The Christmas season, upcoming exams, student job hunting, and lots of visitors have made this a tough time to keep track of things but, before I go on to discuss the reason for the title of this entry, I wanted to make a quick comment on the economic numbers that came out last week.  As expected all the economic data points in the same direction as in the past three months.  If you are an optimist, you take great comfort in the fact that the data seems to be pointing towards continued growth in most indicators.  Industrial production was strong and lending for November was way down from previous months.

If you are a pessimist you worry again that the rapid growth has clearly been fueled by little more than massive credit and investment expansion, and you note that although at RMB 295 billion, net new lending in November is much lower than the 890 billion monthly average for 2009 (and even lower than RMB 477 billion net new lending in November, 2008 – the first time this year any month in 2008 exceeded the same month in 2009), it nonetheless brings the 2009 year to date total to an astonishing RMB 9.2 trillion.  The market consensus is that next year’s lending will total RMB 7 trillion, which is being presented as a gentle tightening of credit conditions.

Since 2008’s net new lending was RMB 4.9 trillion, I would suggest that in any other year RMB 7 trillion would have been considered an extraordinary expansion in lending.  After a year in which net new lending will probably come close to RMB 10 trillion, we would probably need something much lower even to pretend that loan growth next year will be prudent.  Also bear in mind that gossip among bankers suggests that in the rush to grab funding when it was freely available, a significant fraction of 2009 lending is still sitting as unused deposits, to be used next year for current investment projects, so that in terms of real new lending, a part of 2009’s net new loan figures really belong in 2010.  This means that it is very possible that if there really are “only” RMB 7 trillion in net new lending next year, real credit expansion next year will be equal to or even greater than this year.

The other thing to bear in mind is that the RMB 7 trillion that the market expects is not carved in stone.  As I wrote last year in my “All but the Kitchen Sink” entry, Beijing will do whatever it can to generate whatever growth rate it deems necessary, and Beijing can get any growth rate it chooses to get as long at its borrowing capacity is credible.

Next year we will almost certainly see growth of over 8%, and the total amount of new lending will be determined by whatever credit expansion Beijing requires to get there.  This means that the external environment, the increase in trade tensions (the recent “Buy Chinese” provisions announced for government procurement will almost certainly make things worse), and the impact of inventory build-up, among other things, are going to determine what amount of domestic credit expansion we will need.  Since no one can accurately predict any of those things, it is pointless to predict loan growth next year.  One thing that will almost certainly happen, as my friend Logan Wright told me yesterday, is that banks will rush to lend early in the year, so we should be prepared for shocking new loan numbers in the first quarter which will moderate quickly over the rest of the year.

Pessimists looking at the recent economic data would also note the very high investment rates and worry about the cost to future consumption of misallocated investment.  They would hear the continued, and louder, worry about lending at the PBoC and CBRC.  On Tuesday for example both the PBoC and the BoC warned again about credit quality and loan growth, covered in front page reports in the People’s Daily.  Since a rise in inflation will create a real difficult problem for monetary policy, pessimists will also wonder whether or not it is time to start worrying about inflation (I think it is too early, although my students are telling me that their parents are complaining about rice prices).  According to an article in Friday’s Financial Times:

A series of data published on Friday indicated that the rebound remained firmly on track, with industrial production and imports both increasing well in advance of forecasts. One of the main risks to face the economy is a surge in inflation as a result of the massive monetary and fiscal stimulus measures introduced this year.

Consumer prices rose 0.6 per cent last month from a year ago, after falling 0.5 per cent the month before, while prices at the factory gate fell 2.1 per cent last month compared with a 5.8 per cent decline the month before.

Several economists argued that the shift back to inflation was caused specifically by rising food costs, as well as by some rises in energy prices, rather than as a result of the money supply increasing at an annual rate of nearly 30 per cent.

However, the return of even modest inflation will feed into the intense discussion in Beijing about how quickly to ease stimulus measures and whether to abandon a de facto peg against the US dollar and to allow the renminbi to appreciate.

So to summarize, as I have for the last three series on monthly economic data, the numbers will do nothing to resolve the debate within China.  Optimists and pessimists both have more grist for their mills.

Turning away from the recent data, I wanted briefly to discuss urban migration in China.  For a lot of analysts, it seems that the phrase “urban migration” is the correct response to many of the problems you might identify with China’s growth model.  Is there a real estate bubble?  No there isn’t because urban migration will create a near infinite future demand for residential and commercial real estate.  Does China under consume?  Yes but urban migration will raise consumption rates.

This latter claim was highlighted in a Tuesday article in the South China Morning Post, which claims that “President Hu Jintao’s pledge yesterday to spur urbanisation and domestic demand next year has been seen as an attempt to tackle the growing problem of industrial overcapacity.”  The article goes on to say:

Announcing the development strategies at the end of the annual three-day central economic work conference, Hu said the government would focus on urging the rural population to work and live in small and medium-sized urban cities while boosting further the spending power of workers and low-income groups.

At the same time, he ordered that new investment in industries with excess capacity be reined in and the problem of underutilised plants be addressed.  The moves signalled domestic demand had left much to be desired, as the latest statistics showed 21 out of 24 industries incurred excess capacity in the third quarter, compared with 19 in the first quarter, said Zhang Tao, a researcher at the Chinese Academy of Social Sciences.

“The latest data tells us that overcapacity is not only a problem for several industries but across the industries,” said Zhang, who cited a 2010 economic development blueprint backing Hu’s strategies. “It also shows weak domestic demand.”

There is a surface plausibility to these claims about the benefits of urbanization, but they need to be considered much more carefully than they sometimes are.  First, as far as urbanization and consumption go, what China needs, as I argued in last weeks’s posting, is not so much more consumption but rather, as Zhang Tao implicitly points out in the article above, to close the gap between the amount if produces and the amount it consumes.

It is almost certainly true that as migrants move from the rural areas to the cities, their average consumption is likely to rise, but the key here is their net impact, not their total impact.  So if rural migrants move to the city and become engaged in expanding infrastructure or manufactured products – after all they need to earn an income before they can start consuming – they are not necessarily resolving the domestic imbalance.  They may actually be exacerbating it.  If however they migrate to the cities and take jobs in the service sector, then they have a positive net impact.

In that case it is not urban migration per se that matters but rather the strucutre of Chinese economic growth.  If it continues to be capital intensive, and to favor manufacturers and real estate developers at the expense of service industries, then urban migration is not really part of the rebalancing solution.  We would still be stuck with the same old problem – a growth model that favors overinvestment at the expense of household income, and that leads inexorably, in my opinion, to the very imbalances that China is trying to resolve.

After all, during the past decade there has been substantial urban migration in China, and yet the imbalance became worse, not better.  Why?  Because for whatever structural reason, urban migration has favored faster growth in the production of tradable goods than in their consumption.  Until this structural reason (or reasons) changes, urban migration won’t resolve the problem – unless of course in some way greater urban migration itself forces the structural change.

The other claim, that urban migration prevents the possibility of the existence of a real estate bubble, is more pervasive and, to my mind, even harder to justify.  First, I should point out that although I believe we are in bubble territory in both the stock and real estate markets, and clearly policymakers are increasingly concerned that we may be, I am less concerned than others about the economic impact of the bursting of the bubble.  I am much more worried about overinvestment in infrastructure and manufacturing.

Last week (sorry, but I lost the article) I read that the head of one of Beijing’s and China’s largest real estate developers (Vance, I think I remember) publicly warned that we are in the midst of a property bubble, making it the second time in the past month that the CEO of one of China’s biggest real estate developers has made the claim.  He may be right, and of course the muted warnings by the PBoC that we are in the midst of a stock market bubble may also be correct, but to me the wealth effect of collapses in the two markets are not large enough really to matter.  The wealth effect isn’t likely to be big enough to affect consumption.  Not only are these markets relatively small as a share of Chinese savings, but ownership is heavily concentrated among the relatively richer.

The main way a fall in real estate prices would hurt China, in my opinion, is if it causes a sharp drop in real estate development and, with it, a sharp drop in employment and the business activities of industries that feed the real estate sector.  I suspect however that if we were to see a drop in real estate prices, the decline in activity would be much less than expected because banks and the government would continue actively supporting real estate development projects as long as they had the credibility to do so.  This is not an economy where price signals always decide business strategy.

But to get back to urbanization and real estate overcapacity, the logic is that because we can expect 200 million, 300 million, 400 million or whatever number of people moving to cities in the next several years (any number is plausible as long as it is large), then by simple math it becomes obvious that there cannot be overcapacity in real estate.  We need new buildings to accommodate all those new people.

But this argument, or some form of it, has been used to justify nearly every period of overbuilding in modern history.  After all there was huge urban migration in the US in the 1920s, which was used to justify soaring real estate prices in the major American cities, but after 1929-31 real estate prices nonetheless crashed and apartments and offices when begging for tenants – even though urban migration continued for decades.  Another example: I grew up in Malaga, in southern Spain, which has been since the late 1990s and until last year experiencing an out-of-control boom in real estate development and land prices.  For years I had been telling my friends there in real estate (and nearly all my friends were in real estate – itself a very worrying sign) that prices were not sustainable.

But whenever I said this, they would immediately pull out the charts showing the inexorable rise in the number of aging Europeans, point out that all these old people wanted to retire in sunny communities along the Mediterranean, and that all the beaches in southern Europe simply could not accommodate a fraction of the expected retires.  Conclusion?  As long as the sun continues to favor southern Spain, real estate prices could not ever stop going up.  The inexorable pace of migration justified rising prices.

Needless to say the sun is still shining over sunny Malaga, but real estate prices have nonetheless dropped sharply and sales of BMWs and Mercedes (the favorite cars, it seems, for successful real estate agents) have collapsed.  The old people are still retiring, but new apartments are proving impossible to sell.

Massive expected migration, in other words, is not only perfectly compatible with overbuilding and real estate collapses, it may even be a prerequisite.  Bubbles need a plausible-sounding story that allows people to throw caution to the winds, and near-infinite inward migration is one such story.

The problem of course is that even if the migration projections are true, they are long-term projections and they cannot possibly tell us much about either how many people are coming in next year and how much money they will have to spend.  Worse, the migration itself is highly pro-cyclical – overbuilding to satisfy future migration encourages current migration, and more generally more people come when there are more jobs, and fewer when there are less.  The migration pattern can become very irregular and, more importantly, it tends to exacerbate current trends.  For the financial historians reading this, it is the pro-cyclicality of the process that is the grimmest warning signal.

I am not suggesting, of course, that expected urban migration is not important and will not radically change a number of Chinese parameters.  But I will insist that urban migration is not at all incompatible with continued overinvestment, underconsumption, and overbuilding.  In fact these things have gone hand in hand many times before.

Although I am often surprised by how eagerly foreign commentators have embraced the Chinese fiscal stimulus story and see it as a great, shining success, I am happy to say, mercifully, that in China there is a lot more skepticism.  There seems to be a serious debate among Chinese policymakers over the stimulus package.   

The debate lists, on one side, people centered on the PBoC, the CBRC and the National Bureau of Statistics, who are worried that the stimulus may be exacerbating Chinese imbalances.  On the other side are people in the State Council, the Ministry of Commerce and in the provincial and municipal leadership who are more worried that any half-heartedness will lead to a significant rise in unemployment.   

In the past week or so the former, with whom I am of course in complete sympathy, seem to have become increasingly worried and have been making a lot of noise.  The formidable Hu Shilu, editor of Caijing, (and by the way Evan Osmos wrote a very interesting article about her in the current New Yorker) recently made a strong case against continuation of the current fiscal program when she wrote in an editorial this week that “a policy that encourages loose lending and investment is driving China’s economic engine down an old, unsustainable path.” 

Various signals suggested China’s economy had returned to a stable track by the end of the second quarter, giving us an opportunity to reassess macroeconomic policy.  Data released by the National Bureau of Statistics showed that China’s GDP rose 7.1 percent in the first half of the year, and 7.9 percent in the second quarter alone. Apparently, China’s economy has bottomed out. 

Arduous efforts contributed to this upward trend. External developments have had a much more serious impact on China’s economy recently than during the Asian Financial Crisis a decade ago. However, first half growth was only a bit below the level recorded in 1998. And although heavily dependant on exports, China may yet achieve its 2009 growth target of 8 percent, even while other major export countries report contractions. 

These achievements could intoxicate Chinese policymakers. But we see no miracles here. In fact, economic growth recovery in China is being driven by investment. Some 6.2 percent of the country’s first half GDP growth rate can be credited to investment, while consumption accounted for 3.8 percent. The net export business contributed a minus 2.9 percent to the growth rate figure. 

Hu makes the point that the “surprisingly high” Chinese growth is neither surprising nor cause for celebration.  It is the automatic outcome of a huge stimulus, and the real question, as I have argued many times, is not whether high current growth indicates that China has turned the corner on the crisis (it most certainly has not, in my opinion), but whether the cost of achieving this growth is excessive and will lead to more difficult conditions in the future. 

It’s long been acknowledged that China’s traditional methods of achieving economic growth cannot be sustained. However, we are now racing down this traditional path of economic development.  

Dramatic increases in the currency supply and lending have been backing this investment, the single most important engine of economic growth. M2 increased 28.5 percent and yuan-based lending rose 34.4 percent in the first half, setting new records for each. But nominal GDP growth was only 3.8 percent during the first six months of 2009. And these astronomical increases in currency and lending are a double-edged sword that can support GDP growth as well as endanger the economy. 

…It’s high time we re-emphasize the actual policy of moderation. A moderately loose monetary policy is necessary for an unpredictable, downward-sloping economy. However, monetary policy that’s too loose will have more drawbacks than merits once an economy levels out. It’s only a matter of time before loose monetary policy leads to inflation and asset bubbles. 

She concludes, very diplomatically I think: 

In the current economic environment, the more quickly China’s economy grows, the greater the effort needed to adjust future methods of economic development. Now is the right time to consider the timing of exit from stimulus. The third quarter can be a crucial juncture. 

She is not alone in criticizing the stimulus.  Another formidable lady, Wu Xiaoling, former People’s Bank of China vice governor, was interviewed by National Business Daily on Wednesday, and warned that the combination of excess capacity and excessively loose monetary policy was leading to asset bubbles.  According to an article in yesterday’s South China Morning Post, 

“Under conditions of overcapacity, excess money supply will not lead to rises in price indexes, but it could generate asset bubbles,” she said at a forum in comments reported by the Chinese-language National Business Daily.  ”The money has really gone out and if it is a time when there is no investment in the real economy and no one will put the money in banks to earn interest, then the funds will flow into the property market and stock market,” she said.  

China’s central bank may have to raise banks’ reserve requirements to mop up excess liquidity, she said, adding that this was simply a tool for managing the money supply and should not be misunderstood as monetary tightening. 

…Ms Wu said that China faced a dilemma in easing the rate of loan growth. Inflationary pressures would arise if lending continued at the same pace, but without sustained lending, many big projects may wind up unfinished because they are contingent on longer-term financing.” 

Although an increasingly large number of Chinese academics and think tank researchers have been raising warning cries, I think she is the first official or ex-official to go so public with her worries.  That doesn’t mean other public officials don’t act as if they are worried.  The CBRC for example announced this week the good news that the NPL ratio declined from 2.42% at the end of 2008 to 1.77% at the end of June.   

Part of this reflected an actual decline in NPLs, and most of it of course reflects the surge in new loans, but the CBRC is not acting complacent.  They have reinforced credit control policies on second-home purchases and their spokesman insisted earlier this week that there would be “strict enforcement” of the CBRC’s mortgage lending policy.  

According to another article in Caijing, “the authorities have consistently been encouraging banks to raise their loan-loss coverage, reflecting fears that the massive surge in new credit extended in the first half may lead to a rise in bad loans.”  The South China Morning Post had this to say on that subject: 

Beijing has required banks to raise their bad-loan reserve ratio to 150 per cent at the end of the year, forcing the lenders to set aside an additional 70billion yuan ($79HK.4 billion) as provision amid deteriorating asset quality, a fresh sign of China’s mounting worries about a backlash from its stimulus package.  

Liu Mingkang, the chairman of the China Banking Regulatory Commission, told a government working conference over the weekend that all mainland-based banks including local units of foreign giants such as Citigroup  and HSBC Holdings must boost their reserve ratio to 150 per cent, as risks were increasing amid a torrent of imprudent loans in this year’s first half.  

“Rapid growth in banking loans has led to accumulated risks,” Mr Liu was quoted in a CBRC statement as saying. “Reckless operations of banks were seen as some banks rushed to extend loans without due diligence.” 

The article goes on to quote She Minhua, a banking analyst at China Jianyin Investment Securities as saying “The requirement is basically a message that asset quality deterioration is deepening.  A serious problem will probably surface in 2010.” 

And Zhu Hongren, spokesman for the Ministry of Industry & Information Technology, said earlier this week that China, the world’s largest steel producing nation, should curtail “reckless investments” in the industry by withholding project approvals.  According to an article in Bloomberg: 

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.”  

Even Justin Lin, the World Bank’s chief economist, and someone who has been more of a cheerleader for China’s economic model than a critic, made a statement that suggests to me an indirect criticism of the fiscal stimulus package, although he (and others) may disagree with my interpretation.  According to a July 15 article in the Telegraph:  

But for all the warnings I don’t want to exaggerate my account of rising skepticism among Chinese economists and regulators.  In spite of possible back-door attempts by the PBoC and the CBRC to manage the excesses associated with the fiscal stimulus, it is pretty clear I think that policy is still being managed largely by policymakers who are far more worried about rising unemployment in the short term than about asset bubbles and an exacerbation of the unbalanced development model. 

The front page of today’s People’s Daily, for example, makes this clear.  They cite Finance Minister Xie Xuren’s insistence that “China will stick to proactive fiscal policy in the second half.”  According to the article, which is also carried in Xinhua: 

China will continue its proactive policy and reform its economic structure in the second half of this year to boost economic growth, Finance Minister Xie Xuren said Thursday.  Xie told local financial bureaus at a conference in Beijing on Thursday that the proactive policies, which included increased investment from government, tax cuts and subsidies to low income families, had taken effect in stimulating a recovery of the national economy. 

Xinhua today also prominently cites Peking University professor Li Yining as saying that “China should stick to its proactive fiscal policy and moderately easy monetary policy to fuel the economic growth as the foundation for recovery is not solid yet.”  I was not at the conference, so I wonder if professor Li’s comments were spun a little, because according to the Xinhua article he also said that “the current economic advance was pushed by investment, which was not the final demand – stable economic recovery should be sustained by increased consumption,” and warned that Chinese banks should “improve credit quality and structure.” 

So for all the rising skepticism among policymakers and scholars I think there is little doubt that we are going to see still more fiscal stimulus along the lines we have already seen.  If there is indeed global excess capacity, as Justin Lin says there is, I cannot see how an investment-driven program to increase capacity, and one which is almost certain to involve a huge additional misallocation of capital (after all, 8% growth given the sheer size of the fiscal and banking stimulus is actually a disappointingly low level of growth), can be much more than a short-term stop gap.  On the contrary, I think it will make the medium term adjustment even more difficult. 

On that note I want to recommend Victor Shih’s excellent OpEd piece in the Wall Street Journal – Asia yesterday.  He argues that: 

Should this pace of credit expansion continue for the remainder of the year, China may well face a difficult trade-off down the road. The economy is unlikely to face a financial crisis because most of the debt is owed to domestic investors and depositors and China can still prevent large-scale capital flight. However, if inflation spikes next year, the central government will have to choose between shutting off credit, which will reveal a massive nonperforming loan problem currently obscured by a torrent of new loans, or an unprecedented level of inflation. High inflation is destabilizing, as it has caused major runs on the banks before. If additional credit expansion in the face of rising inflation is not an option, the greater the extent to which lending is uncontrolled at the moment, the bigger a nonperforming loan problem the central government will face in the future. 

An often overlooked ingredient to China’s success story is that generations of top-level central technocrats like Chen Yun, Yao Yilin and Zhu Rongji time and again used their political influence to constrain local investment bubbles, thus forestalling high inflation and major financial crises. Past retrenchment campaigns were unpopular and controversial, but senior technocrats nonetheless maneuvered to stop uncontrolled local investment. As credit continues to rocket toward the stratosphere, China is in increasing need of such leadership again. 

Before closing this long post I want to add three additional comments.  The first involves a conversation I had with one of my Tsinghua students who graduated in 2003 and now works as a currency trader.  Last year he bought a few apartments in Chengdu, the capital of Sichuan, his home province, for speculative purposes, and in spite of surging land prices he seemed to think it was a terrible trade.   

I asked him why, and he said that although real estate prices had gone up dramatically since he bought the apartments, and he needed the money back, he nonetheless found himself unable to sell the apartments.  That’s a little weird, I thought.  Rising prices should mean eager buyers, but he can’t get anyone to take the apartments off him?   

Has any other of my blog readers experienced anything similar?  Of course the historian in me remembers that during the final two years of the Japanese bubble, when land prices soared to levels never before seen in history, there were complaints by sellers that transaction volume was so thin that they couldn’t actually sell their land. 

My second comment concerns university unemployment.  I have been writing for three years that unemployment among college graduates in China was soaring, and that authorities were understandably nervous.  So nervous, it seems, that they have been putting pressure on university to do more to get jobs for their graduates by limiting their next-year enrollment to the number of graduates this year with jobs. 

There are, of course, two ways to improve statistics.  One way is to improve the underlying reality.  The second way is just to fake the numbers.  According to a Tuesday article in the People’s Daily:  

I had no idea that I already had a job,” the student, who had been hunting for work, wrote anonymously on a website.  In order to ensure a high employment rate and deliver a satisfactory work report during the global financial crisis, some Chinese universities have been faking work contracts or employment agreement for graduates, Southern Metropolis Daily reported yesterday.  

This kind of thing will mean that the college employment numbers, a very useful figure for understanding the effect of economic growth in China, are now much less useful.  Already the People’s Daily article cites differences between the Ministry of Education numbers and a private firm’s numbers. 

The Ministry of Education said that nearly two thirds of them [2009 college graduates] had already secured jobs before graduation in early July.  But this figure differs widely with an employment report from an independent consulting firm on higher education.  A report from MyCOS HR Digital Information Co said 58 percent of prospective graduates had not signed job contracts by the end of June and that 2 percent had contracts cancelled. 

By the way the article has an interesting graph on the number of college graduates over the past eight years, for those who are interested.  The total number of university graduates has surged from 1.45 million in 2002 to 5.59 million in 2008 and 6.10 million this year.  The intervening years saw 2.12, 2.80, 3.38, 4.13, and 4.95 million graduates. 

My third comment is about the great article in today’s Wall Street Journal on the explosive development of the Beijing music scene, a subject that all my friends know is one dear to my heart.  Anyone who is interested in knowing more about this scene should read it. 

Tags: Steundent employment, Victor Shih

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.

 

Tags: Notes

I am still working on my piece on the global savings adjustment and will probably post it in the next week or so. The main point is to discuss what the implications are for China if we see simultaneously over the next few years an increase in US savings and a reduction in global investment. For today I wanted to discuss some of the economic data coming out of China as well as a couple of debt-related issues.

US debt and the dollar

But first, a quick digression. Today’s Financial Times has an article titled “Fears over US sovereign debts unfounded” which, as the title implies, argues that “Fears of a crisis of confidence in the US sovereign debt market – and a subsequent dollar collapse – are unfounded.” On a related note Bloomberg has an article today which notes that “Russian Finance Minister Alexei Kudrin said the dollar is in ‘good shape,’ further affirming that there’s no substitute for the world’s reserve currency.”

It’s great that commentators are coming back, however temporarily, to a sense of reality and common sense. There never was likely to be a crisis in the ability of the US government to fund its deficits, and all the pleading to foreign governments to continue purchasing dollar assets was based on very fundamental misunderstandings of both the form of the global adjustment and the functioning of the global balance of payments. For the former, the problem we are facing is that as Asian savings soared over the past decade, they were accompanied by a collapse in US savings. This is not a coincidence. An increase in savings in one part of the world requires a reduction in another, and causality can work either way, so please dear readers spare me the whose-fault-is-it outrage – it is not relevant here. The point is that without a marked increase in global investment, one requires the other.

The collapse in US savings was unsustainable, and it is now reversing. This creates a problem of excess global savings, which means financing deficits for creditworthy governments is not going to be a problem and will not result in soaring real interest rates. In fact Paul Krugman has a brief piece, based on numbers from Brad Setser, that shows the explosive rise in US government debt is more than matched by the contraction in household debt.

This is just another way of saying the same thing. Of course I will add my by-now-tiresome point that we do not have to worry about discretionary decisions by foreign governments as to whether or not they will continue financing the US fiscal deficit. Foreigners do not finance fiscal deficits. They finance current account deficits, and one (the current account deficit) cannot occur without the other (the financing). As long as the US runs trade deficits with China (or Russia or anyone else), those deficits will be financed, and the only thing that will stop that is a contraction in the US trade deficit, which is actually expansionary for the US economy and will reduce the need for fiscal expansion.

Remember, the US can force foreigners to invest $2 trillion a year in the US by the simple expedient of running a $2 trillion annual trade deficit. But this cannot possibly be a good thing. If we want the trade deficit to go down, we must also want foreign financing of the US to go down by exactly the same amount. This is not high-falutin’ economic theory, it is rather an arithmetical necessity. (By the way I tried to explain something related this Saturday when, on CCTV9’s Dialogue, two points were made – that the contraction in the US trade deficit was causing great pain in China, and that Chinese officials were warning the US government sharply to reduce its fiscal borrowing. China cannot ask both that the US slowdown its contraction in consumption and that the US government slowdown its fiscal expansion. It is precisely the growth of the US fiscal deficit that will cause a slowdown in the contraction of US net consumption.)

The second point, that the dollar is still in “good shape” as the world’s dominant reserve currency, should be obvious. I have not gotten around to writing why all these spectacular (or spectacularly reported) moves by China and others to “undermine” the reserve status of the dollar – announcements by Putin, currency swap arrangements between China and a host of countries desperate for cash, the announcement by a major Chinese banks that it will make the RMB available for international transactions, and so on – are all of almost no consequence except to the paranoid. At some point I will write more about it.

Debt and risky debt structures are rising

Let me turn to debt. Last week Andrew Batson had a very interesting, and very important, I think, article in The Wall Street Journal, discussing the impact of the stimulus on the government’s real debt position. “The cost of China’s stimulus program,” he writes, “is turning out to be much larger than official figures indicate, raising the stakes for the government’s attempt to restart high growth through massive borrowing.” He points out that a lot of the spending is being funded by provincial and municipal borrowings and by corporate borrowings, “virtually all of which are indirectly backed by local governments.”

He concludes: “As the central government is ultimately liable for those hidden debts, China’s total state debt is closer to 35% of GDP than the 18% shown by official figures.” In fact I have always argued that other not-yet-recognized liabilities, such as hidden municipal and government debt, the bankrupt AMCs, and other non-recognized debt, probably means that real government debt levels are higher than the official numbers by at least 15-25% of GDP, which suggests that, correctly counted, government debt levels may now be approaching 50-70% of GDP. If we throw in the possibility that the current bank-lending spree is also likely directly or indirectly to add to government debt burdens in the future (contingently, through a rise in NPLs), I would not be surprised if policy-makers are already starting to consider the possibility of a debt problem at the central government level. I am not saying that this must happen, but only that it is easy to construct some fairly plausible scenarios, involving the continuing global adjustment and the concomitant Chinese adjustment, that can easily suggest a debt problem.

My concerns of course were not made more palatable after I saw a very interesting article in last week’s Caijing (and what other magazine would have reported this?), with the unsettling subtitle “The property market bubble burst last year, but developers are still afloat thanks to governments, banks and a ’subprime’ solution.”

The article notes how unlikely it is that the massive contraction and the difficulties in last year’s property market were not accompanied by high-profile failures among property developers. This is because, they explain, “local governments and banks have intervened to prop up Chinese property developers following last year’s sharp contraction in the real estate market,” and they show how this has happened.

Focusing on the case of Greentown China Holding Ltd, a large property developer that nearly went bust, they write:

Greentown faltered in the fourth quarter 2008 and stood on the brink of liquidation early this year. But it survived after a bank agreed to refinance foreign debt and a local government approved a grace period for land payments. Moreover, trust funds that use what at least one expert called a “subprime” scheme offered flexible financing for development projects.

Shou said his company has dodged the crisis. But he admitted that pulling through 2008 was extremely difficult. Indeed, Greentown saw a 10 billion yuan gap between its 2008 sales target and actual results. And debt payments loom for 2009.

The article’s authors, Zhang Yingguang and Gong Jing, go on to draw the unwelcome conclusions:

Industry executives think similar, short-term rescues for major property developers have occurred more frequently in recent months than generally acknowledged. For evidence, they point to the absence of high-profile failures in the industry.

This suggests that there are a lot of very dodgy debt deals out there that are based on nothing more than hopes and prayers. This doesn’t imply, of course, that all these deals will go bad. What I am worried about is something a little different – the highly pro-cyclical nature of these deals. If China recovers, these deals will probably do fine and will be repaid, and so will never show up as contingent debt, but if economic conditions deteriorate of course that is precisely when they will go bad.

And of course that is precisely when we most desperately don’t want them to go bad. Throughout history credit bubbles always end up, in their later stages, with these kinds of highly pro-cyclical structures (read about investment trusts in the 1920s for example, or the Japanese real estate and lending markets in the 1980s, or, in case you’ve already forgotten, the sub-prime market not so long ago). As long as economic conditions and liquidity-driven asset prices continue to improve, these highly unstable structures survive and prosper, but just when you most desperately want to avoid their breakdown, when conditions turn nasty, they come crashing down on you. These kinds of structures are what I call in my book (The Volatility Machine) highly “inverted” structures and they systematically increase volatility by reinforcing both good times and bad times.

Recent economic data

Finally, as everyone knows by now, a number of economic indicators were released last week, some good some bad. Some of the good news, according to an article in the South China Morning Post, was:

The National Bureau of Statistics said in Beijing that annual industrial output growth rebounded to 8.9 per cent in May from 7.3 per cent in April, outpacing a median forecast of 7.5 per cent. Annual growth in retail sales rose to 15.2 per cent in May from 14.8 per cent in April, slightly ahead of forecasts, partly due to a moderate pace of deflation.

For all of last year, retail sales were up 21.6 percent. Together, the two read-outs suggested a 4 trillion yuan (HK$4.5 trillion) government stimulus plan, allied with consumer spending, is starting to overcome weak global demand for the exports that powered the country’s breakneck growth in recent years.

Accompanied by the rise in US retail sales, this indicated to many that the Chinese stimulus package is working and that the global and Chinese economies may have bottomed out. In the author’s words, “A growing conviction that the global economy is starting to claw its way out of the deepest recession in six decades has seen stock markets rallying strongly from the depths plumbed in March, while hopes of burgeoning demand have driven prices of oil and industrial metals to multi-month highs.”

The next bit of good news was mainland investment levels. According to another article in the same paper:

Mainland investment surged in May on the back of government pump-priming and a recovery in the property sector, providing fresh evidence that the world’s third-largest economy is leading others on the path to recovery.

Investment in urban areas in fixed assets such as apartment buildings and roads rose 32.9 per cent in the first five months from a year earlier, compared with a 30.5 per cent rise in the first four months, t he National Bureau of Statistics said on Thursday.

Economists said that translated into a 40 per cent leap in May alone. Adjusted for inflation, the increase was even greater because mainland prices have been falling for several months.

Actually I think this is not good news at all. To me it indicates nothing more than that if you pump enough money into investment, investment will rise. A much more important question, and one of course not addressed by the data, is whether pumping money into investment is the best way to force the necessary adjustments in the Chinese economy, and whether this does not represent a ‘doubling up” of china’s bet on the global recovery. That is something only time will tell, and I have written about this enough times elsewhere to leave it at that.

The bad news is that, according to a release today by the Ministry of Commerce, foreign direct investment in the mainland dropped 17.8% year-on-year in May for the eighth straight monthly fall. Honestly I don’t think this is such a big deal except to the extent that it gives us a “businessman’s” view of economic prospects in China that is very different from the economic-recovery view so popular in the Chinese (and foreign) press, although of course it may simply reflect the desire abroad for cutting exposure and cutting capacity.

Much more interesting to me is the trade data. According to an article in Thursday’s People’s Daily:

China’s exports and imports shrank for the seventh month in row in May, the General Administration of Customs said on Thursday. Exports fell 26.4 percent in May from the same period a year ago to 88.758 billion U.S. dollars. Imports were down 25.2 percent to 75.36 billion U.S. dollars. The trade surplus was 13.39 billion U.S. dollars.

The decline in exports and imports in May were worse than the 22.6% fall in April’s exports and the 23.0% drop in April’s imports, although Goldman claims that the decline is more or less flat if measured on a seasonally-adjusted basis.

April’s and May’s trade surpluses ($13.1 and $13.4 billion) were substantially below the equivalent numbers last year ($16.7 and $20.2 billion), so from that point of view we can argue that China is finally starting to reduce the negative net demand it provides to the world. Two caveats are in order, however. First, for the first five months of the year, China’s trade surplus is still up more than 13% compared to last year – $89.1 billion in 2009 versus $78.6 billion in 2008.

Second, imports would have fallen much faster except for the surge in commodity imports. Jamil Anderlini at the Financial Times gives one, benign, explanation for the surge:

Chinese import volumes of many commodities and natural resources surged in May, indicating a rebound in infrastructure building. That supported figures on Thursday showing fixed-asset investment was 32.9 per cent higher in the first five months of the year, compared with the same period in 2008, an implied rise of 38.7 per cent in May alone from a year earlier.

Keith Bradsher, in an article in Wednesday’s New York Times gives possibly a very different explanation:

Strong buying by China has helped lift commodity prices around the world this spring, but growing evidence suggests that a sizable portion of this buying has been to build stockpiles in China, and may not be sustainable.

At least 90 large freighters full of iron ore are idling off Chinese ports, where they face waits of up to two weeks to unload because port storage operations are overflowing, chief executives of shipping companies said in interviews this week. Yet actual steel production from that iron ore is recovering much more slowly in China, and Chinese steel exports remain weak.

Commodities and shipping executives describe Chinese stockpiling in recent months of a range of other commodities as well, including aluminum, copper, nickel, tin, zinc, canola and soybeans. Starting in April, China began stockpiling significant quantities of crude oil.

There have been rumors and some evidence of stockpiling for months, and if this is the case, and of course if the stockpiling is not sustainable, then the import numbers are likely to have been artificially boosted. Real demand by China for foreign goods will have actually been much lower.

Of course all of this has a trade impact. Regular readers don’t need me to rehash the arguments. Suffice it to say that the Chinese fiscal stimulus, rather than an adjustment to the new economic realities, in my opinion, is still based on boosting production and investment and constraining consumption, in spite of statements to the contrary (for example today’s People’s Daily has another front page article in which Premier Wen “stressed the importance of promoting domestic consumption”).

Unless the world recovers rapidly and sustainably and, more importantly, US consumers return to the heady days of financing their consumption by binge borrowing, we are going to need to see a greater trade adjustment in China. Trade tensions are not improving. Last week I had dinner with a very senior China manager at a large German company and he told me expected anti-dumping suits to surge in the first quarter of next year. As if to beat him to the punch yesterday’s Financial Times came up with this story (“China accused of predatory pricing practices”):

India’s small and medium enterprises have warned that they are suffering because of cheap imports from China. They are urging New Delhi to accelerate anti-dumping investigations and impose tougher safety and quality checks on Chinese products.

The appeal for greater government protection came amid rising tensions between New Delhi and Beijing over trade, after a high-profile dispute over an Indian ban on Chinese made toys. India’s Federation of Chambers of Commerce and Industry said on Sunday that a survey of 110 small and medium-sized manufacturers found that about two-thirds had suffered a serious erosion of their Indian market share over the past year, because of cheaper Chinese products.

In its statement, FICCI said the Chinese imports were between 10 and 70 per cent cheaper than comparable Indian products, a price differential that it said was “huge and difficult to explain”. Amit Mitra, the FICCI’s secretary-general, said Indian industries were being hurt by “typical Chinese predatory pricing” intended to drive rivals out of business so that Chinese companies could capture the market – and then raise prices to more normal levels. The bite was felt by companies in a range of sectors, including processed food, light engineering, building materials and heavy engineering, chemicals and textiles, FICCI said.

The fact that Indian wages are lower than Chinese wages is probably not enough to compensate for China’s much better infrastructure, but there are other reasons for the price differential. I discussed some of these reasons in an entry earlier this month.

Tags: Greendown

Last week China Daily had an interesting article on job prospects for university graduates on the mainland.  In 2006, as a reaction to rising unemployment among college graduates – even with GDP growth buzzing at rates above 12% – the government launched a program to help students find jobs as university teachers.  The program has been expanded this year.  According to the article:

 

Schools across China will hire 50,000 college graduates as short-term teachers this year to help ease employment pressure.  That is almost triple the number of teachers hired last year.

 

They will work under three-year contracts with local education departments and be paid by a special central government fund, the Ministry of Education said.  “Most of the jobs are only open to students who will graduate from colleges this year,” ministry spokeswoman Xu Mei said on Wednesday.

 

The newspaper article comes with a graph listing the number of graduates in the past nine years.  According to the graph, Chinese universities graduated 1.45 million students in 2002.  Five years later that number had risen to 4.95 million.  In 2008, 5.59 million students graduated and later this year 6.10 million are expected to graduate.

 

Meanwhile job offers are declining.  The same issue of China Daily has a second article on the prospects for college employment in Guangdong province.

.

Only about 7 percent of the students who are about to graduate in July have managed to secure jobs till now, down 50 percent from the same period last year, the Guangdong education bureau said yesterday.

 

About 331,000 local college students will graduate in July this year, 14.2 percent more than last year.  A large number of graduating students from other provinces have been coming to Guangdong in search of jobs, the bureau said, adding that almost 500,000 graduates would be applying for jobs in Guangdong this year.

 

The demand for graduates has dipped by 20 percent in the wake of the global economic slowdown, Luo Weiqi, director of the Guangdong provincial education bureau, said.

Till March 10, only 7.61 percent of four-year college graduates have found jobs and signed work contracts, Luo said. 

 

In contrast, 8.43 percent of two-year or three-year college graduates, and 14.87 percent of all postgraduates have signed labor contracts, he added.  So far, the bureau has organized 36 job fairs for fresh graduates. However, according to Luo, the number of available jobs in finance and real estate is far less than previous year’s.

 

I have heard that the Guangdong numbers are pretty consistent with numbers from other provinces, with roughly 30% of last year’s graduates still unemployed, and current graduates getting job offers at half the rate of last year – already a bad year.  The (small bit of) good news is that unemployment prospects may increase the likelihood of Chinese graduates starting their own businesses.  Often in the foreign press I have read ecstatic paeans to Chinese entrepreneurialism, some thing that doesn’t jibe at all with my experiences as a university professor or in running a music club and independent music label, and the first of the two China Daily articles seems to confirm my skepticism:

 

Special funds and subsidies have been earmarked to encourage college graduates to work in rural and grassroots positions or to start their own businesses.  However, “most graduates are focusing on jobs in large cities and few would like to start their own businesses”, Wang [Yadong, deputy director of Ministry of Human Resources and Social Security employment promotion department] said.

 

A recent study by the MHRSS found only 0.3 percent of college graduates in 2007 started their own businesses. That is much lower than some developed countries where the rate is about 40 percent.

 

If more Chinese graduates are forced – by terrible job prospects – to consider starting their own businesses, the long term consequences for China should be positive although, as everyone running a small business in China will tell you unendingly, starting and running businesses here is extremely difficult and, what is worse, it is never easy to know when you are and when you aren’t legally compliant.  Still, China really does need more entrepreneurialism and one of the unexpected benefits of the crisis may be to boost small businesses.

 

As for the job creation program, today’s South China Morning Post has a more sobering assessment:

 

New selection criteria are expected to eliminate existing substitute teachers from contention for 200,000 new teaching positions in village schools and give the edge to this year’s crop of 6 million or so university graduates, state media reported yesterday.

 

Under regulations issued by the Ministry of Education, all candidates for teaching positions at mainland primary or secondary schools will have to pass a tough exam that many poorly educated substitute teachers would generally not be able to pass.  It is the first time that the mainland has stipulated prerequisites for teachers.

 

The article goes on to say:

 

But education experts have raised doubts about the scheme’s feasibility, given that fewer than 59,000 graduates have joined since it was introduced in western provinces more than three years ago. Others say the plan simply brushes reality aside.  “Even with government subsidies, rural teaching jobs are still the least attractive positions for the vast majority,” mainland columnist Song Guifang said.  

 

“Village schools could end up with no teachers if regulators raise the recruitment standards too high.  You will immediately understand that this action is leading you down a blind alley when you visit any of the 100,000 shabby village schools deep in the mountains. Qualified candidates that do pass the tough examination are very likely to pass up the offer.”

 

Many substitute teachers in poor areas claim the Ministry of Education has sacked tens of thousands of their counterparts since 2006 without proper severance payments, all the while subsidising the expensive scheme to help jobless graduates.   Substitute teacher Zhang Xicang – from Nayong county in Guizhou, one of the nation’s poorest areas – said he had taught there for a decade and was paid just 50 yuan a month, about 8 per cent of the pay that a fresh graduate would receive for the same job.

 

More than 765,000 students graduate as teachers every year and compete for the 200,000 or so vacancies at primary and secondary schools.

 

Regular blog readers know that I have worry a lot about graduate employment, not just out of concern for my students (most of whom mercifully don’t have to worry about unemployment), but also because I think of college employment as being a very useful way of understanding China’s development model.  If all the growth of the past four or five years has nonetheless been unable to absorb the employment needs of China’s university graduates, that tells us something both about the composition of job creation in China as well as the possible impact of a sharp slowdown.

 

By coincidence an ADB report released today highlights this issue while cutting its growth forecast for China.  According to an article in today’s Bloomberg:

 

China’s 4 trillion yuan ($585 billion) fiscal stimulus spending won’t create enough jobs, making unemployment the nation’s “most pressing issue,” the Asian Development Bank said.  “Investment projects in the stimulus package will generate jobs, but not enough to absorb the growing labor surplus,” the ADB said. “Infrastructure projects are generally less labor-intensive than export-oriented manufacturing.” The ADB cut its forecast for China’s economic growth this year to 7 percent from 9.5 percent in a report released in Hong Kong today

 

I am more than a little skeptical about the 7% growth forecast – I think that will be a tough target to reach – and I suspect it will be further downgraded this year.  The article goes on to say:

 

China will find it more difficult to create jobs than it has in the past, the ADB said. Between 2000 and 2007, 13.6 million non-farm jobs were created each year as growth averaged 10.2 percent a year, the ADB said.  “Employment generation on this scale will be more difficult in the future because employment elasticity — the rate of employment growth to GDP growth — has declined in recent years,” the ADB said.

 

About 9 million jobs may be created this year by stimulus spending with growth in the region of 7 percent, said Wihtol. With 20 million migrant workers already jobless, that still leaves “quite a significant gap,” he added.

 

On a much more positive note last week’s South China Morning Post heralds a surge in real estate prices:

 

A countrywide surge in sales since the beginning of the year has injected a sense of optimism that the worst is over for the mainland property market and a sustainable rebound is under way.  The market improvement was proven by inventory depletion as well as price stability in some cities, analysts said.  

 

While optimists said home buyers had regained confidence after the government’s stimulus package including falling mortgage loans and lower transaction tax expenses, some said the rebound was spurred by pent-up demand and bargain prices.  They were also concerned that prices were not following deal volumes higher.

 

“It is definitely a sustainable volume recovery,” said Lee Wee-liat, a property analyst at investment brokerage Nomura International HK.  Mr Lee based his call of a rise in demand since February – following a short-term rebound by the end of last year – on data compiled by Nomura showing a widespread surge in deal volumes nationwide last week.

 

The number of property deals was up on the previous week’s sales by 24 per cent in Beijing and Tianjin, and 71 per cent and 19 per cent higher, respectively, in Qingdao and Dalian, the data found. In Shanghai, 19 per cent more properties changed hands.  Guangzhou and Shenzhen recorded slight volume declines on the week, Mr Lee said, but remained at around the highest levels seen in the two cities for two years.  The increasing pace of sales was beginning to reduce unsold housing inventory, he said.

 

I have to admit that as a former investment banker I always take bullish statements from members of the selling profession with a big grain of salt.  The Guanghua Students Monetary Policy Committee discusses property prices in each of its weekly meetings, and I don’t remember any of their comments being this optimistic.  Needless to say the rebound of housing prices is very important both to confidence and to bank portfolio quality.

 

On a different note I found another very interesting article in today’s South China Morning Post:

 

Shenzhen foreign-exchange dealer Fang Zhen has been worried for months by a surge in people exchanging yuan for Hong Kong dollars based on fears that the mainland currency would plummet in value amid the financial crisis.  The fears were so strong that they drove up demand for and the price of the Hong Kong dollar on the black market.  

 

People soon realised they could make quick money by buying Hong Kong dollars at official banks and selling them on the black market. Mr Fang said he had reported his concerns to his superiors at the China Construction Bank and industry supervisors at the People’s Bank of China. Since October, many people in Shenzhen had discovered they could make a profit from currency trading between official banks and the black market. The margin between the buying price for Hong Kong dollars listed by state banks and the selling price set by black market dealers was growing. By the Lunar New Year, the gap was up to half a percentage point, Mr Fang said.

 

The widening spread between the official and underground prices was spurred by expectations that the central government would heed calls from influential think-tanks since late last year for depreciation of the yuan against the US dollar, to help beleaguered exporters.

 

Two weeks ago I wrote about the latest (rumored) reserve figures for January and surmised that there were at least $20-30 billion in hot money outflows that month.  The SCMP article is consistent with my assumptions.

 

And finally, on a completely different note, my student Gao Ming is writing a paper that involves a mention of the Mexican crisis in 1982.  He asked me some questions about President Lopez Portillo’s failed attempts to defend the peso, and that question led to some searching.  In so doing I dug up an old quote that I had forgotten.  During the oil boom of the latte 1970s, when every expert knew that oil prices would soar forever and would result in a major realignment of geopolitical forces, the president, presiding over Mexico’s then-massive oil wealth, ecstatically announced that his job was to administer the era of Mexican abundance (“¡Vamos a administrar la abundancia!” he proclaimed).

 

He went on to say: “En el mundo de la economía los paises se dividen en dos: los que tienen petróleo y los que no lo tienen. ¡Y nosotros lo tenemos!” which translates as: “In the world of economics there are two types of country: those that have oil and those that don’t.  And we have it!”

 

What does this have to do with China or the world financial crisis?   Perhaps not much, but it is good to remind ourselves about how utterly wrong we can be about predicting major changes or historic turning points.  By the way Gao Ming’s favorite part of the story was my telling him that for years after his failed defense of the peso (“We will defend the peso like a dog!” he shouted), whenever ordinary Mexicans saw him in public they started barking like dogs.  Mexicans have never lost their very healthy skepticism, it seems.

 

Tags: Lopez Portillo, University graduates

The LA Times came out Saturday with a widely-noticed article on Beijing real estate, which features my friend Jack Rodman. Jack, who runs a firm called Global Distressed Solutions, is a bad-loan and distressed real-estate expert who has spent the last several years in China, and somehow has the energy to poke around among all the spectacular buildings in Beijing and other cities, worm his way in, and see if behind the beautiful façades there is actually some semblance of economic viability.

Apparently not. According to the article:

By Rodman’s calculations, 500 million square feet of commercial real estate has been developed in Beijing since 2006, more than all the office space in Manhattan. And that doesn’t include huge projects developed by the government. He says 100 million square feet of office space is vacant — a 14-year supply if it filled up at the same rate as in the best years, 2004 through ‘06, when about 7 million square feet a year was leased.

…To its credit, the government recognized in 2007 that the real estate market was headed toward a bubble, economists say. In an attempt to make real estate more affordable, restrictions were introduced on ownership of second homes and on foreign home buyers. But the measures came too late, accelerating the crash of an already weakening market.

The Beijing Municipal Bureau of Statistics reported this month that housing sales in the city dropped 40% last year. Chinese economists have predicted that housing prices will drop 15% to 20% in Beijing this year. Shanghai has experienced a similar decline.

Any conversation about Chinese real estate with Jack is likely to be depressing because his terrible stories aren’t much relieved by vagueness. Unfortunately he probably knows as much about the real estate market as anyone, and his conversation tends to be pretty specific and avoid the kinds of generalizations that we often make here, given the difficulty of getting hard data about some of the problems. When Jack talks about empty buildings he gives actual addresses.

And it’s not just foreign newspapers that are warning about real estate trouble. China’s leading independent business weekly, Caijing, also has an article this week that discusses the real estate mess:

Battered by global financial turmoil, foreign investors are moving quickly to liquidate stakes in Chinese property developers. The market is sinking, and investors are eager for a way out. Real estate developers, including some of the nation’s largest, are fighting to stay afloat. And so far, none have declared bankruptcy.

But key developers who snapped up land and, sometimes in a desperate scurry for cash, signed deals with equity funds and investment banks during China’s property market boom are now slipping toward loan defaults and failure.

Worries about the real estate sector are nothing new, of course. The important issue, for me, is the impact of problems in the real estate sector on the banking system. The LA Times article goes on to explain why:

The situation could get worse. Most of the real estate has been financed by Chinese banks, which have avoided writing down the loans. Eventually, they will be forced to, and that probably will have a ripple effect throughout the economy.

The problem is actually a little messier than that. There have been rumors for over a year that with the forced credit contraction of last year a lot of the riskier real estate developers had to turn to the informal banking sector for loans, and it is not at all clear to me how these get resolved in case of payment difficulties. I am assuming – like, I think, most others – that the government will want to avoid a rapid liquidation of bad loans by the banks. They will not want banks to seize collateral and sell it off for fear that this would cause the market to collapse and would result in the kind of debilitating debt deflation that Irving Fischer described in the 1930s, in which assets are liquidated to meet loan payments, causing asset prices to fall, which puts additional downward pressure on loans, and so on in a self-reinforcing cycle.

Now it is not clear to me that this kind of liquidation is always harmful. A strong argument can be made, and has often been made, that the liquidation process makes a crisis feel worse in the short term, but results in a much faster recovery because at some point very low prices create economic value to businesses of owning the assets, and their use of these assets can fuel a rapid recovery.

The classic case is the massive railroad building program in the US in the 1860s and early 1870s, which left the railroad owners saddled with expensive assets which required passenger and cargo rates that were too high to be useful to most potential passengers. Many of the railroads were never able to stop losing money. When these railroads went bankrupt after the 1873 collapse, and were subsequently liquidated, new owners were able to buy them for pennies on the dollar, and so were able to make them profitable while charging much, much lower freight and passenger rates. These lower rates sparked an economic boom by sharply reducing transportation costs, and the final value to the economy was much greater than the initial losses on the railroad assets.

The worst case, by this thinking, is if assets that are not viable at current prices are effectively taken off the market because the owners are not forced to liquidate, in which case they become a pure deadweight for the economy. The counterargument, of course, is the Fischer argument – that forced liquidation is inherently less stable because it causes a self-reinforcing cycle of price collapses.

I am not able to say which argument is correct, and anyway this sounds as much like a political argument as an economic one, but it is worth considering what might happen in China. The consensus, and I agree with it, is that the government is far more concerned about avoiding short term instability than about promoting long term viability, and so will make every effort to force banks to stretch out the restructuring process, avoid panic liquidations, and take assets off the market.

This policy can work with the formal commercial banks, but what is less clear to me is how the liquidation process will work in the informal banking sector. I am not sure whether pressure can be placed on the informal banks to prevent liquidation without seriously interfering with a wide range of market and governance mechanisms. Certainly rumors about some of the fairly brutal collection mechanisms in parts of the informal banking sector suggest that creditors might not be too eager to confront lenders. Unfortunately I do not have much of a sense of whether this process is already taking place. If any of my China-based readers knows more about this, I would really appreciate some help.

For those who find this topic of great interest, there was a fascinating article in Friday’s South China Morning Post.

With the mainland economy tanking to its slowest growth rate in seven years and banks wary of lending as defaults rise, small business operators are hocking belongings and company assets for loans from pawnshops. “Banks are reluctant to lend,” says Huang Jing, deputy business manager at Shanghai Oriental, the city’s second-biggest pawnshop. “But we have a lower threshold and can provide loans much more quickly and with shorter terms.”

Banned at the start of the Cultural Revolution, pawnshops were considered a form of capitalist exploitation that preyed on poor and desperate people. They were outlawed for two decades, until 1987, but now they do a brisk trade. From gold bullion to houses and factory equipment, customers offer a variety of assets to get loans from pawnbrokers.

Quoting Wang Fuming, chairman of a pawnshop with about $1 billion in loans, two-thirds of which are to small and medium businesses (Chinese pawnshops are huge compared to their Western counterparts and can include hundreds of branches and are actually, funnily enough, among the most efficient parts of the country’s banking system), the article goes on to say:

“About 90 per cent of small businesses in Shanghai fail to get bank loans,” Wang says. “The problem is more severe with a weak economy.” The central government has eased its monetary policy and urged banks to lend, with January lending showing a record rate of growth. Yet most new loans are directed at the country’s 4 trillion yuan economic stimulus plan and state-owned companies.

This quote about the difficulty of small businesses in Shanghai to get loans reminds me of the point, very forcefully made, by MIT’s Yasheng Huang in his excellent new book, Capitalism with Chinese Characteristics, about the difficulty small entrepreneurs have had after the reforms in the 1980s. For Huang Shanghai is Exhibit A in his claim that there has been a reversal away from a market economy to a state-led economy in the past fifteen years. He especially mentions that as the commercial banks turned mainly to funding SOEs, it was the informal banking sector that took on the bulk of the financing for SMEs.

Meanwhile, speaking of funding SOEs, there is a lot of talk in the markets about second big stimulus package aimed at delivering more consumer spending (“A second big stimulus package?” some unkind folk may wonder, “Did I miss the first?”). The front page of today’s People’s Daily has an article with the large headline “Communist Party leadership warns of ‘austere’ year for China.” It goes on to say:

The ruling Communist Party of China (CPC) said Monday the country will launch a comprehensive economic package to tackle an “austere and complicated” year ahead.

“We will increase large-scale government investment, implement and readjust a plan to revive industries, make great efforts to boost innovations, and greatly enhance the level of social security,” said a press release issued after a meeting of the Political Bureau of the CPC Central Committee. The meeting was presided over Hu Jintao, general secretary of the CPC Central Committee.

Meanwhile Xinhua yesterday reported PBoC concerns about deflation:

China’s central bank on Monday warned of deflation in the near term caused by continuing downward pressure on prices. Commodities prices were low and weak external demand could exacerbate domestic over-capacity, the People’s Bank of China (PBOC) said in an assessment of fourth-quarter monetary policy. “Against the backdrop of shrinking general demand, the power to push up prices is weak and that to drive down prices is strong,” the PBOC said. “There exists a big risk of deflation.”

While assuring us that it would ensure ample liquidity in the banking system and promote the reasonable and stable growth of credit, the PBoC, along with the CBRC, also stated three days ago that it was planning to investigate the lending spike. According to an article in the current Caijing:

A dramatic increase in bank lending in January has attracted attention from investigators with China’s central bank and regulatory agencies, Caijing has learned.

The China Banking Regulatory Commission plans to investigate the huge cash flow after banks issued 1.62 trillion yuan in loans during the month. Notes trading represented 38 percent of the total credit. Some analysts have claimed companies may be using government-encouraged bank loans to invest in the Chinese stock market, which has rallied since the start of the year.

Until today the stock market had continued its upward surge – although the SSE Composite suffered a dizzying 7.5% drop last Tuesday and Wednesday on concerns that the PBoC investigation, if it determines that a primary cause of the recent market surge was bank lending to stock speculators, may pull the rug out from under the market. The overall surge, largely on speculation about which sectors are going to receive bailout packages from the government, has made China the top performer among global stock markets this year, with the SSE Composite rising about 20% year to date.

A lot of my Chinese financial market friends are very worried that small investors are rushing in too quickly and are likely eventually to get hurt, since what is driving the markets – as always – is not changes in fundamentals but rather rumors of government intervention. The game seems to be to guess which sector will receive the next set of rumors about government bailouts and to buy accordingly.

Even if the rumors are true, I think the market is ignoring how difficult it will be for profitability to revive and how even more difficult it will be for asset prices to stabilize. Even real estate companies have seen stock prices benefit from rumors, although the sector is in serious trouble and it is only because they are in such trouble that the government would consider supporting them. Still, this is always how the stock markets work here – it ain’t about fundamentals, its all about government rumors.

At any rate today, the market may have suddenly refocused on how bad the news outside is, falling straight down after its opening, led by commodity producers and insurance companies, with the SSE Composite losing 4.6% to close at 2200.1. If the next couple of days the market remains bad, the government will almost certainly make supportive noises, so I don’t know if this drop is a temporary fall before prices move up again, or if it is the beginning of a longer decline, but either way I think the market rebound has far exceeded any real basis for optimism. It will be much lower in a few weeks or months.

Tags: Jack Rodman, Pawnshops

Today’s unexpected withdrawal by hurdler Liu Xiang from participation in the Olympics – because of a leg injury – has been a real emotional blow to many of my friends and students in China.  Condolences to all.  It is a disappointment to see such a great athlete unable to defend his title in his own country.   Sad as his withdrawal has been for many of us here, there is still a lot to be excited about as the Olympics wind down.  Tomorrow I will see Brazil play Argentina in the soccer quarterfinals, thanks to the generosity of my former Tsinghua student Richard Zhang, now a rising star at McKinsey, and on Wednesday one of my favorite Beijing musicians, Shouwang, is taking me to see track and field events at the Bird’s Nest (finally I get to see the magnificent stadium from the inside!).

 

But not all the news is Olympic-related.  Xinhua reports today that the first half of 2008 saw a slowdown in the growth rate of loans to real estate developers and buyers.  According to the article:

 

Chinese bankers held loans totaling 5.2 trillion yuan (about 580 billion U.S. dollars) to real estate developers and housing buyers by the end of June, up 22.5 percent year-on-year, the People’s Bank of China (PBOC) said Friday.

 

The central bank said the growth rate was two percentage points lower than the same period last year, representing a decline for seven consecutive months since last December.  Loans to real estate development stood at 1.9 trillion yuan by June, up 17.7 percent year on year. The growth rate was eight percentage points lower than the same period last year.

 

The country’s lenders granted 3.3 trillion yuan to housing buyers buy June, representing an increase of 25.6 percent year on year. The growth rate was 1.8 percentage points higher than the same period last year.  Real estate developers and housing buyers received 398.84 billion yuan in loans between January and June, which was 170.66 billion yuan less than the same period last year, said the PBOC.

    

China’s real estate investment grew fast in the first half, but the housing price decline in some cities has strengthened a wait-and-see attitude among housing buyers, which retarded housing sales.  The country’s real estate developers sold out about 260 millions quare meters houses in the first six months, and the sales value totaled one trillion yuan, representing an decrease of 7.2 percent and 3.0 percent over the same period last year, respectively.

 

The PBoC had been warning banks to control their exposure to real estate.  Obviously the banks are responding, although 22.5% growth year on year is nothing to sneer at, and it should be pointed out that the growth rate in real estate loans still exceeds total loan growth, so as a proportion of total loans real-estate-related loans have not declined at all.  Still, with real estate exposure in the banks (formally recognized as such or, in many cases, not) creating probably the biggest worry for the PBoC in case of a slowdown in economic growth, this is relatively good news.

 

It is clearly a good thing that the PBoC is worried about and monitoring real estate exposure.  Among the many problems faced by the banking system, a sharp decline in real estate prices is probably the biggest single risk.  The still unanswered and vitally important question for me, I think, is about real-estate-related loans in the informal banking sector.  There is a lot if anecdotal evidence of developers turning to the informal banking sector – in spite of short maturities and high interest rates – as a replacement for the restricted funding provided in the past by the formal banking sector. 

 

I don’t know whether or not there is a similar moderation in the rate of new lending among informal banks, but the worrier in me thinks probably not.  At first glance this might seem not to matter.  If informal banks go bust because of excess exposure to bad real estate loans, it might not seem to matter to the formal banking and payments system, and so might have limited impact on the loan portfolios of the large banks and, via the banks, on the underlying economy.  Without knowing the links between the informal and formal banking systems, however, this optimism might be unwarranted.  I can think of at least three ways in which problems in the informal banks can spread:

 

1.        A decline in real estate prices can be exacerbated by forced liquidation of real estate loans extended by the informal banks.

2.        Formal banks may find themselves unexpectedly in a junior credit position if assets owned by a company turn out to have been used to collateralize loans from informal banks.

3.        Informal banks may have directly or indirectly obtained funding from the formal banking sector.

 

On a related note I got an interesting email today from one of my former Peking University students.  He says (with some editing on my part):

 

I just talked to a friend in a city in the south.  Interestingly, he tried to pay back his mortgage loan last week, and get another 3 year loan again (many entrepreneur there rely heavily on this kind of financing as working capital, sometimes, from informal banks of course).  However, he was told that the term of next loan had to be just 1 year instead of the usual 3 yrs, and he has to go through the application process again every year.

Collapsing property and other assets prices in some cities like Shenzhen seem to have made banks cautious of a probable rise in default risk, and the tightening will hurt these small enterprises further.

 

I don’t know how widespread this shortening of maturities is, but a common problem in banking is that when risks are perceived to have risen, lenders often respond (rationally, in the case of each individual bank or investor) by readjusting their portfolios in ways that increase overall riskiness in the system.  

 

For example as lenders became increasingly worried about the risks in Mexico in 1994, one of the consequences was a surge in short-term borrowing by the Mexican government as creditors became increasingly reluctant to extend long-term loans.  This of course increased the risks of a liquidity contraction to the Mexican government, and when that contraction happened, the Mexican government came close to defaulting.

 

This happens all the time as the perception of risk rises.  I wouldn’t be surprised – if there were an effective way to measure loan maturities for all loans in the system, including those extended by the informal banking sector – to see that average loan maturities in China have declined substantially in the past several quarters.  This, of course, increases the overall liquidity risk in the system.

 

Meanwhile the stock market continues to plunge.  On Friday the market experienced its first and only up date since the Olympics started, rising 0.9% to close at 2451.  Today it changed direction dramatically and dropped 5.3% to close at 2321 (this in spite of a 58% first-day jump – which is pretty mild by Chinese standards – in share price for the $1.5 billion IPO for South Locomotive and Rolling Stock). 

 

The Thursday before the Olympics started, the market closed at 2728, so we have seen a total decline of 14.9% during the past eleven Olympic days (seven trading days).  I wrote in an August 11 entry that before the Olympics end we might see the market test 2300, the level below which their have been rumors that the government will intervene.  We are now less than 1% away from that level and we still have the rest of this week to go.

 

It is not completely clear why the markets have behaved so poorly in the last week, although the answer is probably multiple.  A lot of analysts are worried about a slowdown in economic growth, the possibility of an increase in inflation still scares many (as it should), and there is a lot of concern about dilution effect of a possible upcoming sale of non-tradable shares as these become tradable.  There is also worry that hot money inflows may have already begun to reverse themselves (for example see this ChinaStakes.com article).  This perception comes from the widespread belief that the increase in foreign exchange reserves in June was substantially less than the combination of FDI, trade surplus, and other identified inflows.

 

Actually this perception is incorrect, and represents mistakes in the way most analysts count the rise in PBoC reserves.  I discuss why true growth in June’s foreign exchange reserves actually exceeded the identifiable inflows in a July 14 entry.  I don’t think hot money outflows are likely to be the main culprit behind the declining stock market, but I don’t discount the possibility that, as the perception of China’s riskiness increases, and as concern grows about the imposition of further restrictions on short-term inflows and outflows, we may begin to see at least some hot money reverse direction and leave the country.

 

On a related topic, today to a large fund manager asked me whether or not it made sense to buy Chinese stocks at these levels.  From a short-term trading point of view I am not sure I would be in a hurry to buy because I still think we are going to face a post-Olympic hangover that may affect the markets.  I think at least part of the surge in consumer spending last month and this month will have been Olympic related (new TV sets and entertainment units, Olympic souvenirs, sports equipment and clothing, flags, traveling to Beijing, and the kind of spending that comes from exuberance at China’s sporting triumphs), and this is likely to be reversed in the September and October numbers.  That should keep downward pressure on the market.

 

On the other hand over the medium term a number of Chinese stocks probably represent good value.  I haven’t looked at the discount between A-shares (which only Chinese nationals can buy) and B-shares (which foreigners are permitted to buy) in several months because I closed out all my positions much earlier this year (thank the gods!), but because of lower liquidity B-shares have typically traded at a 30-40% discount to A-shares.  If this continues to be the case, I think a very strong case can be made for the selective and gradual acquisition of a diversified portfolio of B-shares, especially in the more defensive industries and less leveraged companies.