Chinese Real Estate Is in the Headlines Again

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 Tuesday, 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.

Comments

[investor88:]

Good objective analysis by Prof Pettis as always. If you read this you will not be easily swayed by bulls chanting China stock market is booming, the saviour of the world. Maybe it is the saviour of the world but look like Prof Pettis before you leap.

Feb 24 10:25 AM

[Mad Hedge F...:]

My old friend, Stephen Roche, chairman of Morgan Stanley Asia, says that the current US bubble is four times larger than Japan’s, whose market is still down 80% from its 1989 high (no typos here). The American consumer, who at the peak accounted for 72% of GDP, has been left for dead. Japan’s bubble was caused by a collapse in capital spending, which never accounted for more than 17% of GDP. If we make China our whipping boy, as the Democratic Congress is historically inclined to do, they could come back to bite us in the hand. Treasury Secretary Geithner’s recent comment that China is a “currency manipulator” hasn’t helped. Our financial markets are now desperately dependent on the Middle Kingdom recycling their trade surplus into our bond market. A Chinese boycott would trigger a collapse in the dollar, and send US interest rates sky high.

Feb 24 10:39 AM

[rlirph:]

There will be no Chinese boycott of US Treasury - simply because China has fes options left on their foreign currency reserves.

China has been investing in overseas companies with disastrous results. Ping On Insurance lost US$1.3 billion in the Belgium Fortress Investments. They would be lucky if they get back 10% of their investment. That investment lasted about a year. Investments in US companies such as Morgan Stanley and Black Rock met with similar fate (losing only two thirds of their investments so far).

China cannot buy gold because the annual worldwide gold production can be bought with just one month China's trade surplus.

In 2008 the US dollar has gained 14% against a worldwide currency basket. China being the largest holder of US Treasury cannot afford not to buy US Treasury notes regardless how unpleasant Mr. Geithner is.

-From a US expat living in GZ

Now China seems to find a good way to recycle the US dollars by giving them to Russia/Brasil in exchange for future oil shipment. They are now shopping for more metal resources buying throughout the world. That is a brilliant strategy.

Feb 24 11:41 AM

[Bab Al Mandeb:]

Help me with the math here.

The article says that 500 million square feet of commercial space has been developed in Beijing since 2006. 100 million square feet is thought to be vacant.

The rate of absorption of that space is 7 million square feet per annum. Pretty scary numbers since that would imply a 14 year period for absorption of the 100 million square feet.

If that's the case, what happened to the remaining 400 million square feet that were developed but are not vacant?

Feb 25 01:17 AM

[Bab Al Mandeb:]

Help me with the math here.

500 million sq ft developed in Beijing since 2006. 100 million sf vacant. Lease rates max out at 7 million sf per year.

If that's the case, who leased the 400 million sf developed since 2006 that aren't vacant?

Feb 25 01:21 AM

[johnthebears:]

Bab, it could be government offices absorbed most of the 400 m sf, typical of a socialist government seeking new and show place offices. If so, does that mean there are many other buildings of lower quality sitting vacant that are not included in the 100 m sf assumed vacant? Would those typically be owned by government or private owners with bank loans?

If so, there could be more than 200 m sf vacant and rising with the reported rise in failures of small business and exporters in China.

I guess the real question everyone is asking now is:

Who leads the world out of depression? China or US?

It looks more likely that we will, given that we still have a free market system and a banking system that may be more viable than in China after a few years of chaos.

Either way, we are in for a long period of deflation before switching to inflation... much longer than Ben suggested in his comments yesterday.

I would suggest that it will take at least 10 years before we return to 14,000 dow. It may take even longer, now that the investment banks will not be able to do CDO's and leveraged by outs as easily as in the past when there was no regulation.

Feb 25 09:39 AM

[William Gamble:]

Personally I believe that liquidation is a good idea because it helps the market reset the price. The problem occurred in Texas during the S&L crises. Originally the Resolution Trust Corporation who had title to the foreclosed properties did not auction them off. So the market froze. It was not until they started to liquidate the inventory that the market started to work.

This cannot work in China. As I pointed out in my book, Investing in China and my article for Harvard International Review five years ago, you cannot collect a debt it China. The legal infrastructure simply does not exist.As the Economist points out in its article on China this week "And so is the nebulousness of Chinese property laws. Purchasers cannot be sure that what they buy they will truly own"

You simply cannot apply the laws of economics that are valid for one set of rules to a system with another set. When the rules change, so does the game

Feb 25 10:31 AM

[WorkinginChina:]

Interesting article by Jack Rodman. Either he knows absolutely nothing about China and is throwing out cowboy comments or every single real estate company, investment bank, and real estate consulting firm in China (foreign and domestic) are wrong.

"By Rodman's calculations, 500 million square feet of commercial real estate has been developed in Beijing since 2006"

What on earth was behind Mr Rodman's calculation?? I'm guessing his definition of "commerical real estate" includes office, retail, residential, logistics, manufacturing, subway stations, railway stations, airports, public toilets?

Yes Beijing is overbuilt and vacancy rates are high, but this is the most ridiculous and overstated figure I've ever seen. According to the 3 biggest real estate companies in the world - CBRE, DTZ and JLL - BJ's total grade A office stock (the good quality international standard buildings or spectular buildings as you call them) is about 20 million square feet, about 10% of Manhatten's grade A office stock.

Feb 25 12:08 PM

[WorkinginChina:]

This is a good overall article, but the reference to real estate is rather vague and one sided.

This article (and the referenced) talk about "Chinese real estate", but largely focus on Beijing (which is an extreme case because it saw a huge development boom in the run up to the Olympics) with a little reference to Shanghai. What about the other 400+ cities in China?

The Tier I cities (Beijing, Shanghai, Guangzhou and Shenzhen) only account for a small proportion of China's real estate stock and activity. There's over 100 cities with a population over 1 million in China. Although Tier II cities (such as Chengdu) and Tier III cities (such as Changsha) are less transparent, their real estate markets are in better shape. There has been a lot of supply, but no where near levels witnessed in Beijing and Shanghai. Also, demand is good because these cities are less exposed to the global recession and the majority of domestic companies not involved in exports are in good shape, growing, making money, and recruiting people.

From my observations working and living in China, the only firms struggling and having sleepless nights are foreign firms. Their CEOs in New York and London are currently in panic mode and pulling the reigns back on their China operations far sharper than is required. I know many people who have been laid off in the past few weeks in Shanghai and Beijing and a lot of them are now being poached and recruited by domestic firms.

But, the majority of domestic firms (the exception being those involved in the export business) are doing well and still recruiting. Yes things are tougher, but still far away from doom and gloom and better than anywhere else in the world. If anything, this is a fantastic opportunity for Chinese firms. They are cash rich in a cash desperate world and thus in the best position to snap up bargain assets (whenever and wherever that occurs) and foreign talent.

Feb 25 12:45 PM

[Michael Pettis:]

A lot of these comments and questions are discussed, including by Jack, on my original site.

Feb 26 07:00 AM