10 Reasons To Short China9 March, 2011, 22:16. Posted by Zarathustra
Tags: Bubbles, Crash, Economy
I have been rather sceptical on China growth story for a while. I have suggested that China needs to bring the growth rate down to contain inflation, which may risk a recession. However, the Chinese government is also worried about the impact of a hard landing, which they will try hard to avoid. Although the Chinese government is aware of the need to rebalance the economy in order to make it less investment-driven and more sustainable, the government invested heavily when crisis came to stimulate the economy, thus the necessary adjustment has been once again delayed.
There are a lot of problems in China economy, and the government knows that. Unfortunately the government is running out of time to carrying necessary changes. No one can tell the exact timing of the next crisis, but there are the reasons why you should be turning bearing on China.
1. Bubbles in Residential Real Estate
Some people argue that there are no bubbles (e.g. Shaun Rein via Bloomberg), and there are some very bearish calls (e.g. Jim Chanos via FT and Andy Xie). Official statistics are completely unreliable, so I have to rely on other things.
Bill wrote quite a while ago on why Beijing residential real estate market wasn’t a bubble. Among other reasons, he wrote:
1. Beijing is the capital city of the largest country in the world with the fastest growing major economy;
2. Beijing’s housing market is really a nationwide housing market. Every person with means in China wants to buy in Beijing. Beijing is the centre of power, it has the best education system in the country and it has the best health system.
6. Using official statistics to calculate average Beijing income to show that real estate is overpriced is misleading. Rich people from all over China buy here, and the official income statistics understate how much money Beijingers have at their disposal
Let’s pretend for the moment the latest rules that effectively ban non-residents from buying properties in Beijing do not exist. Now I can pretty much draw some similarities between these reasons and the frequently mentioned reasons of why Hong Kong property prices are so high:
1. Hong Kong is one of the top international financial centres, situated somewhere in the fastest growing major economy;
2. Hong Kong’s housing market is really an international housing market. Every person with means in China wants to buy in Hong Kong, and even foreigners would like to buy properties in Hong Kong (because we speak English?). It has arguably the best legal system in China, probably the best education system in China, and probability the best health care system as well;
3. Using any statistics to calculate medium household income to show that real estate in Hong Kong is overpriced is misleading. Rich folks everywhere like to buy here.
I have pretty much rejected above reasons in justifying the high prices we have here in Hong Kong, and I pointed out the biggest reason for high prices here in Hong Kong was the rapid monetary expansion (thanks Ben Bernanke). We all know that the money supply growth in China has gone quite out of control, thus China has the same ingredient for a real estate bubble as we have here in Hong Kong. Another metric which support the thesis that it is really bubble is that 80% of families in China are living in properties they own (compare that to only a little over half of the people in Hong Kong live in properties they own). On the surface, there is very little reason why real estate can be so sought-after if 80% of people are already living in their own homes. The only two reasons of why residential real estate is in high demand even 80% of families are living in their own homes that I can think of are 1) people want to upgrade their homes as their incomes grow, and 2) people purchase flats for investments.
While upgrading their homes is a perfectly legitimate reason to buy flats, investment may be driven by overly loose monetary policy. Indeed, inflation in China is now higher than deposit rates, thus investment in real assets look very attractive in a negative real interest rate environment (a much worse option is go to gamble).
The government has stepped up their effort to limit second and third homes purchases by making it harder for people to take out mortgages, so it is now much to buy flats to investment and speculation. It is also right to point out that household leverage is low in China, so the danger does not lie in here.
To seek for even weaker spot, we have to look elsewhere: real estate developers themselves.
As real estate developers rushed to buy land in the past year or so, they have to pay for these newly acquired sites by selling their inventories quick. As the Chinese government impose more and more buying restrictions, they will slow down transaction volume of the market and eventually impact the cash flows of these companies. Some latest analysis suggested that quite a number of these companies have a negative operating cash flow, which is not a good sign even though they may have reported record profits.
While households may not be able to obtain credits to buy third homes, big names China real estate developers are still able to raise debts from the bond market, albeit at high interest rates. Hong Kong-listed China developers are arguably more sound financially than other listed in China and those not listed at all, but since early 2010, these real estate developers have raised US$11,060 mn through the debt market, and the weighted average coupon rate was close to 10%. Compare that to latest People’s Bank of China Policy Rate: 5-year or above lending rate is 6.6%.
Sample of Hong Kong-listed China Real Estate Developers who raised capital from bond market:
|Company||Date||Type||CCY||Size (US$ mn)||Maturity||Coupon Rate||Other|
|Evergrande||Jan 2010||Senior Notes||US$||750||2015||13.00%|
|Agile||Jan 2010||Senior Notes||US$||650||2017||8.88%|
|Evergrande||Apr 2010||Senior Notes||US$||600||2015||13.00%|
|Fantasia||May 2010||Senior Notes||US$||120||2015||14.00%|
|Renhe||May 2010||Senior Notes||US$||300||2015||11.75%|
|Sino Ocean Land||Jul 2010||Convertibles||US$||650||N/A||8.00%||Conversion Price = HK$6.85|
|Shimao||Jul 2010||Senior Notes||US$||500||2017||9.65%|
|Country Garden||Aug 2010||Senior Notes||US$||400||2015||10.50%|
|KWG||Aug 2010||Senior Notes||US$||250||2017||12.50%|
|Renhe||Sep 2010||Senior Notes||US$||300||2016||13.00%|
|Franshion||Sep 2010||Convertibles||US$||500||2015||6.80%||Conversion Price = HK$2.83|
|Central China||Oct 2010||Senior Notes||US$||300||2015||12.25%|
|Glorious Property||Oct 2010||Senior Notes||US$||300||2015||13.00%|
|Renhe||Nov 2010||Senior Notes||US$||300||2016||13.00%|
|China Overseas Land||Nov 2010||Guaranteed Notes||US$||1,000||2020||5.50%|
|Mingfa||Nov 2010||Convertibles||HK$||200||2015||5.00%||Conversion Price = HK$2.90|
|Yuzhou||Dec 2010||Senior Notes||US$||200||2015||13.50%|
|China SCE Property||Jan 2011||Senior Notes||Yuan||304||2016||10.50%|
|Hopson||Jan 2011||Senior Notes||US$||300||2016||11.75%|
|Evergrande||Jan 2011||Senior Notes||Yuan||844||2014||7.50%|
|Evergrande||Jan 2011||Senior Notes||Yuan||563||2016||9.25%|
|Kaisa Group||Jan 2011||Senior Bonds||US$||303||2014||8.50%|
|Beijing Capital Land||Feb 2011||Bonds||Yuan||175||2014||4.75%|
|Country Garden||Feb 2011||Senior Notes||US$||900||2018||11.13%|
|Shimao||Mar 2011||Senior Notes||US$||350||2018||11.00%|
Source: Hong Kong Exchange Filings
The good news here for those Hong Kong-listed real estate developers is that the average maturity date for their debts above is 2016, thus the short-term liquidity issue here is not a great concern for them. But for those smaller and weaker companies (including some privately-held companies which we know nothing about them), the risk here is that some of them will fail even before real estate prices correct, while the others will have to cut prices aggressively to keep cash flowing in.
2. Bubbles in Commercial Real Estate
Real Estate Bubble does not manifest in residential sector alone: we can see building booms in other sectors of the real estate market.
If you are looking for a skyscraper after Burj Khalifa which will make you feel excited, look to China. Even though there isn’t anything coming close to Burj Khalifa in terms of height, the sheer number of buildings under constructions and under planning is simply mind-boggling (not to mention some of the extravagant and ridiculous designs). Andrew Lawrence, the Hong Kong-based real estate analyst who is famous for his invention “skyscraper index” has already expressed concern of the building boom which has invariably led to crisis in the past.
There are more hotels than needed even in big cities. The high-end segment of the Shanghai hotel industry is loss-making. There will be tens of five-star or five-star plus hotels in the pipeline to be opened in Shanghai in 2011. The forecast supply of rooms for international-brand hotels will reach 50,944 by the end of 2012. However, in the first-half of 2009, the high-end hotels in Shanghai were all loss-making, and occupancy in the first two months of that year was below 10%. In 2010, occupancy only reached 68.12% even with the World Expo, with average daily room rate at RMB 1,151 (thus RevPAR of RMB784.06, or around US$120).
If hotels in big cities like Shanghai are loss-making, you should check out this absurd hotel in the small city of Zhaoqing in Guangdong province. The city has 3.7 million population with the famous tourist spot “Seven Star Crags”. This hotel is a “Seven-Star” Hotel (if you know what it is) with 750 rooms and suites and a world-class conference centre with one auditorium which can house 3,000 people and another 60 standard conference rooms. A famously extravagant but pointless feature (and absurd really) of this hotel is that in one of its restaurants, there was a big glass swimming pool where a few ladies swim in it, probably performing synchronised swimming for diners.
3. Over-investment in Infrastructure Projects
Infrastructure projects are well-known for frequent cost overrun and benefit short-fall. With the massive push of infrastructure investments from the Chinese government, we might be seeing miscalculations in a massive scale.
A study by Bent Flyvbjerg found that average cost overrun for railroad projects amounts to 44.7%, and 84% of the times the rail passenger forecasts were wrong by more than 20%, and 90% of the times the rail passenger forecasts over-estimated traffic. The push to build high-speed rail as a part of the fiscal stimulus in 2008 will certainly, in my view, demonstrate some massive miscalculation of costs and benefits. Because of the huge investments and high operating costs, the tickets would have to sold at high prices which are simply too expensive for some people to afford, so migrant workers still opt for “slow-speed” trains. As a result, the trains are under-utilised.
The push to build the high-speed rail network has also left the railway industries huge in debt. After the former Railway Minister Liu Zhijun was removed from office on charges of corruption, the new Minister Sheng Guangzu recently disclose that railway enterprises associated with the Ministry has some 1.8 trillion Chinese Yuan (US$274 billion) of debt. Although he thinks that the debt in under control, it is extremely unclear to me how a to-be under-utilised rail network can possibly make enough money to repay the debt.
The push on high-speed rail network should make the railway network a strong competitor of air traffic because high-speed rail tickets may be cheaper than air tickets, and air traffic in China is famous for its frequent delays (which should not be a problem for high-speed rail). However, China is still planning to build 45 more airports in the next 5 years according to Financial Times. And even more jaw-dropping fact is that 130 out of 175 existing airports in the country are loss-making.
4. Local Government Debts Concern
While the central government’s debt burden is low, there are many off-balance sheet liabilities. I have previously pointed out that local governments of China are often in rather poor financial position. Victor Shih has previously put the estimate of outstanding loans to local government investment vehicles (LGFV) to RMB11.4 trillion, while others have come up some lower numbers. These local governments use these off-balance sheet vehicles to borrow money from banks to fund various projects, and capitalise on the thriving real estate market to sell land to real estate developers to repay the loans. If the real estate market is going to be in a deep trouble, these local governments will be in a very bad shape.
Demographically speaking, China will be losing to India in the long-run. One-child policy has helped China in the past 2 or 3 decades to have a large working-age population relative to total population and keep dependency ratio low. However, the payment of this demographic dividend has stopped, and the one-child policy will lead to a rapid rate of population ageing and fast shrinkage of working-age population relative to total population. Although the government seems to be re-considering one-child policy, it is too late to save the day.
That means China will be facing increasing labour shortage in the years to come, which has to mean two thing. First, wages have to go up in order for companies to retain workers as the labour situation might change from surplus to shortage. Second, profit margins of companies will have to shrink as wages go up.
6. Slowing Growth of Corporate Profits
As labour costs go up due to an increasingly unfavourable demographics, it will mean that profit margins for companies have to go down as companies cannot always pass through all costs to consumers, and will only means a slowdown of growth in earnings. If earnings growth will be slowed in the coming decade, you might want to think whether current stock valuations have factored in slower growth.
7. Asset Prices Up-Trend Will End
The ageing population has some implications on asset prices (equities, real estate) which are not immediately obvious. For equities, large proportion of the population in the age between 35 to 54 years old seems to be associated with higher stock valuation (or in other words, more prone to bubble), and the ratio of 35 to 54 years old to total population has peaked in 2010 for China. Also, ageing has been associated with decline of real estate prices.
Inflation is edging up because of excessive monetary expansion after the financial crisis. The government is aware of the problem of inflation, but they have to slow money supply growth (or total national financing as they are talking about that). The risk is that to bring down inflation, economic growth will be stalled.
9. Oil Shock
China’s Strategic Oil Reserve is apparently enough only for half a month of use. Most of the oil used in China has to be imported, thus the Chinese government will have very little control over the supply of oil, and about 30% of the total world oil supply are, unfortunately, being produced in some of the least stable parts of the world. With increasing demand of oil and virtually no oil reserve as a cushion for oil shock, rapid rise in oil prices will stall the economic growth.
This point is particularly relevant now as unrests in the North Africa and Middle East continue.
10. Banking And Financial Crisis
The headline that China will have 60% chance to face a banking crisis by 2013 (via Bloomberg) is a rather eye-catching one. Not everyone of the above reasons will cause a financial crisis individually.In fact, some of these (like demographics and its impacts) are long-term trend, and some of them have nothing too much to do with the financial system (like oil shock).
While household leverage is not high in China, the impact of a slow down in the real estate market will be felt first by real estate developers who have weaker finances, and that will definitely hurt banks’ loan quality and those who invest in their debt instruments. Local government debts as well as debts associated with infrastructure projects will also be a time-bomb for the financial system.
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