China Real Estate Boom Is Finished? Now What?9 June, 2011, 13:37. Posted by Zarathustra
Wall Street Journal ran this story that residential property prices in 9 major cities are already falling. According to Dragonomics, home prices in nine major cities tracked by Dragonomics recoded a 4.9% yoy drop in April. So one might declare that the story is finished.
Although it can be taken as a good news for the bearish camp, this data point somewhat contradicts other data sources. For instance, CREIS recorded 0.53% month-on-month rise in their 100-city index in May, and prices of top 10 cities rose by 0.11% on an month-on-month basis, while on an year-on-year basis, prices rose by 3.94%. Contradictory data points suggest that it might be hard to say that we are already at the very top of the market, but we are probably close to it as we have seen sluggish transactions volume in various markets across countries.
The impact of a significant correction in China real estate market will be controversial. One usual bullish argument is that household leverage is low in China, such that the chance of a US-style housing bubble burst is very slim. Well, that’s true. But debts are in real estate developers’ balance sheets, as the slower sales hit their revenue and cash flow, such that there is a build-up of unsold inventories as well as debts. If the real estate bubble pops, the more likely first casualties would be real estate developers. To demonstrate that, we have seen a majority of Chinese real estate developers shares performing really badly over the past year or so, highlighting the market’s concern on their difficulties.
The other weakness, of course, would be the indebted local governments, which are (at least for now) relying on real estate related revenue to finance itself. Tao Wang of UBS (via FT alphaville) has pointed out the severity of the issue of local government financing vehicles debts.
More recently, we understand that the CBRC has asked banks to un-bundle LGFP [local government financial platform] loans and re-classify them into a few categories: (i) projects with cash flow that can fully cover debt services and amortization will be classified as commercial loans and excluded from the LGFP loan category; (ii) projects with cash flows that can largely cover debt services; (iii) projects with cash flows that can cover half of the debt services, and (iv) projects with almost no cash flow or viable future income. For the last three categories, banks are asked to increase their risk weighting in calculating capital adequacy ratio and provision accordingly…
… A much bigger type of local debt that has no viable cash flow to cover debt services, the projects were there as pure “public goods”, a solution has to be found on mutually agreeable terms. It is this part, some say amounting to 2-3 trillion RMB [$308bn - $463bn], that is subject to some debate…
This is why the real estate market is so important for these local governments, because they use the revenue from land sales and others to pay off debts. Of course, the central government can always come into rescue as a last resort:
Obviously, as long as there are non-performing loans, banks will have to shoulder some of the burden. Banks have already been asked to re-classify LGFP loans, increase their risk weights and provision accordingly. As a measure of last resort, the central government could come in to help the banks and indirectly bail out the local debtors. As the largest share holder, the central government could forego dividend payments of the banks, give tax credit for write-off of bad loans, and participate in capital-raising should the banks need re-capitalization.
So despite the mountain of debts, the outcome may not be as severe as some would fear.
Or is it?
Jury is still out, but my conjecture is this: yes, the central government will come into rescue with potentially massive fiscal stimulus and potentially massive monetary stimulus. Unlike their western counterparts which have democratic processes to stop massive spending, China has none of these, and at the end of the day, maintaining economic growth may still be their overriding priority, thus after some initial slump in the Chinese economy, perhaps growth can be returned to 7-8% within a year or so.
But here’s the catch. Because the Chinese has no democratic processes to stop them from throwing money into the economy, their forthcoming stimulus (in the event of recession) will make quantitative easing by the Federal Reserve looks silly. One of the big misunderstandings, which is still prevalent among the market, is that the Federal Reserve of the United States is creating a lot money. The reality is that they don’t. They have only created bank reserve, but weak demand for credit has left this bank reserve idle, thus the banking system is not creating as much money as they should. On the contrary, the Chinese is creating much more money than the United States.
Now, there is a intense dislike of the US dollar and Ben Bernanke because Ben Bernanke is “printing money”. The reality is that the Federal Reserve increased monetary base, but broader money supply did not really grow as much because of private sector deleveraging and (potentially) a fiscal consolidation. In China, however, they will have the determination to keep things going, so despite the mountain of debts the Chinese government actually has, the probability of fiscal consolidation will be close to 0%, and banks will keep lending no matter what. Thus my conjecture is that while the Federal Reserve cannot create inflation, the People’s Bank of China can. If you buy into the argument that the Fed is “debasing” the currency (which is not true) such that you hate US dollar, you will probably hate Chinese Yuan even more because the Chinese, not the US, will be successful in inflating the economy.