The latest from Andy Xie highlights the peculiar relationship that exists between rising Chinese land prices and the expansion of Chinese industry.
First, here's a quick refresher on the extent of land price inflation:
The inflation has so far occurred mostly in land and commodities. The land price has increased by over ten times since 2002, thirty times in some hot coastal cities, and over one hundred times in the most speculative areas. For example, in many villages in Zhejiang Province, the land price has risen above 10 yuan per million mu to 100 times the price a decade ago. Even though the land is rezoned for urban use, the price can't be justified under any circumstance. It is nearly ten times the average land price in Britain for urban use. Britain's urban land prices are the highest among all major developed economies. It is reasonable to believe that China's land price is the highest among than all the major economies today, even though China's average wage is one tenth of the developed countries'.
Note that Zhejiang is one of the provinces bordering Shanghai, and is one of China's most prosperous, which is probably one reason why speculation for village land has been particularly strong.
Regardless, here's where the peculiar land/business expansion relationship unfolds:
The increasingly inflated land prices have shown up in the nominal GDP through rising property sales to over 14 percent of GDP last year. Moreover, so much investment has occurred due to the collateral value of land. Local governments have borrowed enormous amount of money (probably around 17 percent of total bank lending) to fund or subsidize investment for creating GDP. The loans are secured with land. Without the high land price it is impossible for this source of financing to be possible. As fixed investment is close to half of GDP and driven by government, it is easy to understand how the land bubble has accounted for a big part of the growth in this cycle.
Recent manufacturing investment, for example, is partly due to high land price. Local governments have been competing fiercely for manufacturing investment. Many companies have learnt to exact so much benefit from local governments that they put down no equity capital for investment. They often ask for free land and use the land as collateral for a bank loan. They then lease equipment from the manufacturers that obtain bank loans for the leases. Essentially, the equity capital is from the land donated by the government. This explains why so many companies have always had negative net cash flow but keep expanding. Indeed, expansion is critical to their survival, as they need new investment to bring in cash to sustain themselves.
Essentially, soaring land prices and intense competition from local governments for industry, has allowed Chinese entrepreneurs to start companies without any capital, and without the need for positive cash flow either. All the risk is on the part of the local governments and the banks who hold land as collateral for the entrepreneur's loans.
This sounds like a nice deal if you can get it as an entrepreneur, in fact it sounds even wilder than revenue-less .Com companies' raising money during the internet bubble. At least they were using equity capital and didn't pose a threat to banks' balance sheets. Given the above, forget about speculating on property prices, that at least has a risk of loss since you have to put money down. The smarter punter is better off speculating on industries, with a new factory for example, if he can get the sweet deal described above, since he'll have almost no skin in the game.
Problem is, the peculiar relationship outlined above explains how Chinese financial institutions and local governments could be hit hard in the case of a crisis, especially as industry speculators create overcapacity. A Chinese economic slowdown could cause a protracted drop in Chinese land prices, coupled with the closure of leveraged businesses which aren't producing positive cash flow. The entrepreneurs involved could walk away scot-free, given that they used other people's money and land to start their businesses, while banks and local governments could be left holding the bag in the form of under-collateralized non-performing loans and declining tax revenue. This can happen in every country during a downturn, but in China the risk may be disproportionately allocated to the banks and local governments, while insufficiently allocated to the entrepreneurs. In this fashion, China may be too business friendly despite all the other hurdles entrepreneurs face.
Mr. Xie's piece is actually about far more than the tangent we decided to extrapolate upon above, and is worth a read.
Disclosure: No positions