Merrill Lynch: China bust upon us

Zarathustra wrote earlier this week:

Deutsche Bank is expecting  a 10% correction in home prices because it would be a disaster if prices are allowed to fall by, say, 30%:

Those who understand China’s political economy should know that a 15% decline in average property prices in 35 cities within a few months must be accompanied by a range of economic and social consequences. These will include a sharp decline in real estate transactions, a visible deceleration in real estate investments, rising unemployment in the property construction and agency sectors, a further decline in construction material prices, demand destruction due to inventory destocking, and finally a worrying decline in GDP growth and the resulting concern of social stability. In other words, the government will most likely not tolerate a 30% drop, and probably not even 15% in our view. We expect real estate policies will likely be relaxed way before a 30% price decline is observed.

I hear that!

The next question is, however, can you be happy to allow some property developers to fail miserably while at the same time limit the fall in home prices to within 10% so that you can avoid “a range of economic and social consequences”, in other words, hard landing?

Or, if Deutsche Bank’s judgment is true that policy will be relaxed well before property prices fall significantly, we can question whether that will be enough to save the market if the downturn has passed the point of no return.  We should all understand that once a trend is established, it is not easy to turn around.  Property prices in the US have failed to bottom-out even with ultra easy monetary policy, for example.

So, the real question is, how do you engineer this landing, which requires the wheels on one side of the aircraft to fall off and a gentle touch down on the other side.

Well, that question has just been cast into stark relief by the following from a Merrill Lynch note:

Credit to Chinese developers is rapidly drying up which will be the trigger for a construction collapse. The rising cost of funding shows the pressure:

– The yields on existing Chinese developers’ bonds in Hong Kong has exploded to around 30%. This means that this source of funding is now shut, as developers could not issue bonds at a 30-35% rate.

– The rate on bank acceptances, another unconventional source of credit, are also surging. The extension of reserve requirements has had a material effect on the willingness of banks to make loans through unconventional channels.

Remember that the developers have a massive need for credit because construction has substantially exceeded sales over the past 18 months. This was never a sustainable situation, but the collapse in credit availability will be the trigger for a slowdown. Apartment construction is 25% of steel demand, so 180 mt of steel demand are now under threat.

As we approach the construction endgame in China we strongly recommend underweights in resource companies and mining services.

I haven’t got much to add except to note that Greentown and Evergrande are both top ten developers in China.

Houses and Holes
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        • Since when in the past ten years has fairness been a concern for a great many Australians? I didn’t see many Australians jumping up and down demanding an end to negative gearing and other government policies that have contributed to our real estate bubble.

          It has been a long time since everyone in this country was given a “fair go.” Instead, many Australians have become very smug materialistic individuals who look down with disdain at anyone who hasn’t gone into debt buying overpriced homes, expensive vehicles and wearing the latest trendy clothes while sipping wine at their summer shack.

          Yes, my heart bleeds for all those property investors who now can’t sell that the party is ending. We all know that a good party ends with a hangover and that the longer the party goes on the bigger the hangover. The party should have been allowed to stop years ago rather than be stimulated by the government.

          Trying to cure a debt crisis by going deeper into debt or ignoring the problem doesn’t work. Sometimes the best thing is to simply go to the toilet and stick your finger down you throat and move toward the recovery stage. Delaying the inevitable or wishing it wasn’t so won’t help in the real world.

          • Here here! I’m over the “what can we do to save this thing gracefully?” Time to blow right up IMHO!

          • The expression is “Hear, hear!” I believe, as in “hear that man!” But I don’t agree, a collapse in commodity prices would trigger pain for everyone, and probably hurt the young & the poor through unemployment the most.

          • Agreed. We Australians had the educational experience of watching crashes in plenty of other countries and yet we refused to learn.

          • It’s immoral to keep the patient on all those drugs that makes said patient lose control of their bodily functions.
            No, have the operation and hope for a full recovery.

          • Amen. We’ve lost the ‘fair go’ ethos that this nation was built on. Reap what you sew; the crops are looking good for a bumper harvest.

          • @Johnno

            Yes, reap what you sow and wear what you sew. We can all hear what is happening here!

          • > No, have the operation and hope for a full recovery.

            Cutting off the snout from the credit trough can be a life threatening operation

          • Agree. This huge expansion in credit has turned Sydney-siders into a pack of wankers and princesses who need to learn from their mistakes. The debt ridden who have lived the life of Riley will demand that they be saved by the government and further drag the rest of the country down with them.

        • However the bottom tier if the workforce are worse off than those getting a complete suite of government transfers.

          What will be the social consequences of such a meltdown.

          Recently University financing had to be relaxed because the sons and daughters of (eg) council worker and part-time staff at woolies get nothing and children of centrelink supported famlies get $6,000 upfront and around $2,500 each subsequent year + youth allowance.

          I can see some major issues here.

        • Like a portion of that 1.5% who work directly or indirectly in mining?
          However would be a bonus for manufacturing, tourism, education and ohter exported services.

    • Yes, but how much time?

      This article suggests that time has arrived.

      God help us if Europe and China blow up at the same time!

      • Why would Europe and China NOT implode together??
        Surely one domino knocks down the next…? I could never envisage a long Europe recession without both the US and China (and other Asia) taking a massive dive too.
        HnH is right though. Be careful what you wish for.

        • Actually, with the proviso that I fervently hope ML is wrong, China’s real estate bubble results from an attempt to rid itself from its external dependence. It would be most unfortunate if it’s external and internal drivers were to slow simultaneously.

          • MontagueCapulet

            I think the last couple of years in China, Brazil, Australia and Germany represent a “decoupling boom”. China and the countries that export to China delayed the inevitable for a couple of years thanks to the enormous stimulus of a credit-financed Chinese building bubble. Since even the USA and Japan export to China to some degree, the whole world benefited to varying degrees from Chinese stimulus. Now that China has reached the limits of that strategy, we’ll see all the countries they were propping up slide back in to a double dip.
            I think the lesson that will emerge from the next couple of years is that it is really one global market, we’re all chained together and going down together. But there was a bit of slack in the chain that allowed us to ignore that fact for a while.

        • ‘Be careful what you wish for.’

          Very true. To be considered by many commenters here at MB that have wished for a collapse scenario in China.

          • There are some things that you can “wish for”, that “wishing for” them makes them more likely to happen – like when voters get the government they deserve.
            But China imploding? This is not a question of wishing for it or not, it is a question of “seeing it coming” – or not.

  1. Hypothetically, lets look at the following and what it will mean for Australia.

    China’s construction boom comes to an end (hard landing) so Australia’s dirt is no longer needed like current and past levels. What does Australia do then???

    • Australia, if it has any brains, moves the tax burden off income (a.k.a. production) and onto economic rent and/or consumption, in order to remove taxes from the prices of exports and thereby get a bigger fraction of the shrunken global market.

      Trouble is, Australia doesn’t have any brains.

      • Gavin can you please run for the Australian Senate ? You only need 14% of the vote to secure a seat. Look at what Fielding has been able to do for six years until recently and he was a total whacko.
        I am serious though no-one in public is saying this.

    • MontagueCapulet

      The Australia dollar will fall to a level that compensates for the fall in commodity prices. We’ll ship just as much iron ore as before, and get paid the same amount of Australian dollars for it. But in US dollar terms our export income will have dropped. A lot.
      I’m thinking that if iron ore prices drop to below $100 a tonne, and the Australian property market drops 30%, and the Reserve Bank drops interest rates to the 2-3% range to deal with the housing slump, we’ll see the dollar near 50 US cents again.
      I’m not saying it that is inevitable, just a plausible scenario.

  2. A timely reminder of the fragility of placing all bets on the resources boom. (Be it government revenue estimates, calls for excessive taxation or concerns about Dutch Disease – any/all may or may not happen).

    Of course I rather hope China muddles its way out of this! I suspect that they will allow a failure or two to send a political message but can only imagine that all measures will be taken to control the situation, particularly in light of potential continued downturn in global demand and impending leadership change in 2012.

    I may be wrong – and that would likely make the economic situation in Australia far more problematic.

    Nonetheless, this note appears be a warning on the possibility of future difficulties – recommending underweight in resource co and mining services – I wonder if this is related to another recent ML note recommending underweight fledgling miners only (late Sept).

    Time will tell if it is China bust or not!

    This recent DB paper on global impact of slower growth in China makes an interesting read:

    • Unless they’re doing a Goldman and telling their clients one thing while doing another. Time to cash up; it is nearly the Christmas party season.

      If this does come to pass, sadly, this will be a long overdue the reality check for everyone.

  3. “Apartment construction is 25% of steel demand, so 180 mt of steel demand are now under threat.”

    Average Chinese apartment uses 3,000 tonnes of steel. I arrive at this figure by assuming average size of 60 square meters and steel intensity of 50kg/m2 (there was a good chart in Rio’s analyst day presentation connecting the dots for hight of buildings and construction steel intensity). So ML is going a bit over the top in assuming that 180mt of steel is used in housing construction. The number is closer to 75mt assuming 1.5 billion square meters of new annual construction.
    However, I do agree on the direction this is heading: DOWN!

    • 50 kg x 60 metres (1 unit) = 3000 kg = 3 mt/unit.

      I wonder if this is enough to build a high-rise?

      Steel demand for autos, rail construction, housing and durable goods exports are all thought to be starting to decline, so demand for iron ore and coking coal must also soon fall, though the magnitude of these declines is not certain.

      Synchronous contraction in China, Europe and the US looks irreversible now….seriously difficult situation.

    • MontagueCapulet

      Actually, it’s 4 tonnes of steel per 60sqm apartment. You don’t have to estimate, the figures are available if you look for them. And floor space is currently being built at 1.8 billion sqm per year, so thats 30 million apartments times 4, 120 million tonnes per year.
      The figure of 180mt per year would be assuming some use of steel in associated infrastucture demand,which will drop as new apartment constuction drops.

      If we take the 120m tonnes per year figure and assume that construction rates fall by 70% post glut then we are looking at a reduction of 80m tonnes per year, less than 10% of total demand.

      The real issue is what happens to prices when you move from shortage to surplus.
      I’d be expecting Australia and Brazil to move similar volumes of iron ore at about half the current price, $90 per tonne rather than $170.

  4. Didn’t you have the Morgan Stanley bloke on here on a video last week?

    The purpose of the video seemed to be that his view on the US economy was much the same as your own. Strangely his view on China was no where near as bearish as yours but that didn’t get a mention. Confirmation bias?

    • If you’re addressing me, then no, there’s no bias because one of the reasons I ran Gerard Minack was because I agreed with his view that China could stimulate again (though not to the same extent).

      I’m not sure where you get the idea from that I’m a China bear. I’m a firm believer in the catch-up growth paradigm.

      Most of my China analysis, what there’s been of it because I’m not an expert, has been directed at:

      a) debunking the Panglossian drivel that China could decouple from a Western recession which was being peddled by some very serious people. Thankfully that seems to have stopped

      b) illustrating the potential for a hard landing or trade war given China’s reticence in raising the value of the currency

      c) making the obvious point that no Asian country has ever successfully transitioned from mercantilist growth to continental growth without slowing dramatically

      d) And related, the commodity bubble and the supply response that will kill it

      Basically although I think China has a lot of growth ahead of it, I don’t see Australia benefiting as much as it has to date.

      But bottom line is I’m neither bearish nor bullish on anything. I’m interested in return versus risk.

      • That deserves +1 I learn way to much form you HnH your like a virtual Wikipedia!

        +1 HnH Metadata!


        Thank you.


        • LOL “form” = “from” unless I have me broad Aussie accent on … which I have not had since 1971 to be honest!

  5. I used to do a bit of gliding. If you watch a glider emulating the first graph, guess what happens next…

  6. The same underlying problem: in Japan in the 1980’s, and South Korea. California 2000’s; and Arizona and Nevada. Spain. Ireland. Britain.
    Yet to blow: China. India. Australia.
    The underlying problem is “planning gain” in urban development. It might be corrupt officials in China and India. It might be honest developers having to outbid each other for the available land that the local Green-driven government rations out. But the end result is the same.
    The economics profession has hardly failed WORSE anywhere than on this specific point. The dear old Queen of England asked “why did no-one see the GFC coming”? She has not been given the right answer yet.

  7. Credit to Chinese developers is rapidly drying up which will be the trigger for a construction collapse.

    Credit to two developers appears to be drying up. What of the others? Are these two the Bear Sterns of Chinese property developers whereas others are ok? Incomplete information from which to draw any conclusions.

    Remember that the developers have a massive need for credit because construction has substantially exceeded sales over the past 18 months.

    These would appear to be a general statement applying to most if not all developers I would have thought. Would welcome 2 cents worth from someone in the construction industry. Yet the very next sentence …

    This was never a sustainable situation,…

    If it was never sustainable how else would construction get funded other than by (a significant portion of) credit, not just in china but in most places? FFS!

    Apartment construction is 25% of steel demand, so 180 mt of steel demand are now under threat.

    180mt is only under threat if the entire apartment construction in China ceases — assuming the value is in act 180mt — other commenters seem to dispute this.

    If apartment construction contracts then the drop in steel required will be whatever % the contraction is. A 10% drop would see an 18 mt drop in steel use etc. So are these hand waving psychos really saying 100% fall in construction or are they headline seeking?

    …and so on. Breathless reporting of a calamity with scant data to support the hand waving IMO. Show me more data. If the end game is truly upon us as they claim there should be plenty more of it (data) available to support their claims.

    • Some fair points there and some unfair.

      They said “under threat” not done for.

      This is an excerpt, not the full report, and it was not released for publicity purposes.

      Two top 10 developers, which is a fair canary to point to.

      I accept we need more evidence but you’re overly sceptical and I’m now wondering about cognitive bias the other way.

      • …no, I just think if they are going to put that sort of stuff out there then they have to make the case.

        Fair enough if those are excerpts but it is undergraduate stuff in terms of solid analysis building a case. Certainly not something you’d want to be paying money for if you were a client.

      • You obvisouly don’t read analysts’ reports too often; “sell” calls are as rare as hen’s teeth, especially from mainstream financials like ML!

        It take nuts to bet against China, and its much easier to sit on the fence and revise the view as it all unfolds.

        • LOL very true – I meant it tongue in cheek in light of:

          Merrill Lynch: China Bust Upon Us.

  8. H&H I wouldn’t claim to know what going to happen in China, but they have a pretty big foreign paper reserve $1.4T approx, and I saw one of the FED guys on TV saying few were buying US debt, so it might be interesting to see if China is bringing funds back to plug the local debt problem, and also given the Congress also passed the currency bill yesterday…are we going to see money and trade wars between to US and China build up?

    • You are correct and they know how to protest (doe not get reported well) – also blogs and social media are very-very hard to use in China i fact bordering on the impossible.

      This is a real concern for the Communist Elite in China.


  9. whoa….

    and re: wanting or not wanting “collapse”.

    I would, possibly contraversially, suggest that it was always going to collapse – either economically, via itself (ie, the global system, in its current paradigm);

    OR massive wealth transfer CONTINUES and then it brought down by the disenfranchised.

    Economic or social end: pick; not “if”.

    The structure, combined with human nature, IMHO, was always going to end nastily one way or another…especially with vested interests abusing the system (includes the average man!) and not being prepared to forgive systemically-enabled debt.

    My 45345345 cents

    Be nice 😉

  10. The anecdotal accounts from households (could-be buyers) in Shanghai is that property prices are now down at least 15% in that market and still dropping.

  11. Any view on the trend/forecast for India’s steel/Fe demand? To replace reduced demand in China?

    • I though the forward indicators for Indian industrial production were also negative….along with Taiwan, Korea, Brazil….you name it….

  12. From a developers perspective, I was bearish on China prior to visiting it March and more so following that visit.

    Property prices are just divorced from incomes and much of the infrasture simply cant be paying its way.

    The mother of all bubbles, as I see it.

  13. Some thoughts. Crisis and opportunity. Can the CCP get one more roll of the buildout dice?

    Can the CCP force developers to go west to the interior and beyond, under threat of death? This would be easy because if the shtf, the CCP will be looking for scapegoats. It has readymade ones.

    The developers would operate under a money-marshall from the CB/CCP. The old pretence of independent companies.

    The socialist game is wealth redistribution.It is glorious to get rich. And if you are a good commo, it is heavenly to rob them. Can the CCP pull off a Robin Hood to placate the poor and capture the moral high ground?

    How popular was Putin in rounding up the a-hole oligarchs in Russia? They conformed, were exterminated, disenfranchised or fled. When you got ’em by the balls, their hearts and minds are sure to follow.

    Command, control, conform. For our friends we interpret the law and for our enemies we prosecute the law.

    There will be no bust as Mandarin speaking Chairman Kev will have some welfare-to-work programs for them. Oops, no welfare. Bad luck then.

  14. There is an excellent article in “Foreign Policy” Magazine, by Daniel BLUMENTHAL, entitled “The Top 10 Unicorns of China Policy”.
    Google it, it is subscription only, unfortunately. The whole thing is good, there are 10 points; number 3 is the best and the most relevant here:
    “Point 3. “China will inevitably overtake America, and America must manage its decline elegantly.”
    – “This is a new China-policy unicorn. Until a few years ago, most analysts were certain there was no need to worry about China. The new intellectual fad tells us there is nothing we can do about China. Its rise and America’s decline are inevitable. But inevitability in international affairs should remain the preserve of rigid ideological theorists who still cannot explain why a unified Europe has not posed a problem for the United States, why postwar Japan never really challenged U.S. primacy, or why the rising United States and the declining Britain have not gone to war since 1812. The fact is, China has tremendous, seemingly insurmountable problems. It has badly misallocated its capital thanks to a distorted financial system characterized by capital controls and a non-market based currency. It may have a debt-to-GDP ratio as high as 80 percent, thanks again to a badly distorted economy. And it has created a demographic nightmare with a shrinking productive population, a senior tsunami, and millions of males who will be unmarriageable (see the pioneering work of my colleague Nick Eberstadt).
    The United States also has big problems. But Americans are debating them vigorously, know what they are, and are now looking to elect the leaders to fix them. China’s political structure does not yet allow for fixing big problems.”

    • Blumenthal’s article:

      The China story remains to unfold. One point I would challenge is:

      “But Americans are debating them (big problems) vigorously, know what they are, and are now looking to elect the leaders to fix them”

      Thus far, the US political system appears in inadequately skilled to effectively deal with the crisis to hand. Hopelessly conflicted, ideologically split, entropic with no clear consensus on just what the problems are and what actions necessary to fix them.

      At this point I fail to see the leadership and vision urgently required to address the myriad of social and economic problems facing the US.

      Both countries face enormous challenges.

      • I agree the US political system is currently moribund….and lacks the necessary vision. However, the key factor is not the politicians, it’s the US people, and they are debating the issue of what to do among themselves. Like all crises, the first part of any solution is the finger pointing, and then, eventually there will be more consensus about what caused the problems and how to fix them….during which process, ordinary people become more politically active…there is plenty of evidence this is happening across the US. Interestingly, Youtube and other social media are places where frank discussion and debate is possible, without the filtering provided by the vested interests of MSM. It will take time for the pressure for change to percolate through into the ranks of the professional pollies, but it will, and there will be an invigoration of the US political process as a consequence. It may not be completely peaceful.
        In China, on the other hand……