, in reality, doing even worse than Japan did…

I hope that I’m being needlessly alarmist here. But it’s impossible not to be worried: China’s story just sounds too much like the crack-ups we’ve already seen elsewhere. And a world economy already suffering from the mess in Europe really, really doesn’t need a new epicenter of crisis.

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Next up is Associate Professor Partick Chovanec from Tsinghua University, who has penned an article suggesting that the Chinese housing bubble may have just popped. It’s well worth reading in its entirety. But for the time poor, here are some key extracts:

For years analysts have warned of a looming real estate bubble in China, but the predicted downturn, the bursting of that bubble, never occurred — that is, until now. In a telling scene two months ago, Shanghai property developers started slashing prices on their latest luxury condos by up to one-third. Crowds of owners who had recently bought apartments at full price converged on sales offices throughout the city, demanding refunds. Some angry investors went on a rampage, breaking windows and smashing showrooms.

Shanghai homeowners are hardly the only ones getting nervous. Sudden, steep price reductions are upending real estate markets across China. According to the property agency Homelink, new home prices in Beijing dropped 35 percent in November alone. And the free fall may continue for some time. Centaline, another leading property agency, estimates that developers have built up 22 months’ worth of unsold inventory in Beijing and 21 months’ worth in Shanghai. Everyone from local landowners to Chinese speculators and international investors are now worrying that these discounts indicate that “the biggest bubble of the century,” as it was called earlier this year, has just popped, with serious consequences not only for one of the world’s most promising economies — but internationally as well…

Real estate woes are already sending shockwaves through China’s broader economy. Chinese steel production — driven in large part by construction — is down 15 percent from June, and nearly one-third of Chinese steelmakers are now losing money. Chinese radio reports that half of all real estate agents in the southern city of Shenzhen have closed up shop. According to Centaline, more than 100 local government land auctions failed last month, and land sale revenues in Beijing are down 15 percent this year. Without them, local governments have no way to repay the heavy loans they have taken out to fund ambitious infrastructure projects, or the additional loans they will need to keep driving GDP growth next year…

The impact of a housing downturn would have a significant impact globally. International suppliers who have been fueling China’s construction boom — iron-ore miners in Australia and Brazil, copper miners in Chile, lumber mills in Canada and Russia, and multinational equipment makers such as Caterpillar and Komatsu — could be hard hit. Heavy losses on real estate and related lending could damage investment and consumer confidence, undermining the rising tide of Chinese demand that has been a much-needed growth engine for everything…

Residential real estate construction now accounts for nearly ten percent of the country’s total GDP — four percentage points higher than it did at the peak of the U.S. housing bubble in 2005…

Local governments depend on a healthy real estate market to generate revenue from land sales (as the state owns the land), and property development has long been a key driver of the GDP growth that the central government both demanded and prized…

Because the industry kept on building, there has been no negative impact on GDP. Real estate investment has continued growing at nearly 30 percent annually. But inflation began to rise from 1.5 percent in January 2010 to a peak of 6.5 percent in July 2011, and authorities began to sweat. They broadened their cooling efforts. The central bank tightened credit expansion, and China’s economy began to slow. As 2011 progressed, developers scrambled for new lines of financing to keep their overstocked inventories. They first relied on bank loans (until they were cut off), then high-yield bonds in Hong Kong (until the market soured), then private investment vehicles (sponsored by banks as an end run around lending constraints), and finally, in some cases, loan sharks. By the end of last summer, many Chinese developers had run out of options and were forced to begin liquidating inventory. Hence, the price slashing: 30, 40, and even 50 percent discounts.

And the slowing Chinese property market is captured well in the following Bloomberg article, which contrasts current plummetting house prices in a key holiday destination with the boom times of 2010:

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Zhu Lei, a property agent for the Serenity Coast luxury residential and hotel complex in Sanya on China’s Hainan island, recalls clients carrying suitcases of cash to shop for holiday apartments last year.

“We didn’t even have time for toilet breaks because there were just too many clients,” Zhu said. Today, sales in the second-biggest city on the tropical island compared to Hawaii for its sandy beaches and weather, are “bleak,” he said.

A two-year lending binge and the government’s plan to transform Hainan, in the South China Sea, into an international tourism destination helped fuel a 48 percent surge in Sanya’s home prices last year, making it the nation’s best-performing property market. As China in 2011 switched gears with policies such as increased deposit requirements designed to curb speculation, Sanya’s home prices have dropped 28 percent since last December.

The massive debts accumulated by local government financing vehicles, in order to fund infrastructure and fixed asset investments, are a key byproduct of the 2008 stimulus package unveiled by the Chinese Government. The following report by Bloomberg provides some nice analysis of the size and scope of these debts and questions the ability of China’s authority’s to respond with similar measures should the economy slow once more:

Debt accumulated by companies financing local governments such as Tianjin, home to the New York lookalike project, is rising, a survey of Chinese-language bond prospectuses issued this year indicates. It also suggests the total owed by all such entities likely dwarfs the count by China’s national auditor and figures disclosed by banks.

Bloomberg News tallied the debt disclosed by all 231 local government financing companies that sold bonds, notes or commercial paper through Dec. 10 this year. The total amounted to 3.96 trillion yuan ($622 billion), mostly in bank loans, more than the current size of the European bailout fund.

There are 6,576 of such entities across China, according to a June count by the National Audit Office, which put their total debt at 4.97 trillion yuan. That means the 231 borrowers studied by Bloomberg have alone amassed more than three-quarters of the overall debt.

The fact so few of the companies have accumulated that much debt suggests a bigger problem, says Fraser Howie, the Singapore-based managing director of CLSA Asia-Pacific Markets who has written two books on China’s financial system.

“You should be more worried than you think,” he said of Bloomberg’s findings. “Certainly more worried than the banks will tell you.

“You know how this story ends — badly,” he said.

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Finally, the idea that the Chinese authorities would promptly intervene to avert a hard economic landing have been put to rest by Fortune’s Gordon Chang, who sites three reasons why the Politburo will be tentative to act this time around:

The last time the global economy tumbled, Chinese leaders took action, decisively and quickly. In July 2008, the Politburo adopted measures intended to boost exports and in November of that year the State Council announced its massive stimulus plan. This time, Chinese leaders seem tentative.

There are three possible reasons for their relative inaction. First, they can be underestimating the severity of the situation. That’s unlikely, however. Chinese leaders can be accused of many things, but obliviousness—at least when it comes to their economy—is not one of them.

Second, they may realize that, despite the accelerating downturn, there is not much they can do. In response to the last downturn, they increased the country’s money supply beyond reasonable levels, thereby making monetary policy ineffective, and applied too much fiscal stimulus, burdening banks and lower-tier governments. They can implement another round of stimulus, but that would only make current problems—principally inflation and the property bubbles—only worse and buy them at most 24 months. As Fan Gang implied, perhaps they have decided that now is the time to take the medicine.

Third, Chinese leaders may be prevented from acting effectively by the country’s once-in-a-decade political transition, which formally begins next fall and continues for perhaps two years. Unlike 2008, when the Communist Party and central government moved fast, the current paralysis at the apex of Beijing means that technocrats can now adopt only modest and inadequate steps.

All in all, it’s a bear’s picnic, with worrying signs for Australia’s China-dependent economy.

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A special thanks to Bernard Hickey at Interest.co.nz for providing some of the links.

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About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.