“I hear and I forget. I see and I remember. I do and I understand” – Confucius
Confucius was full of wisdom. The ancient Chinese philosopher and scholar continues to impact society today with his aphorisms and proverbs, the most famous of which is the “Golden Rule” which most of us learned as children (his version read “Never impose on others what you would not choose for yourself.”)
The quote above reflects man’s inability to learn from hearing or seeing – only by experiencing an event, does man understand. This teaching is particularly relevant to financial markets: business cycles, debt cycles, financial crisis, economic policies and investor behavior. Despite a wealth of financial history at our fingertips, in aggregate, investors tend to repeat the same mistakes over and over again, always thinking “this time is different”.
In this two part blog series, we will take a look at China and some of the signs that suggest major problems ahead for the Chinese economy.
The growth of debt in China in the last 5 years has been breathtaking. Since 2006, the Chinese banking system (both formal banks and the shadow banking vehicles) has expanded by 87% of GDP. As a percentage of China’s GDP, debt has risen to 220% of GDP. That is approximately equal to two times the expansion of credit in the US between 2002 and 2007 at the heart of the US property bubble. Similarly, that expansion of credit is also fueling a property boom that is reaching epic bubble proportions. All of this comes at a time when growth is slowing and the demographics are working against China.
Before the housing market collapsed and the financial crisis hit, the US economy was flashing warning signs. Indicators are flashing similar signs about China’s economy, the second largest in the world. Will the Chinese learn from our mistakes or are they destined to repeat our history – understanding only by living through a financial crisis themselves. Taken together, these signs paint a picture we’ve seen before:
- Real Estate Bubble: Vanke Group (China’s biggest property developer) vice chairman, Mao Daqing, via a leaked recording, refers to China’s property market as “a dangerous bubble and already deflating.” Mr. Daqing also made a comparison to previous Asian real estate bubbles: “In 1990, Tokyo’s total land value accounts for 63.3% of US GDP, while Hong Kong reached 66.3% in 1997. Now the total land value in Beijing is 61.6% of US GDP, a dangerous level.”
Excess Supply: Mr. Daqing also commented on inventory, housing production and transaction volume in China’s 27 key cities. Per Mr. Daqing, 21 of the 27 cities his group surveyed had inventory exceeding 12 months; of which 9 cities have inventory greater than 24 months. Transaction volume in those 27 key cities dropped 13%, 21% and 30% year over year in January, February and March of this year. The risk is particularly high in second-tier cities where most new construction is concentrated. Housing production per 1000 people in China has now reached 35 – no other country has a figure greater than 14.
- Land Sales and Property Taxes: New housing starts fell 15% in April from a year earlier and land sales fell by 20%. Analysts estimate that the Chinese government depends on land sales and property taxes for 39% of their revenues. Some
analysts suggest that stripping out those land sales would cut China’s growth rate in half. The IMF suggests that China is running a budget deficit of 10% of GDP once land sales are backed out.
- Cooking the books and doubling down: Just like during the US financial crisis, Chinese officials are making a number of changes to keep the real estate boom going. Banks are changing the way loan-to-deposit calculations are made to allow for greater lending, first time buyers are being offered no-money-down purchases and property developers advertise that property prices “will never fall”. A year ago, officials tried to crack down on shadow bank lending only to see interbank lending seize up. Since then, there has been a policy U-turn as the Finance Ministry is actively pushing for faster spending by loosening banks’ leverage caps.
- Slow Growth: China’s GDP grew 7.4% in the first quarter and is forecast to grow 7.3% this year, the weakest pace since 1990. China recently cut the reserve requirement ratio (“RRR”) for banks and can consider cutting further from 20% to single digits which could generate $2 trillion of stimulus through new bank lending (keep an eye on this as further decreases in the RRR could be a sign things are getting worse, not better).
Next week, we’ll look at other indications (namely unemployment and debt) that China’s economy might be headed to a place we’ve been before here in the US. – PJ Grzywacz