Why a Chinese Real Estate Bubble Supports a Stronger Dollar

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 |  Includes: CYB, UUP
by: Mercenary Trader

This news out of Chinais disturbing:

It is a scenic jewel, a hamlet of hill-hugging chalets, elegant church spires and ancient inns all reflected in the deep still waters of an alpine lake. Hallstatt’s beauty has earned it a listing as a Unesco World Heritage site but some villagers are less happy about a more recent distinction: plans to copy their hamlet in China.

After taking photos and collecting other data on the village while mingling with the tourists, a Chinese firm has started to rebuild much of Hallstatt in Guangdong province, just 60 kilometres away from the Hong Kong border, hoping to attract wealthy mainlanders, “homesick” expatriates in Hong Kong and tourists. The project had drawn a mixed response from residents in the original village.

Remarkable! You thought pets.com blowing through $300m was crazy? You thought it was crazy to build hundreds of homes worth $500,000 in remote desert towns where the average household income was only $47,000?

Not compared with this. China likes to do it bigger and better…

It turns out that the developer of this crazy real estate program isn’t a real estate developer. It’s the largest metals trading company in China.

The biggest Chinese metals trading company is building a Disney-like replica of an obscure, but beautiful Austrian village – on speculation that rich Chinese folk from Hong Kong will want to live there!

This information is from Michael Pettis – one of the shrewdest China observers. He points out that many –- or even most — State Owned Enterprises (SOEs) in China are involved in real estate, even when their main business isn’t real estate.

Mr. Pettis also points out that these companies are not relying on traditional financing options to get these projects done.

China Cracks down on lending, but Ponzi finance finds a way

China started to crack down on out of control real estate financing last year, but this just shifted the financing to other methods.

One common method uses copper as collateral. The Chinese government actively supports the financing of manufacturing, and one of the ways they do it is to allow below market financing of base materials, like copper and iron.

The setup is beautiful:

  • Financing to purchase copper purchases is very inexpensive – 1.5% vs. 10%+ for other lending. This is far below other market interest rates.
  • You don’t have to pay the full amount until the metal is delivered. The delivery process for copper takes at least 3 months. With a tiny bit of work, you can extend the payment for the copper out 9-12 months.

It’s not a stretch to assume the largest metals trading company in China knows how to use copper as collateral for crazy real estate deals.

And since copper has been in a bull market for the last year, banks are glad to lend money to purchase copper, with the purchased copper as collateral.

It’s great business for the banks, as long as copper is going up in price. When the price of copper falls too much, however,, it all collapses as the bank’s balance sheet gets hit exactly as profits are being squeezed.

Michael Pettis calls this “Inverted Balance Sheet” financing. It’s closely related to the idea of “Ponzi Finance” by the late, great economist Hyman Minsky.

China moves from Speculative to Ponzi Finance

Prof. Minsky identified three types of borrowing — and one of those types of borrowing is more fragile than a Ming dynasty vase:

  • Hedge Financing: Where the cash flows from the investment cover both the interest and the principal. This is healthy borrowing.
  • Speculative Financing: Where the cash flows from the investment cover only the interest payments on the loan, and not the principal payments. This can be useful for improvement projects.
  • Ponzi Financing: Where the cash flows from the investment do not cover the interest payments or any principle repayments. This type of financing requires ever higher prices in the asset to be able to cover the loan repayment, and is not sustainable over the long term.

Ponzi financing requires ever higher prices. Flat prices are not enough to generate the profits to cover the loan costs for Ponzi financing.

Chinese real estate markets mash up Ponzi financing with the inverted balance sheet financing of Michael Pettis. It’s a turbo-charged version of Ponzi finance.

If the prices of real estate or the price of Copper start to go down, then the Chinese real estate market will be under significant pressure. As long as both are increasing, the bubble can continue.

One of the signs of Ponzi finance is inexperienced investors borrowing money and using it to fund wacky projects, because borrowing money is so cheap. I think the Austrian village project by a Metals Trading company fills these criteria.

The bust is the most vexing problem of economics. That’s why China is doing all it can to avoid the real estate bust.

Ponzi financing isn’t rational – so the bubble lasts longer than rational people expect

Ponzi finance lasts much longer than any rational observer expects.

Both the internet bubble and the real estate bubble lasted years longer than people expected. The markets continued to go up for years past reasonable values.

The entire point of Ponzi finance is unreasonable — it involves borrowing money that can’t be repaid unless prices go up! And people are making enough money that nobody wants the bubble to end.

China faces significant inflation today. China has made a series of moves to combat the inflation. To slowdown lending, China:

  • Raised interest rates for lenders
  • Raised reserve requirements
  • Cracking down on using metals financing for real estate speculation

Raising rates is one of the factors that causes bubbles to pop. Higher interest rates restrict lending, which reduces demand for the collateral. When collateral prices start to tumble, it causes a price death spiral.

China faces a dilemma – it wants inflation to slow due to social unrest, but must be terrified of the consequences of a stalled economy.

It’s trying to slow down real estate lending, all while keeping the banking sector from imploding.

The pressure is further compounded by the only way out for China. China’s best bet to avoid a catastrophic slowdown is through juicing their export sector.

But there is a huge problem with this solution. Chinese inflation is bad – bad enough that they are taking serious steps to combat the inflation.

The best way to combat the inflation is to let their currency get stronger. Yet, the only way to juice their export sector is too continue to keep the Chinese Yuan undervalued.

The best solution to their real estate crisis – juicing the export sector by forcing their currency to be weak – will cause even greater inflation.

Not only that, but Ponzi finance bubbles tend to last longer than anyone expects. These factors make it hugely tricky for China.

This cannot end well for China. The only question is when, not if, it will end badly.

Trading implications of the Chinese Bubble

The trading implications of this are clear: China will try to do all it can to keep the bubble going while trying to defuse the ticking bomb of its banking sector.

It must keep the bubble going but at a slower pace while exports pick up the slack – because staying in the bubble is much easier than trying to reignite a stalled economy.

In response to the bubble expect:

  • Copper prices supported by Chinese Government: By this point, the Chinese government knows they have a copper collateral problem. China will place a government “sponsored” bid under Copper to keep prices stable or higher. Copper won’t correct to a reasonable price simply because the consequences for the Chinese economy are too large at this point.
  • A stronger USD as China resumes and increases Treasury Purchases: China will attempt to shift activity from its overheated real estate sector to its export sector by resuming their awe inspiring purchases of Treasuries. Keeping their currency weak is the main lever to stimulate the export sector.

China needs another sector to pick up the slack in Chinese demand that won’t spur more internal inflation.

The only sector large enough is the export sector. Their typical lever over the export sector is through currency manipulation. Their purchases of Treasuries to stabilize and possibly increase over the next few months.

Here is where they face a dilemma. Their best way to contain internal inflation is to let the currency appreciate. But due the demands of the real estate bubble, letting the currency appreciate would devastate the export sector.

This cannot end well for the Chinese, but that does not mean we cannot trade their attempts to survive the crisis. Expect a stronger U.S. Dollar.

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here