Foreign investors have lent $54bn into China's real estate sector since 2010, much of it at remarkably low rates. China Vanke, China's largest developer, paid just 2.6 per cent last year on an $800m offering of 5-year bonds. Whilst Morgan Stanley suggest a further $30bn of syndicated offshore loans remain outstanding.
In addition, at least 60% of all companies listed on China's A-share market have invested in real estate development during the past decade. And all of its banks depend on housing mortgages as a main source of revenue. Whilst local authorities have depended on property development for up to 40% of their revenues.
This is hardly surprising, as the market has been a great money-making machine over the past 15 years. Before then, all urban property was built and allocated by the state. There was not even a Chinese word for mortgage, as there was no such thing as private residential property.
But this all changed in 1998, when the market was liberalised. Small construction companies, who up to then had done building work for the state, saw an opportunity to move into property development. And they soon found an enthusiastic market due to China's lack of an effective system of social security.
China's women have the upper hand when it comes to getting married, as the one-child policy has meant that 117 male babies are born for every 100 female babies. Surveys thus show that 70% of young women think that "housing, a stable income and some savings" are essential for any man wanting to get married.
Young bachelors have, thus, routinely turned to their extended families for help with raising the finance for a home. And as prices were doubling every few years since 1998, the "bank of mum and dad, and grandparents, and cousins" has always been happy to help. Plus, of course, the government weighed in with its $10tn credit bubble since 2008, as it sought to insulate the country from the financial crisis in the West by encouraging domestic construction.
The rise and fall of Shen Caixing, known locally as "Cement Shen" in Fenghua, a city of half a million people around 120 miles south of Shanghai, typifies what has happened. As Bloomberg reports, there are 90,000 "small developers" in China like Cement Shen who could now be at risk as China's real estate market finally begins to crack under the weight of its impossibly high prices.
Shen was the founder of Zhejiang Xingrun Real Estate Co., and a pillar of the local community and chairman of the local Real Estate Association. His 14-year property career summarises all that has been wrong with China's development during its "lost decade" under the previous leadership:
- Shen started out with a cement and renovation business, and became one of the city's first property companies
- These companies hardly existed before 1998, as urban property was all owned and built by the state
- Xingrun's latest deal involved building the Peach Blossom development in Fenghua
- It bought the land for this in 2010, at the height of the bubble, and its value has since fallen 30%
The key issue is the high level of property prices. Bloomberg reports it would now take 145 years for the average Fenghua resident to afford the cheapest home on the development. Average disposable incomes in the city were Rmb 39, 414 last year ($6341). Yet, the cheapest Xingrun home cost Rmb 5.7m for a 285 square metre apartment (3077 sq ft). Rmb 25m was needed to buy the top-of-the-range 500 sq m homes.
Just as in the US pre-2008, people came to believe prices could never fall. But last month, Xingrun went bankrupt, owing Rmb 3.5bn ($563 million). And to almost everyone's surprise, the government failed to intervene to support the company. This highlights the determination of the new leadership to change China's economic direction towards a more sustainable path.
As state-owned China Daily commented under the headline "No pain, no gain for China's reformers":
"Yes, there will be defaults by funds tied to unfinished property projects. There will be bankruptcies of companies burdened with excess capacity. There will be banks with ugly balance sheets - and runs on small financial institutions. Some cities, and some industries, will have to endure almost as much distress as they would under shock therapy.
The problem is that what began as a simple exercise in liberalisation has developed under China's system of artificial interest rates and currency controls into an epic speculative bubble. Bank deposit rates have been held low to provide cheap financing for the giant State-Owned Enterprises, whilst capital restrictions forced ordinary Chinese to invest domestically.
The result is that China is now home to millions of empty apartments. There were 64.5m of these as early as 2010, as their owners believed that capital growth, not rental income, was the key to success. Wealthy Chinese, able to circumvent the controls, have recently created the same effect in many Western cities, where the lights never go on at night in many Chinese-owned luxury homes.
This would never have happened if the previous leadership had not deliberately aimed at creating a "wealth effect" to boost consumption via lending bubbles. This allowed people in cities like Fenghua to buy homes at prices which they can never afford to repay. In turn, of course, this led many Western companies to invest in China in the false belief that it was now home to a thriving and growing middle class.
But an average disposable income of $6341 would not count as being middle class in any Western country. And thus, China's real estate bubble has been an accident waiting to happen for some time. Cement Shen's bankruptcy is, therefore, probably best seen as the "Bear Stearns" moment for China's property sector, named after the US investment bank whose March 2008 bankruptcy signalled the start of the US sub-prime crisis.
Of course, as with Bear Stearns, those who have done well out of the previous system are now loud in their denials that a systemic problem exists. China's richest man, Wang Jianglin, owner of developer Dalian Wanda, told state media, "There are only two possibilities to explain why people are predicting a collapse of Chinese real estate. Either they have ulterior motives or they have insufficient intelligence."
Who, after all, can forget the immortal quote of Chuck Prince, then Citigroup CEO, in August 2007, when it was already obvious to any informed observer that something very nasty was about to happen to the US financial system: "We see a lot of people on the Street who are scared. We are not scared. We are not panicked. We are not rattled. Our team has been through this before. We are 'still dancing'."
But as the Financial Times describes in an extensive analysis, "Many of the listed developers have been active in the smaller cities now suffering from oversupply. Country Garden and Evergrande - both active in offshore bond markets - have more than half of their developments in cities deemed "least preferred" by Alvin Wong, a Barclays analyst."
Investors have also begun voting with their feet. Bonds sold by Evergrande, Country Garden and China Vanke now trade at about 92 cents on the dollar, whilst Country Garden shares have dropped by a third since the start of the year. As the FT commented, "if China's best developers found themselves cut off from global debt markets, it would place financing pressure on the sector as a whole."
Even more worrying is that the fallout from this speculative mania will not be confined just to China.
Too many investors have fallen for the myth that China is somehow different, in spite of the evidence that its post-Mao economy has seen several major downturns of the kind that now seems underway again today.
And too many Western companies have rushed into China in the belief it is the "new, new thing," and have failed to recognise the debt-fuelled foundations of its apparent middle class appearance.
The writing, however, now appears to be on the wall. As the China Daily article concluded: "Most or all companies that still operate in the old industrial economy and pursue obsolete development strategies will face a long, painful path to reform."
How should investors position themselves in response? Clearly, bonds and stocks related to China's real estate developers are likely to continue to weaken. Equally at risk are funds run by the large Asian-based fund managers, as well as investments tied to Asian benchmark bond indices. Chinese real estate developers have come to dominate regional dollar bond markets, and are responsible for around 40 per cent of Asian (ex-Japan) new issuance of non-financial dollar bonds so far this year.
The bottom line - investment in Chinese real estate no longer looks "safe as houses."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.