China’s Real Estate Boom And Fiscal Stimulus

I let myself get a little behind on my China reading this week but just caught up with two excellent posts by Michael Pettis. After casting about trying to understand a bit what was going on in that country and where it might be headed I found his blog and now use it as the starting point for whatever conclusions I might draw. I do read others but Pettis is the base I use to build on.

Anyway that’s a long winded way of saying that you need to spend some time reading his last two posts — links here and here. The first is a recap of an email discussion he had with a real estate investor who apparently spent a lot of time touring China and came away with some incredible insights. I’ll get back to that in a second. The other is a rather long blog about the Chinese stimulus plan and its impact on the country. Actually, the two posts fit nicely together.

The post dealing with Chinese real estate is fascinating, at least to me. As I mentioned, the email came from an investor who is a fund manager. He notes some rather striking examples of overbuilding in several areas that he visits and puts some questions to Pettis about how he thinks the country would cope with a collapsing real estate bubble.

The replies from Pettis are striking only in that they demonstrate the difference between Western economies and China’s economy. Pettis contends as he has consistently before that the control the government exerts over the banks gives them much more leverage than the West enjoys. Accordingly, he expects that China could ride out a major bust, in fact would act to prevent one, but at the expense of long-term lower growth. He generally tends to see major problems with the Chinese economy devolving into a Japanese like malaise as opposed to a cataclysmic crash.

Finally, let me leave you with some points this particular investor made to Pettis in a follow-up article. He has some observations that I’ve not seen elsewhere and towards the end makes a couple of really good points about the Chinese affinity for real estate and the perverse results that the government’s stimulus program is producing.

¨ “Real estate prices are up 70-80% in the last five years. Generally speaking, real estate prices in China are equal to or slightly greater than 2007.  Land prices in Beijing and Shanghai are up 10x in the last 5 years.  In 2004, I remember whole market sentiment was different.  The amount of restrictions was much, much higher – for example completion schedules were controlled.  From my impression, the increases in the property sector have been because of loosening of regulations.”

¨ “The buying sentiment is back to 2007”.  X is bullish because the affordability ratio is down from 80% (e.g. requiring 80% of your monthly income to meet mortgage payments) to 50-60%.

¨ “When the real interest rate (on bank deposits) turned positive, the housing market went downhill.  It was directly correlated with the property market.”

¨ Most of the developers are buying land again, and the price has skyrocketed.

¨ Gearing ratio for the industry hasn’t come down, but they’ve rolled over short-term loans for long-term loans.

¨ Q: What else can the government do to promote the sector other than liquidity?” A: Not much.  They can introduce more land at a cheaper price.

¨ The government is outright lying about inventory overhang in major cities.  X was laughing about the Beijing government’s claim that it’s only a 2 month inventory overhang in the city.  He figured closer to a year from personal observation.

¨ No evidence of major consolidation in the market at this point.  The listed developers haven’t been coming out with many acquisitions.  X estimated that 5-10% of the small-time developers in Guangdong province can’t get their projects done.

¨ A freaky deduction of my own: Even at the darkest hour of the crunch, the real estate developers decided it was easier to go renegotiate loans with the banks than lower their prices!  They never had to lower their prices even though they were making gross margins in the range of 30-40%!!  That’s not a bailout from the banks, that’s a handout!  Then again, such a huge portion of Chinese savings have been put into real estate that if prices came down the government would be worried about the wealth effect decreasing people’s consumption.

¨ It would be fair to say that a large majority of the residential real estate excess we see is in the outskirts of cities.  Anecdotally we’ve observed and heard these projects often get sold even though occupancy rates remain dismal (0-30% dismal).  Realistically speaking, lots of these projects will never be occupied.  If a meaningful portion of Chinese household savings is in real estate that never will be occupied or won’t transact for the next decade (and then transacts at a potentially lower rate 10 years out given that the building has been rotting for ten years and the construction quality sucks), are those savings really there?

¨ Just to clarify, we do see plenty of excess inside cities.  It’s a bit harder to spot (because it’s hidden by other buildings instead of popping out of a field).  And you definitely observe blatant commercial/retail excess in prime locations, and those stocks haven’t recovered.

¨ Our analyst’s view is that “As long as the government provides the liquidity, it will support the market.”  Why do Chinese like real estate so much?  My view is there is an unusual cultural affinity for real estate ownership in China.  Aside from that however, if your interest rate on your savings account is 2% or less, then real estate can look pretty attractive in comparison.  That’s why you end up with so many sold and unoccupied units on the outskirts of cities in China.  The “Well, we might as well buy an apartment instead of leaving it in the bank” thought process is probably pretty common in China.  So keeping interest rates low enforces the property market in two ways: by making mortgages cheap, and by increasing the incentive for households to move their savings into real estate.  Considering how many unoccupied units we see in China, it’s certainly remarkable that the secondary residential property market is as miniscule as it is.  This all tells us that Chinese homeowners’ holding power is extraordinarily high.  So in shorting Chinese real estate we’re competing against 1) the buyers drying up and 2) Chinese holding power staying strong.  That’s kind of an ugly thing to bet against.  The fundamentals could stay insane for quite a while longer?  What makes the buyers dry up?

¨ China needs to increase domestic consumption for stable internally driven growth.  You can’t increase domestic consumption if you’re buying real estate.  So this is yet one other way that this whole liquidity injection is preventing a transition to a consumption-based economy.  You really do wonder how long the Chinese will keep up this level of “pump priming”.  If they realize how much they’re screwing themselves for the next decade, the central government might just tighten liquidity.

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