I have wanted to discuss more on the real estate sector for a while even though I have to confess I am far from being an expert on the topic, and this in a market which even the experts find terribly confusing. What the real estate market is really telling us about underlying monetary conditions and the health of the economy is one of the most debated topics in China, and one on which there is the widest range of views – itself an indication of future expected volatility.
Fortunately one of the readers of this blog and a fund manger, SM, wrote me the following very interesting email (slightly edited) last week. It is not intended to be an overall picture of the Chinese real estate market but is, rather, notes generated during and after a visit through certain parts of China to gauge the investment climate. At the end of his notes he appended a few questions for me.
I don’t know how much you travel around China. T and I do a fair bit, and most recently we were in Guiyang. I thought I’d seen insane excess in the past – 200 thousand square meter malls completely empty next to apartment complexes with 40 thousand units and 30% occupancy rates, etc. etc. But what we saw over there is rather hard to fathom. It seems the Guiyang city mayor had the same idea as the Shenzhen mayor – to move the old downtown to a piece of undeveloped land.
Of course Guiyang has a quarter the population and probably a quarter the per capita income of Shenzhen. They built sprawling new government buildings about a 20-minute drive north of town. And then the residential high rise projects started going up. From driving around the area, we figured well over 100 20+ storey buildings.
What was most distressing was that the development has been totally uncoordinated – a project with 15 buildings here, in another field two miles away a project with one building, another mile in another direction three buildings, sprawled over what was easily over 30 square kms. of farmland well north of town. Every building we got close enough to see was either incomplete/under construction, or empty. Our tone gradually went from “Haha, another one!” to “Oh my God, another one.” We conservatively guesstimated that we saw US$10bn of NPLs in one afternoon. The only buildings that were occupied were six-storey towers built to accommodate the peasants who had been displaced by the construction.
Back in the city proper, every neighborhood we saw was a convulsing mess of buildings being torn down, new ones being built, and unfinished high rises starting to crumble. We have a few questions we’d love to hear/read you chew on (all the hard questions of course):
1. What will determine whether China experiences a steady slowdown (possibly sub-par growth rates over next decade) vs. a crash of the economy. Is controlling credit and SOEs enough to prevent a collapse of the typically most volatile component of the GDP – fixed asset investment? If they can prevent a crash, then maybe it’s all worth it? (the premise for shorting rests on the place crashing)
2. How high can the debt go and for how long can they keep on rolling over dud loans, dud payables, defunct real estate projects, before it becomes truly unsustainable? Do we have any precedents to go by, what would be the clues to look for that it’s cracking? And which are the pieces of the chain that are most fragile and most difficult to control by the government? (inventory, evidence of flight capital)
3. Could the Chinese create a mess of monetary and fiscal policy and create a big inflationary push or are they paranoid enough inflation to resist it? Given the poor Chinese reporting how should we track these trends?
4. What’s the chance that the Chinese want to create a full blown economic bubble that they wish to ride on for like 5-10 years in hope of then miraculously diffusing it because the early excess would be taken care of by demand created by later bubble growth? All in their light “justified” by China still having a low base for most things
Yes, these are all very tough questions and I am not sure I can answer them, but here goes anyway.
What will determine whether China experiences a steady slowdown (possibly sub-par growth rates over next decade) vs. a crash of the economy. Is controlling credit and SOEs enough to prevent a collapse of the typically most volatile component of the GDP – fixed asset investment? If they can prevent a crash, then maybe it’s all worth it (the premise for shorting rests on the place crashing)?
In my opinion crashes are results almost exclusively of balance sheet instability, and there are broadly speaking two things that determine the stability of balance sheets, and to be technical these are really the same thing but we often think of them differently: the amount of debt and, more importantly, the structure of the debt.
It is easy to see why the amount of debt is an indicator of balance sheet instability, but we often ignore how much more powerful the structure of debt is. What I call “correlated” debt in my book (The Volatility Machine) is debt whose financing and refinancing costs move in the opposite direction of asset values (and by the way I consider NPLs as just a kind of financing cost). When the underlying economic conditions are good and asset values are rising, the financing cost is also rising, thereby eroding part of the benefits, but when asset values are falling so are financing costs. This provides some stability to the balance sheet.
“Inverted” debt does the opposite. It performs brilliantly when underlying conditions in the asset side of the balance sheet are strong, but abysmally when things go badly. The more inverted a capital structure is, the more intoxicating its performance is when times are good, but also the more prone it is to collapse. A very simple kind of inverted financing was, for example, the way prior to the 1997 crisis South Korean companies borrowed heavily in dollars to fund domestic activity. When the country was growing rapidly and domestic asset prices rising, the won strengthened in real terms so that the cost of financing actually declined. CEOs were able to see both sides of the balance sheet improve at the same time and their equity values soared.
But when the domestic economy collapsed, asset values and operating profits declined with it. Unfortunately because this led to capital outflows and downward pressure on the won, the financing cost of all that dollar debt soared, and CEOs got hit with collapsing asset values and soaring debt at exactly the same time, with the concomitant collapse in equity.
An important part of unstable debt structures is the possibility of self-reinforcing behavior and mechanisms that exacerbate volatility (I guess I can never talk about debt without revealing my membership in the Hyman Minsky cabal). There were at least two very obvious mechanisms in the South Korean case. First, declining equity ratios increase the probability of default, which forced asset sales and declining enterprise value. Both – the former mainly when everyone is doing it – are self-reinforcing. Second, when there is downward pressure on the won, companies who have large dollar liabilities must hedge by selling won and buying dollars, which puts more downward pressure on the won, forcing less leveraged companies to hedge, and so on.
I talk a lot about all of this elsewhere in this blog and in my book, so pardon the race through the topic, but this is all just a way of saying that the amount and structure of liabilities, as well as mechanisms for slowing or speeding up the liquidation process, will determine whether or not there is a crash or simply a long, slow landing. I think because of the tendency of NPLs to vary intensely with the speed of lending and, more importantly, with underlying economic conditions, they add a lot of inversion to the balance sheet. Many analysts will estimate an NPL ratio and input that into their projections, but I think this can be misleading. For example, we might think that on average 10% of the loans will go bad, so we will do our calculations of the total cost and use that cost however we see fit.
But that doesn’t really help us. If an average expectation of 10% loss is correct, for example, we can be certain that we will never actually see a 10% loss. What we will see instead is that if all goes well and the economy grows quickly, NPLs might actually hit only 3%, but if the economy goes badly NPLs will surge to 17%. In other words the rise in NPLs will be exactly what we don’t want – it will be minimal when we can afford it anyway and huge when we can’t. By the way I have several times mentioned the 2007 IADB book Living With Debt, which points out that nearly every recent Latin American debt crisis was “caused” by of a sudden surge in contingent liabilities – the two most important sources being external debt, whose value surges in a currency crisis, and non-performing loans, whose value surges in an economic slowdown or after collapsing asset prices.
So to get back to the original question, will we see a crash, or a steady slowdown? My guess is that there is significant and rising instability in the banking system’s liabilities, and far more government debt than we think, all of which should indicate a rising probability of a crash, but I think the ability of the government to control both the liquidity of liabilities (i.e. to slow them down, or to forcibly convert short-term obligations into longer-term ones) and the process of asset liquidation (at least within the formal banking system – I don’t know about the informal), suggests that if a serious problem emerges we will probably see more of a “Japanese-style” contraction: a long, drawn-out affair as bankrupt entities are merged into healthier ones, liquidations are stopped and selling pressure is taken off the market by providing cheap and easy financing, and so on.
This is a long way of saying what I have often argued – that what we should expect in China is not a financial collapse but rather a long period – maybe even a decade – of much slower growth rates than we have become used to. There are many reasons to expect a short, brutal collapse followed eventually by a healthy rebound, but government control of the banking system eliminates a lot of the inversion that in another country would force a rapid adjustment. This is not a note of optimism, by the way. As the case of Japan might suggest, the long, slow adjustment may be socially and politically more acceptable but it may also be economically more costly.
The second question was:
How high can the debt go and for how long can they keep on rolling over dud loans, dud payables, defunct real estate projects, before it becomes truly unsustainable? Do we have any precedents to go by, what would be the clues to look for that it’s cracking? And which are the pieces of the chain that are most fragile and most difficult to control by the government? (inventory, evidence of flight capital)
Debt levels can get quite high – look at Japan – if they are funded by fixed-rate, long-term, local currency-denominated bonds. Remember that in Japan, by controlling deposit rates and most other form of interest rates, the government was able to force most of the financing burden onto households. I think the Chinese government can do the same thing too, although massive deposit outflows in the mid 1990s inflation period and in the post-1998 period, and even many cases of bank runs, suggest that there are limits to that policy. The real danger is that by forcing the cost of cleaning up the banking system onto households, the government will implicitly constrain consumption growth, which seems to have happened in Japan too.
I would say that rising inventory levels and flight capital, as SM points out, are key indicators to watch closely. The third question:
Could the Chinese create a mess of monetary and fiscal policy and create a big inflationary push or are they paranoid enough inflation to resist it? Given the poor Chinese reporting how should we track these trends?
I think policymakers are more worried about inflation than they are about rising NPLs. I also think there may be structural impediments to creating inflation, although I need to read up a lot more about Japanese policy in the late 1980s and 1990s to get more than just an intuitive feel. The fourth question:
What’s the chance that the Chinese want to create a full blown economic bubble that they wish to ride on for like 5-10 years in hope of then miraculously diffusing it because the early excess would be taken care of by demand created by later bubble growth? All in their light “justified” by China still having a low base for most things.
I am not sure how that would work. If the bubble is inflated by pouring resources into production capacity, the problem becomes how to absorb that production. Until now the answer to that question was pretty easy – Chinese consumption was rising quickly and the US absorbed the huge increase in excess production generated by the Chinese development model. I am pretty sure that the US won’t be able to play that role any more, and I am also pretty sure that no other foreign country can step it to replace the US.
Finally, for reasons I have discussed often enough, I am also skeptical that Chinese consumption growth will rise sufficiently quickly to fill the gap. The consumption rate will certainly rise in China, and the savings rate decline, but it can easily do so with a slowdown in the rate of consumption growth and a much faster slowdown in the rate of GDP growth. Frankly this is the outcome I am expecting.
Since this posting was supposed to be about real estate, I want to quote from a subsequent email also sent to me by SM with additional notes from some meetings they had. It is very interesting reading the notes of seasoned real estate investors. I have done some very light editing but kept the flavor of the comments unchanged.
¨ “Real estate prices are up 70-80% in the last five years. Generally speaking, real estate prices in China are equal to or slightly greater than 2007. Land prices in Beijing and Shanghai are up 10x in the last 5 years. In 2004, I remember whole market sentiment was different. The amount of restrictions was much, much higher – for example completion schedules were controlled. From my impression, the increases in the property sector have been because of loosening of regulations.”
¨ “The buying sentiment is back to 2007”. X is bullish because the affordability ratio is down from 80% (e.g. requiring 80% of your monthly income to meet mortgage payments) to 50-60%.
¨ “When the real interest rate (on bank deposits) turned positive, the housing market went downhill. It was directly correlated with the property market.”
¨ Most of the developers are buying land again, and the price has skyrocketed.
¨ Gearing ratio for the industry hasn’t come down, but they’ve rolled over short-term loans for long-term loans.
¨ Q: What else can the government do to promote the sector other than liquidity?” A: Not much. They can introduce more land at a cheaper price.
¨ The government is outright lying about inventory overhang in major cities. X was laughing about the Beijing government’s claim that it’s only a 2 month inventory overhang in the city. He figured closer to a year from personal observation.
¨ No evidence of major consolidation in the market at this point. The listed developers haven’t been coming out with many acquisitions. X estimated that 5-10% of the small-time developers in Guangdong province can’t get their projects done.
¨ A freaky deduction of my own: Even at the darkest hour of the crunch, the real estate developers decided it was easier to go renegotiate loans with the banks than lower their prices! They never had to lower their prices even though they were making gross margins in the range of 30-40%!! That’s not a bailout from the banks, that’s a handout! Then again, such a huge portion of Chinese savings have been put into real estate that if prices came down the government would be worried about the wealth effect decreasing people’s consumption.
¨ It would be fair to say that a large majority of the residential real estate excess we see is in the outskirts of cities. Anecdotally we’ve observed and heard these projects often get sold even though occupancy rates remain dismal (0-30% dismal). Realistically speaking, lots of these projects will never be occupied. If a meaningful portion of Chinese household savings is in real estate that never will be occupied or won’t transact for the next decade (and then transacts at a potentially lower rate 10 years out given that the building has been rotting for ten years and the construction quality sucks), are those savings really there?
¨ Just to clarify, we do see plenty of excess inside cities. It’s a bit harder to spot (because it’s hidden by other buildings instead of popping out of a field). And you definitely observe blatant commercial/retail excess in prime locations, and those stocks haven’t recovered.
¨ Our analyst’s view is that “As long as the government provides the liquidity, it will support the market.” Why do Chinese like real estate so much? My view is there is an unusual cultural affinity for real estate ownership in China. Aside from that however, if your interest rate on your savings account is 2% or less, then real estate can look pretty attractive in comparison. That’s why you end up with so many sold and unoccupied units on the outskirts of cities in China. The “Well, we might as well buy an apartment instead of leaving it in the bank” thought process is probably pretty common in China. So keeping interest rates low enforces the property market in two ways: by making mortgages cheap, and by increasing the incentive for households to move their savings into real estate. Considering how many unoccupied units we see in China, it’s certainly remarkable that the secondary residential property market is as miniscule as it is. This all tells us that Chinese homeowners’ holding power is extraordinarily high. So in shorting Chinese real estate we’re competing against 1) the buyers drying up and 2) Chinese holding power staying strong. That’s kind of an ugly thing to bet against. The fundamentals could stay insane for quite a while longer? What makes the buyers dry up?
¨ China needs to increase domestic consumption for stable internally driven growth. You can’t increase domestic consumption if you’re buying real estate. So this is yet one other way that this whole liquidity injection is preventing a transition to a consumption-based economy. You really do wonder how long the Chinese will keep up this level of “pump priming”. If they realize how much they’re screwing themselves for the next decade, the central government might just tighten liquidity.
I thought the last two points were especially interesting points to ponder.
these fund managers get burnt because they go with western mentality/history/data points to places completely different. i can tell because i’m on the ground in eastern europe myself.
it doesn’t matter that land prices surged 5x in 3 years and then doubled again. what matters is what was the base price in relations to wages/incomes. and if wages (or liquidity induced affordability) increased 10x then prices are sustainable. before ’05 you had to buy CASH 100%. i bought a flat in ’03 and paid cash. so the base prices at the time reflected that. now incomes might not be sustainable, but i don’t know what’s going on in china.
michael i have a somehow related question re debt if you don’t mind. can bernanke actually pull it off? (i’m using US because we have numbers handy. i think europe is much much worse)
let’s say the debt/GDP “hole” is $25t because:
1)recent years growth/prices were sustained by about $55t in debt in relation to $14t GDP.
2)let’s assume sustainable ratio is 2x GDP or $30t. so 55-30=25.
let’s also assume he can skillfully print/bailout everyone as they come, such that the CPI stays at 2% in the foreseeable future. the rest of the world is stunned anyway and he controls the bond market.
so the main question is:
is that it? can he replace $25t worth of 20 years of mal-investments without an impact on the economy?
because if he (they) can, then hard work/diligence is not necessary anymore. as it stands, i think i should just buy any asset, regardless of price/affordability because i’ll be saved by moratoriums/debt jubilees/bailouts/QE.
very interested to know your thoughts.
Thanks for the great post. Outside of the financial realm for a second, one also has to be worried about the significant environmental and resource impact this obsession with real estate is having. How many of these ill-conceived “New Citys” have gobbled up good arable land? For a seriously resource constrained country, using real estate as a substitute for bank accounts isn’t exactly smart policy. I remember not too long ago some top officials in Beijing were dismayed when some new satellite images demonstrated how much farmland had been converted to industrial/urban use in the last few years. Unfortunately, this concern does not seem to have been reflected, in any way, on the ground. My god, our farmland is disappearing! Hurry, make sure the banks crank up the real estate loans!
I think it’s also important to remember that in China the real estate mania is being driven by forces outside the realm of pure financial return or investment mechanisms:
1) Officials are under significant political pressure to “modernize” their cities, to provide tangible evidence of “progress” for promotion or what not. This almost always equates in cavernous but useless exhibition halls, miles of empty buildings in the middle of nowhere, roads rebuilt every two years, etc. Without this political impetus (and lack of accountability) there is no way madness like the Guiyang new city your correspondent describes would ever get built.
2) The Chinese government is focused on keeping as many unskilled people employed as possible. Damn the returns or leverage, just keep them building stuff quickly, at all costs. Not exactly a long-term perspective, but count me as one of those people who doesn’t believe China has some well thought out 100-year plan to dominate the world.
What your “correspondent” describes sounds identical to what I saw in my home town of Nanjing, circa 1993-1997. 10 years later, all of the projects I thought were insanely optimistic and destined to failure are wildly successful. The vacant farmland surrounding the huge (but seemingly impossibly far) University town, for example, has been completely filled in with vibrant residential + commercial districts.
So, if your correspondent was in-country in 1995 and what he’s seeing today is significantly different than China’s previous experience in urbanization… please do let us know. If your correspondent just arrived within the last 5 years filled with certainty about what development “should” look like… well, let us know that, as well.
On a similar note… I suspect Stephan van der Mersch wasn’t in Shenzhen in the early ’90s. If he had, then he probably wouldn’t have had much optimism for the dirty, rough farmland and fishing villages being ripped apart for wide streets and tall skyscrapers. I spent time in Shenzhen in ’93, and I think Guiyang 2009 is probably significantly more impressive.
An illustration of what he is talking about is in a short clip on Hugh Hendry’s site:
Michael,
I think one of your not-so-implicit assumptions is that most Chinese bubble stimulus goes into productive capacity. Sure, this can’t go on for very long without wrecking the banking system — there’s no demand for the production from that capacity. In short, its not self-sustaining, even for a relatively short length of time.
But there is another, more self-sustaining way, and you consider it but don’t give it much weight. A real Chinese bubble would involve inflating incomes/aggregate demand. This would reverse the trade surplus, generate hot money inflows, cause asset prices to rise, create demand for farm production, drive agricultural prices higher — at a faster rate than input costs — and generally would not result in an immediate increase in NPL’s.
Of course, such a policy would have two costs: inflation and/or higher NPL’s in the medium term. You seem to conclude that China will not take this path. Is it because they fear inflation too much? Or because there is no mechanism for inflating incomes?
I don’t know about the politics of inflation. As far as mechanisms are concerned, the tried-and-true method in Brazil and Argentina is to raise public salaries and have the Central Bank print money to pay for it. Surely China has enough of a vestige of its communist past so that public salaries are a material part of aggregate income?
I’m not saying this would be a good medium-term outcome for China — quite the contrary. However, that wouldn’t stop them from trying it…
The Chinese are not alone in their love for housing, as the U.S. Congress and many economists focus on boosting home prices.
One thing that struck me about the Chinese, however, is that it would be very popular for the government to allow home prices to fall. It’s an instant and massive transfer of wealth from the rich to the poor, who currently cannot afford a home, whereas in the U.S., the majority of voters are homeowners. If I was the Chinese Premier, I’d come out in favor of reducing home prices to make them more affordable. Instead of a crash, it’s a poverty alleviation program, with the government bailing out the bankers behind the scenes.
Also, I’m starting to wonder which is the worse bet—Treasuries or real estate? Maybe China needs to shift its rhetoric.
Michael, did you see the recent spike in 3 mo PBOC bills (on bloomberg, or my latest entry)? Is it possible that this is going to be a kind of stop/start tightening/loosening rather than the laxity seen in the case of Japan in the 1980s? Its hard to see China passing any kind of contentious reforms or privatizations right now.
if credits continue to grow at the rate of 30% odd percent vs GDP growth of even 10%, we will see credit to gdp ratio of 190% by year end of 2010. in US at the peak of the credit bubble this was 210%. in H1 09 there were 7tn RMB loans extended, vs economic expansion of slightly above 1tn. it took roughly about 7 yuan of credit to generate 1 yuan of gdp. at the peak of the credit bubble in US this was 4.5. make your bets.
Thanks for the information
Hi Michael, thanks for sharing this. I completely agree with all the points. As you pointed out, a sharp crisis is unlikely because the debt holders are Chinese depositors, who believe that the central government will always bail out banks. The scale of the problem is potentially staggering, which would make the 2 trillion USD foreign exchange surplus insufficient….
Victor
The process of moving city centres isn’t unique to Guiyang. Many cities are experiencing a rapid increase in housing and commercial property stock, which seems tied to plans for a large amount of rural-urban migration, and cross-city urban migration.
I am mainly based in the Northeast, and see this policy across several cities here. Popular incentives help in driving this, and also drive an increasing proportion of dormant property, incentives include offers such as “Buy a home at a minimum price of XXX Yuan, and you’ll have a local hukou.” In addition, local residential prices in the Northeast have boomed over the past H1, while commercial prices have remained stagnant, and industrial prices have decreased slightly, from the more reliable anecdotal sources I’m in contact with, a strange end-of-cycle pattern for real estate, suggesting we’re not end of cycle, or this cycle bears atypical characteristics.
I would agree with your general point on NPLs, and would add that slower growth affectstax revenues significantly. Reports earlier this month suggested a significant fall in tax revenues in early 2009 drove the tax office increase inspections substantially. Revenues from income tax and value added taxes (of which value added tax is more substantial) would be affected by a sustained lack of growth.
Prof. Pettis, thanks for this insightful post about real estate. However, I have a long-time question about the real estate about China. I always have this assumption. China, as a developing country with still majority of population in rural area, has a fundamental demand for real estate in city while the productivity goes up and urbanization moves on. This seems to me be the very basic theme in Chinese real estate. One way or another, and sooner or later, the large portion of migrating workers (MING GONG) today, and maybe plus much more would settle down finally in urban area as the agriculture really cannot absorb all the work force. If you consider this, real estate price seems to only have one way, rise. Maybe the extra capacity now, has some structure difference (high-end extra vs low/middle-end demand) and time discrepancy (short-term excess vs middle/long-term demand). But in the middle/long-term (decades or a few decades), I feel this would be the most important factor for the real estate. And this single point distinguishes China from Japan or any other western developed country. What do you think about this? Thanks.
A couple of questions/comments Michael. First, on the information challenges. One unsettling thing for me as I read this is that a great amount of it is based on expert opinion and guesses. Nearly everyone complains about the transparency, but it bothers me a lot that while I think there are sound observations here, the underlying data/facts/details are somehow missing. All throughout Stephan’s comments/questions are “clues, hints, trends” that try to flush out some data.. I did notice your answers very carefully, but I find myself still trying to get hold of something more substantial in the way of relevant data. Can you help on this more?
Secondly, you say your guess is that chinese policymakers are more concerned with inflation than NPL’s. If i read the tea leaves correctly (and the comments here by Stephan and you), aren’t housing purchases the major source of increased consumption? I mean, the low mortgage interest rates, higher land and apartment prices coupled with the chinese love of home ownership, and the incentives that government financing is providing to developers suggest to me higher inflation and consumption. Also, how can you say “there may be structural impediments to creating inflation”? Do you remember the run up in food prices in 2007 in china when there were challenges to pork production? Food and housing seem to me to be the things most bothersome to chinese policymakers when it comes to inflation, cause they both have the potential to generate large amounts of social unrest, dont you think?
Very intriguing post. Thanks for sharing!
Guojun Zhou, it is true that over the long term migration from the countryside will probably force relentless price increases in urban real estate, but I don’t think “this single point distinguishes China from Japan or any other western developed country,” and although this possibility suggests that in the very long term Chinese urban real estate on average may be a great asset, it should not imply that Chinese real estate markets are immune from overbuilding and breakdown.
Japan and western countries all went through the same urbanization phase, and there are many poor countries today who have urbanized or who, like China, are trying to urbanize. In none of those cases did prices go straight up. They shot up and then crashed in huge waves of real estate bubbles followed by massive panics and collapses. I think many China scholars often assume that what seem like reasonable long term predictions are also accurate short-term predictions, operating on the same scale.
But long term trends can encompass huge short term volatility. For example when the richest man in America, John Jacob Astor, dies in 1848 he was reputed to have said on his deathbed that his biggest mistake was ever selling New York real estate. In other words over the very long term new York real estate always went up, but that did not prevent the New York real estate market from experiencing dozens of bubbles and collapses in the 18th and 19th centuries (one took place shortly after his death). The same will almost certainly happen in China.
On the Rural to urban migration, i was told by a committee member that they are planning to move an additional 400million to urban / satelitte suburban constructions within 20-30 years.
A rare interesting article from the Atimes on “baoba” and the shift from “scientific development” back to “GDP worship”
:
http://www.atimes.com/atimes/China_Business/KG23Cb01.html
Guojun Zhu, your description also applies to the U.S. during the first half of the last century. Huge numbers of people moved off of small, marginal farms to urban centers. That was true in the 1920s, and it was a period of flat prices. The depression (as it was rightly called then) of 1920-21 was a severe deflationary contraction which followed a period of high, worldwide inflation.
The U.S. went from a booming, export-led economy to one more dependent on internal consumption. The CPI (with 1982-84=100) went from a peak of 20.9 in 1920, to a trough of 16.6 in 1922, then recovered some, but basically was stable through the 1920s. In October 1929 it was 17.3. And that was during the “roaring” twenties. Of course, subdued price inflation was probably mostly due to the gold standard.
In the 1930s, people left farms in droves and real estate prices plummeted.
Seen Macroman today on China’s M2 money growth?
http://macro-man.blogspot.com/2009/07/exits.html
That’s a little worrying. How can they grow the money supply, keep interest rates down and maintain the peg to the US dollar all at the same time? Shouldn’t the RMB shoot up against the USD?
Over-production fears in the steel industry
China Should Curtail ‘Reckless’ Steel Capacity Growth (Update1)
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By Bloomberg News
July 22 (Bloomberg) — China, the world’s largest steel producing nation, should curtail “reckless investments” in the industry by withholding project approvals.
China’s demand for steel is about 500 million metric tons, less than the annual output capacity of 660 million tons, Zhu Hongren, spokesman for the Ministry of Industry & Information Technology, said at a conference in Beijing today. Zhu is reiterating figures given by the China Iron & Steel Association in February for last year.
Crude steel output in China rose to a record 266.6 million tons in the first half as the nation’s $586 billion stimulus package spurred demand from builders and carmakers. Annualized, this would beat the 460 million tons output forecast by the steel association for this year.
“The industry must produce according to market needs, and avoid adding to the excess capacity,” Zhu said. “They should avoid reckless investments. The government must also take action to curtail additional investments by companies that are already in excess.”
Has anybody calculated the carrying capacity of China to see if they could sustain such a mass migration to urban areas? I know that potable water and arable land is not plentiful there.
bomlat, whom posts here, has an interesting video linked on his blog.
http://bomlat.blogspot.com/2009/07/future-non-performng-loans-in-china.html
I agree completely with Guojun’s point.
I think it’s a rather lazy assertion (made above in different forms by both MPettis and Bob_in_MA) that we can look at urbanization patterns in the United States and the developed West as a proxy for how real estate prices should be moving in China. For a thousand and one different reasons, China’s urbanization story is significantly different.
Bob, I think if you look at the relevant statistics, you will find that American urbanization in the 1920s (even if you take into account foreign immigration) is probably an order of magnitude slower than Chinese urbanization so far in the 21st century.
I think if we look on the 3-5 year time frame, there will clearly be a large collection of NPL related to commercial real estate. For that matter, anyone visiting Haikou today can still find unfinished relics from the construction frenzy of the ’90s. But on a 10-year time frame, the vast majority of these “excesses” will be absorbed. I hope the more impulsive equity backers will be wiped out, but I think debt holders with a long enough time horizon will be made whole.
On the Youtube video linked above, asserting that Guangzhou is some how rife with vacant commercial real estate… I’ll just provide this link:
http://www.cbre.com.cn/china/eng/document/MarketReports/prc%20mv%20q1%2009%20eng_final.pdf
Page 6 for Guangzhou statistics. CBRE reports a 17.2% vacancy rate for “prime office” (class A/B) in the first quarter. That’s a large number, and easily translates into multiple skyscrapers. (How many skyscrapers are in Guangzhou’s CBD? Hundreds, certainly.)
But keep the number in perspective: southern California office vacancy rates have just broken 30%+, and are expected to climb further. And even during the boom years, it’s very rare to see single-digit vacancy rates. 17.2% vacancy rates are probably not profitable for the developers, but as a whole it is simply not catastrophic to lenders.
A few comments: First, the China Construction IPO today (how refreshing to see that a monster SOE can still jump ahead in the queue when the market is hot) seems like a pretty strong signal that new residential housing construction is encouraged. Intersting that they sold equity even when money is relatively cheap and available for such firms. Second, this is also a boon for land prices, as developers have access to loans and can buy new land, boosting revenues to local governments, another positive for bureaucrats. Third, building uses steel and other industrial output, and this puts cash in circulation, rather than leaving it in bank deposits by enterprises, which have ballooned. So all in all, this is a short-term good thing in the eyes of policy makers, and they don’t have a plan B for later in the year. If they don’t do this (even though I would agree that at the city-level there is too much sold-but-vacant developments out there, which is not that bad considering that the purchases are not heavily leveraged), then the risks of a debt-deflation trap rise. In order to keep prices from falling, demand for industrial output has to become real, and the property sector seems to be a good place to start. This also has to happen because the policy mix for stimulating household consumption is out of whack, as it was at the end of the last cycle – real rates on deposits have been rising as the CPI falls along with the wage share of GDP. A supply side capacity glut in important sectors is a huge impediment to reflation if necessary on the demand side as well, because it is negative for wages and employment. Long-term good real estate is a great bet as real exposure to the RMB, but given the structural features of the economy at present, encouraging a mini building boom seems but a short-term fix.
Interesting. After six years in China, and “owning” real estate in China, another discussion on “owning” property in China. What I fail to understand about the whole discussion is: nobody “owns” property in China, perse. Everything is under long-term lease; usually 60 years, with a 15-20 year turnaround to retain value on the sale.
Ultimately, every piece of property built will be torn down and rebuilt and resold again in, let’s say, 20 to 40 years. That makes for an interesting twist on comparisons to western real estate economics and owner-models so many seem to be comparing China to.
Also, once “leases” and building slow down to the point of affecting the economy, all one really has to do is introduce free-hold (ownership) and you kick start another long buying frenzy.
Comments welcome… (I’m hangin’ out over at Kaching.com)
to all those that think that china needs to build a new york every year for the next 40 years:
china’s definition of “urban” includes density of 2,500 per km2. in most of the western countries (e.g. US, Germany), 2,500 is a cutoff point for counting a settlement as “urban”. by that definition China would probably be 99% urban. a lot of the chinese “villages” are highly industrialized. the notion that china is very “un-urbanized” is being utilized by local officials like in this article to confiscate land from farmers and sell it to connected parties.
in addition, china now has more residential real estate floor space per capita than south korea, and per household almost same as japan. there’s no physical shortage of real estate in china.
Sorry to post just another link
“Rich China, Poor Peasants” looking at the dominance of state monopolies in China’s growth.
http://online.wsj.com/article/SB10001424052970203946904574301110723410346.html
this is blocked too in China, so whatever method you are using to get to Pettis, use it again here.
Great discussion, but I also have some trouble with the migration/real estate causal link. I have difficulty connecting the housing needs of recent migrants to urban areas with the sort of developments that are going up (high-end residential, luxury malls and so on). As che notes in the comment just above mine, it seems the “migration” meme is thrown about for more self-interested purposes (land grabs and sales). There is a difference between building housing for migrants and building a luxury residential compound that migrants live on during construction in a shack.
As has been discussed here several times already, if real estate is an investment hobby of the urban middle class then I don’t see how that will mesh well with accommodating massive inbound migration. Are recent rural arrivals really going to set up shop in a spankin’ new glass tower? It seems to me that migrants instead end up in peripheral urban villages despite all this new construction that is supposed to accommodate their arrival (well, at least according to some economists).
Real estate development in China is fascinating, but tossing off causality to rural-to-urban migration is too easy and superficial in my opinion. I think it is disingenuous to pretend this is somehow all being done for them.
But on that note, anyone have some information on the construction of low-cost housing? I know the Bejing gov’t had made that one of their priorities not too long ago, but haven’t seen/heard much of it since.
As for the vacancy rate, it seems as though this indicator requires some further clarification. You can determine the vacancy rate from two directions. 1) You can base your data on observed vacant buildings. 2) You can base your data on sales records, provided you’re able to access them.
Since method no. 2) is not easily feasible, I assume method no. 1) is also widely applied. However, we should note that method no. 1) can only be used for commercial real estate, as, in the context of residential real estate, many vacant apartments have actually been sold to rich politicians or business people for various purposes (capital preservation, spec, vacation residence, etc.). Hence, it would be wrong to regard such apartments as “vacant” and thus include them in the housing inventory. I’m sure the real(!) residential vacancy rate is much lower than the nominal one.
Joel, you are right. That is the reason why a Japanese style bubble in land values (in the Plaza Accord era)is unlikely to occur in China.
Che, higher population density is not equivalent to higher development. The key index should be per capita residential floor space, which is probably much lower in China compared to other industrialized nations. Therefore overproduction in residential buildings is less likely a problem in China at this stage.
I cover the commodity chemicals industry in Asia which supplies lots of the raw materials to construction etc.
The overseas producere are makig money while they can but scratching their heads as to why China is buying so much.
They keep asking where all the stuff they are selling is going – into chemicals inventories, into inventories of finished goods or as this excellent piec says, also perhaps into inventories of empty properties – http://www.icis.com/blogs/asian-chemical-connections/2009/07/where-have-all-the-flowerspoly.html
Thanks for some excellent stuff I’ve linked through to over the past few months.
Best Regards
John Richardson
Dragonbay: “…many vacant apartments have actually been sold to rich politicians or business people for various purposes (capital preservation, spec, vacation residence, etc.). Hence, it would be wrong to regard such apartments as “vacant” and thus include them in the housing inventory.”
That’s a rather interesting argument. You seem to be assuming that those buying an apartment for purposes of “capital preservation” have no intention of ever using that capital for anything else. Or at least will only sell to someone who will use it likewise. So, apartments in China are being priced at something completely removed from housing needs.
I don’t know if it was your intention, but you just made the best argument yet that China real estate is in an unsustainable bubble.
Discussions in China lead me to think that the property market is almost functioning as a shadow savings deposit. I’ve met several Chinese people who collect unused properties in the same way that others collect gold coins. As a reserve tradeable asset that they think is tangible and will thus hold its value. The validity of the last assumption should be more in doubt than it is, however.
Che:
“in addition, china now has more residential real estate floor space per capita than south korea, and per household almost same as japan. there’s no physical shortage of real estate in china.”
I’d love to see a source on this claim. It’s completely counter-intuitive to me, which doesn’t at all imply it’s wrong… it just means I’d like to better understand the background.
I agree with seatrus, re: population density being a poor metric for measuring “urbanization”. Perhaps we should use per-capita economic productivity as a measure… that’s the real implication of “urbanization” in China, not how densely people are packed together. In any case, Germany’s metric most definitely doesn’t apply.
On the issue of per capita real estate floor space… I just saw a statistic that in 1999, per capita real estate floor space for urban dwellers was 9.8m, while for rural dwellers was 24.4m. That was 10 years ago, but the point is, rural dwellers have *larger* housing.
So, if you take that into account.. I question whether you can use any sort of national average for per capita real estate for comparison purposes. For the vast majority of Chinese consumers, a “large” tile-covered, poorly insulated farmhouse in the countryside can not compare with a “small” urban apartment.
Hey Prof,
Some bullet points at the end of the article is just absurb,
You can’t increase domestic consumption if you’re buying real estate????Then why I buy house after house?At least house is your asset to pay for consumption.
Q: What else can the government do to promote the sector other than liquidity?” A: Not much. They can introduce more land at a cheaper price.
This answer also wrong.the last thing local governments want to see is a declining land auction price,for,obviously political reasons.
CCT, we have to be careful about dismissing overbuilding concerns on the basis of its having “worked” last time around. It often happens that insane behavior turns out not to lead to disaster, but that doesn’t mean that it won’t the next time. Remember that technically in finance when we argue that a project is excessively risky, that doesn’t mean that it must fail. That only means that it has a higher probability of excess returns or of failure, and that higher probability, even if it symmetrical, can lead to serious problems. So although crazy overbuilding might have paid off once before, that doesn’t make it less crazy. And if you agree with me about the US/China imbalance thesis, you might also argue that making a risky bet when the US economy was surging and US consumption growing even more quickly is a very different proposition when the reverse is happening.
By the way almost no one I know trusts the official vacancy rates. A friend of mine who works in the financial service industry in Shanghai took advantage of the recent total solar eclipse to do his own vacancy rate analysis. His message to me: “Today’s eclipse provided a perfect opportunity for keen-eyed observers on the ground to see how many floors of the International Financial Center (aka The Bottle Opener) are actually lit and ready for use: 25% at most. Hope that’s of use the next time you comment on speculative office building.”
David Pearson, I think Chinese policymakers are unlikely to take an inflationary path given the historical social problems that have always been associated with inflation, but there may be a bigger constraint. Japanese policymakers tried to ignite inflation in the early 1990s in order to solve their own consumption and collateral problems, but all they got was deflation. I am not completely certain, but it seems to me that the Chinese financial system, like the Japanese in the 1980s and 1990s, can only channel monetary expansion into creating capacity, not consumer demand, so creating inflation may not be as easy as we might think. I say that knowing full well that I have been inconsistent on the subject since I have always believed that inflation in 2007 and 2008 was monetary, and not caused by one-off food price increases. I need to think more closely about the relationship between monetary growth and credit growth, where I think the resolution of this inconsistency might lie.
Keith, data is always a problem. See my latest entry on college unemployment, for example. This makes all of our analysis more theory-based because we often need to make assumptions about what the data should say and then check to see if these assumptions are plausible.
Mike, there have been a lot of studies done on the “carrying capacity” and most of them make for gloomy reading. Water shortages in particular are a real problem and may reach crisis proportions in the next decade.
Moneyillusionist, I can’t comment on the validity of these arguments as applied to China, but in the late 1980s many economists also argued that infernally high real estate prices in Japan constrained consumption, in at least two ways. First, high prices fed through rents to force up retail prices, so that high real estate prices acted as a form of consumption tax. Second, high real estate prices forced future homebuyers into very heavy saving (and current home buyers into high mortgage payments) to pay down the deposits. I know as a former New York resident that New Yorkers tend pay a larger share of their total income for rent or mortgage payments than other Americans, so it is not inconceivable that high real estate prices can act as a tax that limits consumption.
Michael,
You’re certainly right about risk. But if an “unlikely” event has occurred in any model, that’s ground for carefully reassessing the model.
China’s success from 1995-2005 isn’t a guarantee that highly risky real estate investment will always be successful, but it does lean weight to the alternative model, which states there’s tremendous underlying demand (unique from what’s been observed in other countries) due to the on-going urbanization process. But yes, some caution is reasonable.
By the way, not sure what your friends observation about the IFC brings to the conversation. The IFC has just been topped off not long ago, and even the first tower isn’t projected to be finished + brought to market until 2010.
Prof Pettis,
But shouldn’t house rents be included in consumption?So one part of consumption up,other parts of consumption down,we still don’t conclude total consumption go down.
Anyway,normally housing boom is a bullish sign,so consumption normally would go up.
World economy is in shambles and China is not going to save the day. Your wonderful article shows how screwed up their state of affairs really is.
Why do the Chinese want to buy some much real estate? Because they see some people who became super rich doing this before, so they think this is a great way to become rich. Its much easier than working or investing in an enterprise.
I’d be curious to know how much is second homes or third homes.