A Comprehensive Look At China's Property And Infrastructure Bubble

Includes: BHP, FRFHF, RIO
by: Just Another Investor


Psychological and social incentives are the driving forces in real estate prices.

Economic data demonstrate that the bubble is unsustainable.

Investment opportunities to profit from a collapse in property prices.

It's been no surprise that China has had the best GDP growth for the past couple of decades. The rise in wealth has been a virtuous cycle, jettisoning many of its citizens out of poverty. However, much of the growth has been investment-driven due to growth in infrastructure and property, rather than consumption-driven. There could be a tipping point at which its growth could slow down or - worse - contract. Here are some of the causes for the boom in property prices in China.

Power of Incentives

Marriage in China
The male:female sex ratio in China has been at an imbalance for decades; ratios range widely from as low as 50% to as high as 60% in the cities. Because of this imbalance, to attract a bride, one of the prerequisites is to own a home that can be a cornerstone for the young Chinese couple. Since buying a home is inadvertently tied to marriage, this can result in a home-buying frenzy as prospective grooms try to display their financial status, instead of progressively upgrading their homes at later stages in their lives.

Hukou registration/record system
The HUKOU or Huji registration system enables denizens of a municipal government to have rights like basic welfare and access to public education. To achieve public education beyond middle school, a person needs to have a HUKOU, otherwise they have to migrate back to their home village or city. Citizens who have HUKOU in their municipality and are residing there are more financially secure. On one hand, there are a lot of cities that create lot of jobs because of having a competitive advantage in manufacturing, but on the other hand, the migrants' permanency cannot be secure because of huge backlogs in getting HUKOU. This disparity pushes prices up, but at the same time restricts real estate purchases to only those who are on record with their local government, causing an inequality in home ownership.

To illustrate with an example, consider a city with 100 denizens, wherein only 10 of them have an exclusive right to public education and no restrictions on multiple property ownership. If the city attracts a lot of migrant workers, obtaining a HUKOU becomes a self-fulfilling prophecy: The other 90 try to speed up their registrations to catch up, and eventually it becomes like a bidding process where, once you get the HUKOU, you end up buying a home irrespective of the prices.

Lack of investment products and capital outflows
The Shanghai stock market index peaked in October 2007 to around 5900, subsequently was off 65% from the peak and stayed there over the past few years. A common investor in China can either invest capital in a savings deposit yielding 3.5% to 4.5% for 3-5 years, or dabble in real estate investment, which has been rising in the past 7-9 years at double-digit returns. With lack of capital outflows to other countries, China focuses its capital to be spent on existing projects in the country. This has also funded shadow banking as short-term commercial paper funding for real estate projects, as well as loans to developers, mining firms and other companies reaching for yield as trust products.

Constrained low interest rate environment and lax credit policy
In a decade of GDP growth in the teens, the deposit interest rate dictated by the central bank has been artificially set to a low value. In real terms, roughly in the past decade with around 10% GDP growth, the savings deposit interest rate has stayed pretty much the same, with roughly 3.5%. The result is the flow of capital to other financial assets, which have performed very well over the past few years. These include mainly investing in real estate, loans to manufacturing companies, mining companies and property developers. The banks over the past decade have handed out loans at 6.5% to 8% with deposits at 3% to 5%, and had a net interest margin at 3.5% to 4% constantly over the years. This plowed in huge profits because, as their assets grew, so did the profits. The non-performing assets as a percentage of total assets have been less than 1%, which is indicative of a booming economy. Credit issued by banks in the past 5 years has been roughly $12 trillion to $13 trillion, and has far outpaced growth in GDP. Simply put, $1 in credit does not achieve $1 growth in the economy; the additional abundance of credit will dissipate even if the Chinese economy slows a bit.

Property taxes as a long-term lease
Taxes on property in China are not due annually, as in most developed countries. The tax is implicit as the property owner leases the land under the building or apartment for 70 years. After the 70-year lease, the local government can either seize the land or allow the homeowner to renew the lease. The local laws are winding and complicated, as this was part of Chinese housing reform in the late '90s. As such, we have only surpassed 20 years of long-term lease with another 50 years to go (for the oldest lease). The effect of long-term leases where the government owns the land is huge speculation in home prices, because owning a home then can just be a store of value: Until you sell it, there are no capital gains to be paid. This makes housing seem more a collectible - like a piece of art or coin collection - which are usually purchased as a store of value rather than income generation, like farmland or a rental apartment. Absence of annual property taxes was also one of the biggest reasons for the Japanese property bubble in the 1980s. So if the real estate property is held only for a couple of years, it can cause big swings in property prices, as depreciation of the property is the only cost incurred. Because of property being a store of value in the eyes of the property owner, owners are unwilling to rent out their properties and collect income on them.

Local government revenue and auction process for land parcels
Since there are no annual property taxes, local governments earn their revenue by providing government services, but the lion's share of their revenue comes from selling land they own to property developers to develop and sell it to individual home-buyers. As a result, there is an incentive for the local government to not only sell land at higher prices, but also to attract a lot of property developers - the reason they conduct open-auction bidding. Years of profitable development of properties created a positive feedback loop: Homeowners sell land parcels at higher prices via auction; real estate developers sell high-rise apartments and houses at a premium; then local government evict farmers and demolish low-cost housing to sell the land again. This cycle will continue as long as property prices keep going up!

Shifting demographics
Population growth in China has roughly been 1.5% (YoY) in the last decade, and is gradually decreasing because of the one-child policy implemented in 1979, with population growth currently at 0.44% for 2014. The demand for housing should then mostly be from the rising middle class and urbanization. China currently has more than 50% of its population urbanized, and the rate of urbanization is slowing down. Moreover 65% of the population is above the age of 30, which is the average age of marriage in China. So combining these various factors - tepid population growth, slowing rate of migration and urbanization, and fewer younger people forming households - the demand for housing in China as a whole should not exceed the growth, which would only lead to oversupply. Affordability is going to be an issue as the average Chinese person has to bear the additional burden of caring for the aging population, as older Chinese are living longer thanks to better medical care and a higher standard of living.

Centralized monetary policy and decentralized GDP growth
The central bank of China sets the discount rate for lending, and PrOC sets GDP forecasts for that year. It is then the task of the local governments to achieve that growth, the advantage being that it becomes a market-based system and unleashes the potential for capital. The disadvantage is that there is a lack of oversight from the central government. The local governments, in order to achieve the GDP growth targets, leverage themselves to fulfill the level of infrastructure needed to sustain a high standard of living. This will lead to excesses, as the quality of GDP growth is undermined, and if only the quantity of GDP growth is emphasized. To just improve the GDP numbers of a municipal a local government, it can chose to build another building which contributes to growth irrespective of whether the building may be occupied or remain actually vacant. Supporters in favor of China's actions have usually said China needs to undertake this massive infrastructure to accommodate future migrant workers or the next generation; however, when you look at the underlying numbers on population, migration and urbanization growth, the validity of this is questionable. Economic activity should define GDP growth - not the other way around.

Affordability and Speculation
Decades of highly profitable real estate investment for the property owner, developer, banks, and anyone who has a vested interest in the development, has attracted a lot of capital. It then becomes irrational to think that home prices can never go down, as it does not pay to bet against conventional wisdom. The very reality of rising home prices drives speculation and attracted lot of people towards this sector. The rise in commodity prices is another example of that, as China consumes roughly 30%-50% of world's commodities. From a rational perspective, buying a house or apartment should still be compared to traditional yardsticks, like median household income and median home prices; renting versus buying a home; affordability indices; and supply and demand. For example, the disposable income for an average Chinese is 25,000 yuan or roughly $4,000 per year. The average 100-square-meter home costs $160,000, or 40-year unleveraged ratio for home-price to disposable income per year. In many urban areas, affordability is such that it takes roughly 50%-70% of disposable income to service the mortgage of the home, a highly unsustainable level. If the Chinese government has to engineer a rebalancing to shift from investment-driven to consumption-driven home ownership, this shift cannot happen as long as the bulk of capital is directed toward infrastructure development.

Economic statistics

Demographics for 2014:

Age structure:

0-14 years: 17.1% (male 124,340,516/female 107,287,324)

15-24 years: 14.7% (male 105,763,058/female 93,903,845)

25-54 years: 47.2% (male 327,130,324/female 313,029,536)

55-64 years: 11.3% (male 77,751,100/female 75,737,968)

65 years and over: 9.4% (male 62,646,075/female 68,102,830) (2014 est.)

Population growth rate:

0.44% (2014 est.)

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Birth rate:

12.17 births/1,000 population (2014 est.)

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Death rate:

7.44 deaths/1,000 population (2014 est.)

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Net migration rate:

-0.32 migrant(s)/1,000 population (2014 est.)

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urban population: 50.6% of total population (2011)

rate of urbanization: 2.85% annual rate of change (2010-15 est.

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Source: CIA world factbook China

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Number of housing units built from 2004 - 2012:

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Source: National bureau of statistics China.

An important statistic: Working population in China in year 2000: 720 million. Working population in China in year 2012: 767 million.

In a population of 1.3 billion, as a very crude estimate, there could be 400 million Chinese households, and the number of houses sold (at a 100-square-meter average) is around 64 million in the past decade. The above numbers do not include the year 2013, which was actually a record year.

Floor space under construction, completed, started, and sold:

Click to enlargeSource: National bureau of statistics, China.

China has 6 billion square meters in residential buildings being constructed right now, which equates to roughly 60 million houses and apartments being built.

In spite of significant construction, inventory is still very high; supply has already far exceeded demand, as shown by floor space sold and floor space constructed. Yet new buildings are still being built, as shown in the floor space started this year. The above represents residential only, though office buildings are also being built at the same pace.

Investment opportunities
The best opportunity right now is to short commodities, as China takes a huge chunk of the world's output of commodities. From the annual reports of Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP), it takes about 35-50% of commodities, so once China slows down construction, the parabolic prices of commodities are going to fall. Buying long-term put options on stock prices of Rio and BHP Billiton seems the most advantageous to me. I currently hold put options on Jan 2016 at strike prices of $45 and $55.

A significant portion of my net worth (more than 50%) is in Fairfax Financials (OTCPK:FRFHF), which has an asymmetric on a fall in commodity prices. Currently, the company holds CPI-linked derivatives, which will be valuable if commodity prices fall. As an individual investor, my options are limited, so I have opted for an indirect investment through Fairfax.

I am also continually looking for a sound bank or insurance company in China that might have steered off the bubble. Once the bubble deflates, investors will stay away from all financial institutions, and all stocks will be punished. In buying a sound financial company in China, there is a high reward once confidence comes back. Alas, I am yet to find one.

Disclosure: The author is long FRFHF, as well as short RIO and BHP through put options. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.