China: forget fancy handbags and look to caustic soda
By
MoneyWeek editor-in-chief
Merryn Somerset Webb Aug 14, 2012
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China and high end goods: they’re a combination made in money heaven. That, at least is the current view of the industry, of much of China’s population and of course of the global stock market. You can see why.
Look at UK fashion company Burberry. Not long ago it was a relatively staid UK brand. Today it has a market capitalisation of £5.9bn with a recently reported 39% rise in profits. And the likes of Louis Vuitton, Gucci and Prada regularly report sales up 40% plus in China. The boom seems unstoppable. Prada has 22 stores in China already, and late last year said it intended to open another 50 over the next three years.
And it isn’t all about handbags and bangles. It’s about expensive cars too. The likes of BMW and Audi have stormed into China and fast reaped the benefit of a high-profit market in which customers want all the extras. Already, 60% of the rise in sales at BMW and 74% of the rise in sales at Audi so far this year are accounted for by China. And overall China is forecast to make up 50% or so of the total sales of Audi, BMW and Mercedes by 2015. Given that there were practically no cars on the road in China 30 years ago, that’s quite an achievement.
If you are interested in amazing numbers proving stunning growth there are plenty more around (there’s a great website called factsanddetails.com that lists brain addling amounts). But what if it is none of these numbers that really matters? What if what really matters is about prices in the Shanghai property market and US caustic soda exports?
Take the Shanghai bit first. Where does all the money come from for the Chinese to be the world’s biggest consumers of luxury goods? From the booming economy, which is in large part a function of the property market and of construction in general.
Let’s look at how it all began. China has long been printing money to buy dollars and keep its exchange rate pegged. In a normal environment, this would have led to inflation. But that’s not what happened. To prevent it the government set the interest rate on deposit accounts very low in order to make real interest rates (after accounting for inflation) negative. That helped keep consumption low (a mere 34% of GDP by 2010 – a record low for any country) and inflation down.
However, people hate negative interest rates - they tend to react to them by moving money off deposit and into speculation of one sort or another. The Chinese went, like the rest of us, for the obvious. They became a nation of property speculators. Some used cash to buy flats and others borrowed money short term from unofficial lenders to get their hand on deposits to do so. But they all bought if they could – flats became a sign of security, something that would always protect against inflation.
Then came China’s massive 2008 stimulus programme, designed to keep the country growing at speed even as the financial crisis took out the rest of us. This focused heavily on encouraging lending to construction, infrastructure and housing.
The result? Huge credit growth and some whopping pumping up of the property bubble. By 2011 residential real estate made up nearly 10% of GDP; 14% of the workforce was in construction; and China was using up more cement per capita than even Spain at the peak of its construction bubble.
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Prices were soaring. Edward Chancellor, of global investment management firm GMO, points to a 2010 NBER study which showed house prices up by 140% in three years in the biggest Chinese cities. Everyone with any cash or any way of getting any cash owned houses: even on official estimates 18% of households in Beijing owned two or more properties and 40% of flats in the major cities were being bought not for use but for investment. They were often left vacant.
Overall numbers from Eclectica Asset Management suggest that China has spent twice as much as the US relative to the size of its economy on its property bubble. Not bad going given what has happened in the US since.
The boom has infected the entire economy. Chancellor reckons that around 35% of bank loans are “directly or indirectly related to Chinese property”. Local governments have also taken out huge loans backed by land grants to finance their increasingly extreme-looking infrastructure projects, while on some estimates a good 50% of China’s GDP is linked to the property market one way and another. That makes it pretty much the biggest emerging market property bubble ever.
We haven’t learnt as much as we should have over the last few years. But the one thing that is surely clear to all by now must be this: bubbles always pop. And so it is with this one.
Prices were down 6% in the 20 major cities in China in the first quarter according to Knight Frank (although most saw minute increases in June). Transactions were also down 27% year on year in those cities. The total floor space of residential units for sale was up 47%. At the same time housing starts are down around 15% year on year. The fact is that while there are plenty of apartments around to buy, they don’t look so easy to sell anymore.
The other thing we have probably learnt is that when housing bubbles pop, economies crumble. Is that happening in China yet? There are signs. There are regular reports of rising capital flight as rich Chinese, seeing more financial danger than opportunity at home move their money out (check out house prices in Vancouver!). In a recent survey from the Bank of China and the Hurun Report 60% of Chinese millionaires said they were considering emigrating, with concern about worsening business conditions being one of their reasons for doing so.
At the same time, corporate profits are falling, foreign direct investment is slowing, and the trend in even the official GDP growth numbers is very firmly down.
And caustic soda exports from the US? These matter, because caustic soda is used in a huge variety of things – from mining to paper to water treatment. Exports surged in 2009-11 in response to China’s stimulus programme. But today, numbers from chemical intelligence agency ICIS show they are now flat. That suggests growth in many areas is also flat.
Look at all this, and suddenly the numbers we looked at on luxury goods in the first two paragraphs here aren’t bullish. They’re bearish. Instead of being well exposed to one of the greatest money machines in history, the world’s big luxury goods companies are over exposed to the mother of all credit bubbles, the mother of all housing bubbles and, coming one day soon, the mother of all deleveraging episodes.
The vast majority of people, shutting their eyes to the fact that the share prices of most luxury goods companies have already started to come off, will tell you that this won’t happen – can’t happen. The Chinese government, they will say, can manage it all. They have so far. After all they have said that they intend to maintain growth and to keep property prices at a “politically satisfactory level.” These people might be right.
But before you start buying too many Prada shares you might want to check to see if they are the same people who told you that 2000-2007 was a period of Great Moderation: that US house prices never fall; that demand for houses not supply of credit is the main driver of property booms; that the ECB has a plan; and that a Greek exit from the euro isn’t possible. Just in case.
• This article was first published in the Financial Times
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