Brace yourself: China is heading for a hard landing
John Stepek Jan 20, 2012
The curse of the skyscraper has struck again. Noting the “unhealthy correlation” between the building of skyscrapers and financial busts, Barclays Capital has been publishing a Skyscraper Index every year since 1999, as a sort of early warning indicator. Building skyscrapers is often symptomatic of “a widespread misallocation of capital and an impending economic correction”. In short, when countries start competing with each other to play host to the world’s tallest building, a financial crisis isn’t far behind.
So which country is building the most skyscrapers this year? It’s China, with 53% of the global total. And whose property market is now crashing? That’s right. China’s. Prices of new houses fell for the third month in a row in December, according to official figures. The drop was widespread – falling in 52 of the 70 cities monitored by the National Bureau of Statistics.
Although prices overall are still up by 1.4% year-on-year, that nevertheless compares to growth of 6.4% for the whole of 2010. Local evidence is far more gloomy. Another property agency, Homelink, reported that prices of new properties in Beijing fell by 35% during the month of November alone, as developers slashed prices to clear stock. On the China Law blog last month, Steve Dickinson talked of prices falling by 30% in Qingdao (a city on the east coast of China), where he lives. Sales have slumped, work on uncompleted projects has slowed or stopped, and developers have stopped buying land.
There are dozens of other horror stories out there, including tales of families pooling their savings to put deposits on flats, only to see their value then plunge as desperate developers try to offload the unsold units. As for sales of existing houses, the situation is similar to Britain.
There’s a stand-off between sellers and buyers – buyers expect double-digit discounts, sellers still want to get away with 5% off. Sellers are, by and large, still not in a position where they are being forced to sell up (though that could change as the economy worsens). As a result, while sales prices are only a little lower, sales volumes have plunged. The important point to take away is that, whatever you hear from the bullish voices, “the bubble has already burst”, as Dickinson puts it. Now it’s a matter of dealing with the fallout.
Why are prices falling now? Up until 2008, China’s economy was based on booming exports. The financial crisis put an end to this by freezing global trade almost overnight. In reaction, the Chinese government went on a massive spending spree, pumping out loans via the banking sector to fund infrastructure development. But as inflation ticked higher, the government started to pull the reins in.
However, while China’s leaders began tightening rules around property transactions as early as spring 2010, developers kept right on building, expecting the government to relent. As tends to happen in property bubbles, they had come to believe that “the government can’t let house prices fall” (sound familiar?).
But with the government more concerned about inflation than growth last year, it continued to tighten. Developers started to run short of funds in autumn of last year, as Patrick Chovanec, who teaches at Tsinghua University’s School of Economics and Management, notes on Chovanec.wordpress.com.
So how much does this matter for the rest of China – and for you as an investor? The short answer is: a great deal. In fact, the Chinese property market may be “the most important sector in the universe”, as Jonathan Anderson of UBS put it last year. “Real estate and housing construction pervade [China’s] entire growth model.”
Faced with a shortage of places to put their money (bank accounts pay far less than inflation, while local stockmarkets are even more volatile than our own), Chinese investors have bet heavily on good old bricks and mortar – not for rental income, but simply for capital preservation and appreciation.
If property loses its appeal in the eyes of the Chinese investor – which certainly seems to be happening – then developers won’t get paid. As developers run out of money, they won’t be building any more. That has two big knock-on effects. For one, it means less business for everyone connected to the construction industry.
But at least as importantly, it cuts off a crucial line of funding for local governments. China’s local government funds big infrastructure projects partly through money raised from land sales – according to Chovanec, land sales account for around 40% of their revenues. With land sales stagnating and prices plunging, those projects can no longer be funded.
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This is a major problem for China. Investment in property accounted for around 13% of GDP growth in 2011. Even if they build the same amount this year as was built in 2011, it would “take GDP [growth] down to 6.6%”, reckons Chovanec. For an economy whose ‘stall speed’ is generally seen as 8%, that’s a hard landing. A fully fledged crash would be worse – this doesn’t take into account the knock-on impact on the financial sector or the wider construction sector, which could account for as much as a quarter of China’s total GDP. Indeed, Stephen Green of Standard Chartered reckons that around half of China’s economy is linked to the fate of the property market.
It means the country is running out of growth drivers. The export-driven model has already collapsed. Net exports actually detracted from GDP growth in 2011, and with Europe – one of China’s biggest export markets – either already in recession or heading there, the same is likely for next year. With property investment cooling off rapidly too, China is left with “consumption and government spending as the two main economic drivers”, as Reuters notes.
But consumption simply isn’t growing fast enough to replace the growth created by infrastructure investment in recent years. As a story in the Financial Times this month noted, as well as empty apartments, the country is scattered with under-used shopping centres. “A boom in the number of [shopping] malls without a matching increase in actual shopping gets to the heart of… the fundamental problem of the Chinese economy: too much investment, too little consumption.”
We also suspect – judging from experience elsewhere – that it won’t be easy to build a consumption boom on the back of a collapsing property market. Even if most Chinese properties aren’t bought with excessively large mortgages, seeing 30% of your investment vanish overnight isn’t the kind of figure that makes you want to go out and celebrate.
The bulls argue that the Chinese government can “engineer a soft landing”. The latest GDP data, showing that China’s economy grew by 8.9% in the fourth quarter of 2011, beating expectations for 8.7% growth, were taken to prove this point, buoying stocks earlier this week.
But this ignores the fact that this was the slowest pace of growth seen in two and a half years, and the fourth quarter in a row of slowdown. On top of that, the data were artificially boosted by factories rushing to get jobs cleared before January’s Lunar New Year holiday, suggesting that first quarter growth will be significantly lower.
Meanwhile, even though sales of residential floor space fell by 8.4% year-on-year in December, completed space was still growing. Rising supply at a time of falling demand spells further price falls, as Stephen Green and Lan Shen of Standard Chartered point out. “This sector… remains the biggest risk to China’s economy.”
But won’t the Chinese authorities just loosen monetary policy again? It seems unlikely. For a start, another stimulus would just create the same problems. China initially tried to rein in the property boom for fear of growing social unrest as the divide between the ‘haves’ and ‘have-nots’ grew.
If the crashing property market puts a dent in the balance sheets of banks and local governments (credit rating agency Fitch reckons around 35% of bank loans are either directly or indirectly related to Chinese property), the country may need to focus more on bailing out its banking sector.
More to the point, as Dickinson puts it on the China Law blog: “Once a real estate bubble bursts, there is no government powerful enough to stop the resulting collapse in prices and subsequent effects.” You only have to look at the efforts of central banks in America and Britain to recognise that.
As Bernard Tan points out on Fullermoney.com, monetary policy operates with a significant lag. Even if the Chinese government slashes rates hard and fast, it normally takes around 12 to 24 months for stocks to bottom out after rate cuts have begun. The property cycle moves more slowly. The US housing market, which started to collapse in 2006, is still bumping along the bottom six years later.
The point is that, while China should be able to bail out its financial system in the event of a collapse, “it is going to mark the end of the investment-led growth model. This will not only lead to lower growth rates in China, but will be a major global event, given the world’s reliance on China’s ‘economic miracle’,” as Pivot Capital puts it.
The last resort of the bulls when confronted with these arguments is to say that even if China does crash, every growing economy in history has faced these speed-bumps – the US endured several depressions on its road to economic dominance. To which we’d say: we agree entirely.
We’re not necessarily saying that this is the end of China’s growth story. Yes, it faces many challenges in the longer run, including unhealthy demographics and the fact that authoritarian governments do seem to have limited shelf lives. But all the progress of the last 20-odd years isn’t going to be wiped out overnight.
Indeed, in many ways a slowdown is just what China needs – it needs to start focusing on finding ways to encourage its citizens to make use of all that infrastructure, rather than building ever more of it.
However, that rebalancing process won’t be easy. Is the world prepared for a China that’s falling into recession, and are markets pricing such an outcome in yet? We don’t think so. We look at ways to protect your wealth and to profit, if you’re feeling bold, below.
##MMN - Investment basics##
Protect your wealth from a China slowdown
China accounts for nearly half of global demand for iron ore, steel, lead and coal, among other things. So a sharp drop-off in construction rates is likely to be bad news for commodity prices.
We suggested in mid-June last year that it would be a good idea to sell out of mining stocks and basic industrial commodities ahead of a Chinese slowdown. The FTSE 350 Mining index (comprising 24 FTSE-listed miners) went on to fall by as much as 27% by early October, as the European crisis saw investors abandon risky and cyclical assets.
The sector has since rallied somewhat, and is now about 7% down. But we’d suggest that this gives investors another opportunity to get out if you haven’t already. The earlier growth scare was based on a general fear of a Europe-driven financial crisis. The notion of a Chinese slump is not yet being priced in to markets.
The developed economy most exposed to a China slowdown is Australia. In 2010, China bought 37% of its mineral exports, up from 5% a decade earlier. That helped China overtake Japan as Australia’s biggest trade partner. China is also now the biggest source of foreign students. It recently overtook the UK to send the most tourists. China’s domestic stimulus programme, which boosted demand for Australian resources, is the main reason Australia sailed through the financial crisis unscathed.
Growing trade with China has disadvantages, says Michael Sainsbury in The Australian. “Australia is now more dependent than any other country on China (bar possibly Taiwan) and its continued economic growth.” Unfortunately, Australia has not prepared for a Chinese crash, says Melbourne-based economist Ross Garnaut.
Despite the boom Australia has run an average annual budget deficit, on a cumulative basis, of 4.8% since 2003. It hasn’t created a sovereign wealth fund, invested in non-mining infrastructure or reformed other parts of the economy. Instead, the wealth from natural resources, coupled with increased debt levels, has triggered a boom in housing and finance.
The Australian housing market is now one of the most expensive in the world judged by either price-to-income or price-to-rent ratios. The banking sector dwarfs the national economy at 3.5 times GDP. The Australian dollar (AUD) is also trading at near-record highs against the US dollar.
If Chinese demand for commodities dips, both house prices and the Australian dollar would fall, as Australia’s economy slows. That could start a vicious downward economic spiral, says M&G’s Anthony Doyle on the Bond Vigilantes blog. A slowdown would force the central bank to cut interest rates and “reduce the Aussie dollar’s appeal as a higher yielding currency”.
That would spook holders of Australia’s debt – more than 80% of whom are foreign – and could lead to a sell off of Australian government bonds, making it harder for the country to finance its debt and putting yet more strain on the Australian economy.
The most direct way to profit from the bursting Australian bubble is to short the Australian dollar. Spread betting is a short-term (highly risky) way to do it.
If you don’t fancy your chances at timing the market, the ETFS Short AUD Long USD (LSE: SAUP) is a London-listed exchange-traded product that tracks the MSFXSM Short Australian Dollar Index, meaning that the value of your investment should rise if the Australian dollar falls against the US dollar.
The other sector to avoid is luxury goods. The ‘wealthy Chinese buyer’ has replaced the Russian nouveau riche as the buyer of last resort for expensive goods, from fine wine to over-priced art to designer handbags.
But growth in demand for these is unlikely to be impressive if China’s middle classes are faced with the threat of falling property prices, rising unemployment and rapidly slowing growth.
In its latest – by no means downbeat – report on China’s luxury market, Bain & Company notes that growth “gradually softened in the fourth quarter” and luxury brand executives are only “cautiously optimistic” on the year ahead. Given that most stocks in the sector trade at a premium right now, that strikes us as good enough reason to avoid them.
• This article was originally published in MoneyWeek magazine issue number 572 on 20 January 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, sign up for a three-week free trial now.
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