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Property Bubble, Inflation Hedge or fundamental revaluing - Chinese Property in the post financial crisis era

During the financial crisis, the Chinese government mandated the largest acceleration of bank lending as a % of GDP in the history of the modern world. Its goal was to stimulate the economy at all costs. Growth = Jobs. And the country needed jobs as masses were unemployed as factories closed down due to the contraction in exports to it's trading partners.

Early in the crisis, the local governments started to buy all oversupply of properties in order to remove inventory off the books of the real estate developers who were unable to pay for the land they had purchased and who were also unable to pay the banks back what they had borrowed. Most developers were so leveraged and thinly capitalised that the financial crisis left them insolvent. Which created the need for government assistance.

Before the financial crisis the real estate market had been subject to implicit lending restraints in the governments attempt to cool the market after the huge upswing between 2000-2005, and 2006/2007. The financial crisis hit and the development of land banks was brought from a slow pace to a complete stop.

These three factors led to a very unusual swing of events. Just as the expansion of lending and hot money from international investors hit the real estate market, there was very little supply and very few projects in the pipeline. This caused an initial spike in prices which started the buying avalanche.

The rich understanding economics jumped straight in; knowing that monetary inflation was being used to heal the economy and that property was the best way to leverage up and take advantage of the new opportunity.

Then came those that needed to purchase homes out of fear they would be priced out of the market. In China, wedding rings are not so important. But having a property for you, your wife and child to live in is pinnacle. Without a property you own (not rent) you have very little chance of finding a suitable partner. Due to the demographic landscape and the evolution of living patterns, this force was particulary strong and created a sizeable bid to prices in general. Panic buying always has the effect of strong price rises.

At the same time foreign investors learnt they could swamp the chinese market with their hot money through backing investment in hong kong developers. The hong kong developers have played this game before and met the demand by huge stock issuance on the hong kong markets. The recipe was set and huge growth was certain. It was a zero sum game. Borrow at low rates in USD, invest in property in the undervalued RMB. This was a new type of carry trade, instead of playing for interest rate differential. Investors were looking at currency profits and asset appreciation, whilst borrowing at artifical negative rates in USD.

Then came the novice investors who had saved for years in saving deposits that always depreciated in real terms due to the inflation effect of the governments 'jobs at all costs' mandate. After the great fall in the chinese stockmarket, a lot of chinese learnt the ponzi dynamics of the stockmarket. Where do you put money that will retain its value. The choices are very few and far between. Properties appeal was too strong to ignore for this section of investors. The frugal savers with a small appetite for risk started to allocate their savings differently. Our of savings into property.

As with most developing economies, corruption is integral in the system. With an expansion of bank lending, came an expansion of those in the right power circles taking a slice for themselves. Due to currency controls, a lot of money was laundered into property domestically. Property databases and registration is still in its infancy in China. Property provides the perfect home for 'grey' money.

It was a perfect storm, because local governments were presented with an opportunity to make up for their loss of revenue caused through the financial crisis and fall in export value. What better way than selling land at a premium because of the implied state support of the central government. Banks were happy to lend, because they themselves had implicit support of the government. Everyone knew implicitly what was going on.

As with all bull markets the feedback cycle is self-fullfilling. As property moved up, more people, companies, local government had paper profits. Investors purchased more property and then as the property carried on its ascent they had the ability to fund evermore purchases. The local governments had increased ability to demand ever higher land premiums. The developers, eager to make as much as they could hoarded properties and created further wood on the fire. No supply, lots of demand, rising land costs is a recipe for huge property price gains.

It is no wonder the above manic behaviour from the industry and its customers had led many to state there is a property bubble.In fact almost every economist following China has declared the property market in China a bubble. To the untrained eye and without delving further a bubble could be the knee jerk conclusion.I, however disagree; firstly bubbles are very hard to see and having a contrarian slant I submit the very fact everyone thinks it is a bubble means it isn't. This is the nature of bubbles.

What constitutes a bubble?

Many people have different ideas of what constitutes a bubble. But almost everyone agrees there has to be an extensive appreciation in the price of the asset. Many remember the 'dot-com' bubble where stocks went up 3000-4000% in price in a matter of less than year. Looking back, have prices in China moved up on par with these increases.

Those that are familar with chinese property know that pre-1990, property was mainly owned by the government. The privatisation of property came very late in the development cycle. In 2000, the market started to develop into a fully functioning privatly owned property market like us in the west are use to. With that came a huge expansion in price. Between 2000-2010, property in Shanghai have in general gone up around 1200%. Which some would say is evidence of a bubble. I dont agree, if we look into the price rise there is a lot of other factors we need to consider before announcing to the world that China is on a 'treadmill to hell' or is on the brink of collaspe.

1. China, in the last 10 years has gone from a realtively poor country to the second largest economy in the world. GDP has increased close to 500% in the last ten years. A 500% increase in GDP warrants a significant revaluing of private property prices. Many believe that if the RMB was floated, it would strengthen significantly. So on the basis the currency is 20% undervalued, GDP growth over this time,on a dollar basis probably sits closer to 600%. This is a monumental increase in GDP.

2. Inflation worldwide has been huge, because of the governments desire not to report actual inflation figures (which is universal across the world). Very few people actually understand how money has devalued over the past 10 years. Having looked at the price series of many goods and from personal experience, I estimate money had devalued by at least 2.5 times in the past 10 years. 250RMB in china in 2010 buys you the same amount of goods, 100RMB bought you in 2000. Prices are subject to price distortion. But overall, all factors included. Money has devalued 2.5 times.

3. Even now after the huge run-up of prices, China's cities like Shanghai and Bejing are not even priced in the top-10 most expensive countries for residential property. This paints a very interesting conflict, how can property be considered bubble valuations when property is not even as expensive as place like Mumbai.

If we take the above into consideration, we find that the 1200% increase, adjusted for inflation brings the increase on an inflation adjusted basis to around 480%. 480% rise is no means a bubble, but actually reflects the GDP expansion quite closely. Infact I submit that property in other countries has shown far more worrying trends and is not supported by the huge prosperity that China has created over the last ten years.

Many say that the run up in property is a bubble because the lower class and lower middle class can not afford to buy. And the wages to property price ratio is off the scale. I think this ignores the dynamics of the wage differential between the classes and this arguement should be reserved for the subject of how the lower classes are being allocated a very small piece of China's new found wealth due to structural imbalances. It does not predict or justfiy property valuation. Far from it, it actually gives support to higher and higher valuations. If the lower classes (which are a very large portion of China's enourmous population are being allocated very little of China's prosperity. Then others in the system are being allocated more, in layman terms this means the rich and upper classes have even more money to buy new appartments. If very few individuals are taking a large piece of the prosperity pie, then these individuals will have the resources to drive the property market higher and this is exactly what is happening.

The higher middle class and upper class have the money to pay for property at its current level and this justifies the price. If they did not have the money, then they would not be paying cash for properties, which is more common than people can ever believe. Those that are buying using finance almost always put a 50% down payment down. This is the defining difference between the USA property market and Chinas. Strategic foreclosure by property buyers will only occur in China when property has fallen 50%. Where as in the USA, strategic foreclosures became a viable option after 10% drops. In the USA some people borrow LTV of 105% to pay other buying expenses. This is unheard of in China.
Disposable incomes in the higher classes is a lot bigger than the west due to the lower living costs associated with the subsidisation of living in China. Taxes are very low as no real personal tax collection system is in place. China lacks many taxes the west has. This means that any prosperity in the higher classes always translates in the ability to expand investment. Where as in the west, further financial prosperity only creates higher and higher tax liabilities.

On this basis I conclude that Chinese property is not only priced at fair value, but the hands holding the property are strong enough to endure periods of price deflation. The ownership structure is very skewed due the wage differential between the rich and poor. And this also skewes the rental yield and other metrics of the property market. But It does not in anyway predict bubble valuations. This market is very unique, but isn't most things in China?!

The structure of ownership does predict possible volatility however and if things continue could easily lead to a situation of property moving far away from fundamental valuation, after all price rises are very agressive. But it is certainly premature to announce we have moved away from fundamental valuation; let alone we are in bubble territory.

Chinese Policies, removal of risk in banking sector. Or centralisation of power.

Many believe that the Chinese government is worried about the effects of a property market collapse on the banking sector. The issue at hand is not the financial consequences of the run-up in prices and the latent financial risk it produces. The issue is the social consequences of concentrating the prosperity of Chinese development in the hands of the rich. This is not a new factor, it is something that has plagued political divide for years in the CCP closed Politburo circle.

After the opening of the coastal cities, China's prosperity was monopolised in the coastal areas. This created a localised power corridor that under Jiang Zemin was not broken, infact many obsevers agree that the Shanghai born Jiang Zemin was instrumental in sucking power away from the political capital and concentrating it in Shanghai. As the economy developed, the central government lost more of its power to the local prosperity centres like Shanghai. This put future re-balancing at risk, because it meant that Shanghai and other centres would be the engines of growth and had the say in allocation of China's future wealth distrubtion.

Hu Jintao worked very hard to re-centralise wealth distribution which included political rebalancing of Shanghai's power by removing Chen Xitong. It was planned that this removal would allow a central rebalancing of power and allow wealth to be distributed into the interior. This among many things, would reduce social risk and lead to a “harmonious society,”

The recent rise in property prices has led to further polarisation of wealth distribution and further widening of the independence of local government policies from the central government. This has created huge social risk and the central government has decided to face this now rather than allow a potential problem from developing. The economic planners know inflation affects the poor most negatively and creates huge social tension. The unfortunate events in 1989 were started by protests because of inflation and this is very fresh in the minds of the Politburo.  Risks associated with inflation and its social consequences now outweigh the emergency need to stimulate the economy that emanated in the depths of the financial crisis. And the Politburo has taken decisive steps to circumvent risks that it sees as potentially destabilising.

The draconian property policies recently have moved to squash inflation expectations with the prime objective of rebalancing wealth distribution, creating sustainable growth, ease social problems/inflation expectations and allocate lending capital to other areas of the real economy . The central government wants control of property prices and the recent moves are illustrative of this. Before this occured the central government met with local leaders with the explicit aim of making very clear, the central government intended to put the brakes of price appreciation. And they needed to brace themselves.

Economic Landing

Many are worried that the recent moves are going to create a vacuum of price falls. This will lead to the bubble bursting and a hard landing, especially on the backdrop of sovereign default risk and the solvency of western banks.

Of course the flip-side of the coin is that China is trying to engineer a mid-cycle soft landing. This does not make for good news headlines. People love to hear about bubbles bursting. But on the assumption China can engineer a mid-cycle soft landing and achieve its lofty goals. A positive stabilising of property prices will emerge. Stability at fair value will squeeze out a great deal of speculation and will lead to a better ownership structure in general. This makes property a less volatile investment going forward.

For this reason allocating some of your portfolio into Chinese property is a sensible strategy, to date the Chinese have managed to achieve what they have set out to do and betting against them this time could potentially leave your portfolio lacking an essential component. The drive of urbanisation and inflation makes future appreciation very likely. The market is in landing mode, so there are short term risks. In the medium term property valuations are attractive especially in the lower-end of the market.

Long-term risks (5-15 years in the future) will remain until wealth is distributed more evenly. However this long term risk does not justify and outweigh the medium term propensity for appreciation.

Going forward we believe that the stockmarket will be subject to some further price falls unless there is a global propensity to more risky assets, it seems likely the banks will recapitalise by selling stock. And this and the governments price policies will create less demand in the property market. But any pullback here is the perfect time to buy. And even though we remain cautious on property over the next 2-3 months, we believe it opens a sizeable opportunity to invest.

The above comments do not reflect those of China Enterprise, but the authors. The contents of the above are for informational and educational purposes only and can not be deemed as advice. Before making any investment decision we advise you to seek independent advice. Please see our full disclosure in our profile.


Disclosure: Long Residential Property