A branch of Centaline Property Agency in Hong Kong © Bloomberg
Indebted Chinese property developers threaten a domino effect on western credit markets , as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
Second-order impacts are starting to appear as a result of China’s lockdowns. These are having a big impact on the critical property sector, which makes up as much as 25 per cent of gross domestic product.
Housing sales fell almost 40 per cent in February and seem likely to be down again in March, while developer Evergrande cut prices to try and maintain its cash flow. This creates growing risk in the offshore dollar market, where property developers have been significant borrowers, with Fitch already warning of possible defaults. It is unclear whether local authorities can provide much support, as their dependence on revenue from land sales means their own position is weakening.
Rightly, the world’s attention has focused on the impact on public health of the coronavirus pandemic and the best ways of mitigating it. But as Martin Wolf highlights in the Financial Times, the virus is an economic emergency too, with the ability to plunge the world into a depression. Talk of the reforms made to the world’s banking systems since 2008 misses the point. The risk is now centred on the vast build-up of corporate debt since the global financial crisis, under the easy money policies of the world’s central banks.
China’s property sector is unfortunately the epicentre of this debt. As we noted in the FT in August: “Its tier 1 cities boast some of the highest house-price-to-earnings ratios in the world, while profits from property speculation allowed car sales to rise fourfold from 500,000 a month in 2008 to 2m a month in 2017.” Last month’s collapse of car sales back to 2005 levels of 244,000 confirms the damage that has been done.
Sales by China’s top 100 property developers plunged by 44 per cent in February, and Caixin reports that over 100 builders went bust in the January-February period, normally one of the busiest times for property sales. Equally worrying, as Caixin’s chart below illustrates, is that, although the largest developer, Evergrande, bucked the trend, this was only because it cut prices by 25 per cent in February and offered 22 per cent reductions this month.
There are few signs of a sustained upturn, with S&P reporting that housing starts were down 45 per cent across January-February. S&P adds that property sales could fall 20 per cent this year, if the effects of the lockdowns are still being felt in April, as seems likely.
The issue is that we are now starting to see second-order impacts of the lockdowns emerge, particularly in terms of consumer affordability and supply chain disruption:
- The economic impact of the initial lockdowns was focused on two areas — companies and consumers. Companies were shut down, and consumers were quarantined
- In turn, this led to a number of key impacts within and outside China
- Within China, demand disappeared for a wide range of products as consumers were unable to leave their homes; supply also disappeared as companies shut down
- And ‘out of sight’, critical logistic arrangements were being completely upended by quarantine measures, and the need to prioritise essential food/medical supplies
We can probably assume that truck drivers have now been released from emergency duties and from quarantine (if they travelled from infected areas across provincial borders). But we have no idea if their basic equipment — containers, specialist materials, etc — is in its normal place. We do know, however, from the shipping industry that its activity has been severely disrupted, with ships away from their usual moorings and many idled due to lack of work; containers and crew are equally disrupted.
It is safe to assume that most Chinese companies and consumers are short of cash and that consumers will cut back on all but essential spending, further depressing demand. This creates the risk of a vicious circle, whereby property sales remain depressed, reducing developer cash flow still further after most building activity came to a standstill during the lockdowns.
Fitch Ratings identified five Chinese corporations with a high risk of refinancing in a recent report, four of which are in the homebuilding sector, citing concerns about near-term capital market debt maturities and the unpredictability of the epidemic. A further sign of stress, as the Financial Times has reported, is that land sales are now running at less than a quarter of average levels.
Two key facts highlight our concerns:
- Chinese developers ramped up their offshore dollar borrowing by 52 per cent to an all-time high of $75.2bn last year, according to Centaline Property Agency, as onshore funding became more difficult. And as S&P reported in November, before coronavirus hit: “For some developers, offshore yields to maturity have surged well beyond the mid-teens, reflecting low investor confidence.”
- Chinese borrowers also tend to operate on a short-term basis, with an ICE BofA index of Chinese high-yield securities in dollars having 2.7 years to maturity, compared with 5.9 years for a similar US index.
We have warned here for some time that China’s property market has been ‘subprime on steroids’. Property sales have been buoyed by vast government stimulus programmes. And western investors have flocked to lend in the offshore dollar market, attracted by the high interest rates on offer compared to those in their domestic markets under central banks’ zero-interest rate policies.
The renminbi’s weakening beyond Rmb7 to the US dollar adds to the difficulties developers will face in servicing their dollar debts.
The potential for a domino impact on western credit markets from a coronavirus-related downturn in China’s property market should already be keeping regulators up at night.
Paul Hodges and Daniël de Blocq van Scheltinga publish The pH Report.
London house prices are “falling at the fastest rate in almost a decade” according to major property lender, Nationwide. And almost 40% of new-build sales were to bulk buyers at discounts of up to 30%, according of researchers, Molior. As the CEO of builders Crest Nicholson told the Financial Times:
“We did this sale because we knew we would otherwise have unsold built stock.”
They probably made a wise decision to take their profit and sell now. There are currently 68,000 units under construction in London, and nearly half of them are unsold. Slower moving builders will likely find themselves having to take losses in order to find a buyer.
London is a series of villages and the issues are different across the city:
Nine Elms, SW London. This $15bn (US$20bn) transformation has been ‘an accident waiting to happen‘ for some time. It plans to build 20000 new homes in 39 developments at prices of up to £2200/sq ft. Yet 2/3rds of London buyers can only afford homes costing up to $450/sq ft – thus 43% of apartments for sale have already cut their price.
West End, Central London. This is the top end of the market, and was one of the first areas to see a decline. As buying agent Henry Pryor notes:
“Very few people want to buy or sell property in the few months leading up to our monumental political divorce from Europe next March, which is why 50% of homes on the market in Belgravia and Mayfair have been on the market for over a year. Yet there are people who have to sell, whether it be because of divorce, debt or death, so if you have money to spend I can’t remember a time since the credit crunch in 2007 when you could get a better deal.”
NW London. Foreign buyers flooded into this area as financial services boomed. Rising bonuses meant many didn’t need a mortgage and could afford to pay £1m – £2.5m in cash. But now, many banks are activating contingency plans to move some of their highly paid staff out of London ahead of Brexit. Thus Pryor reports buying a property recently for £1.7m, which had been on the market for £2.25m just 2 years ago.
W London. Also popular with foreign buyers, even areas such as Kew (with its world-famous Royal Botanic Gardens) have seen a dramatic sales volume decline. In Kew itself, volume is down 40% over the past 2 years. And, of course, volume always leads prices – up or down. Over half of the homes now on sale have cut prices by at least 5% – 10%, and the pace of decline seems to be rising. One home has cut its offer price by 17.5% since March.
Outer London. This is the one area bucking the trend, due to the support provided by the government’s ‘Help to Buy’ programme. This provides state-backed loans for up to £600k with a deposit of just 5%. As Molior comment, this is “the only game in town” for individual purchasers, given that prices in central London are out of reach for new buyers.
The key issue is highlighted in the charts above – affordability:
- The first chart shows how prices were very cyclical till 2000, due to interest rate changes. They doubled between 1983 – 1989, for example, and then almost halved by 1993. In turn, the ratio of prices to average earnings fluctuated between 4x – 6x
- But interest rates have been relatively low over the past 20 years, and new factors instead drove home prices
- The second chart shows the impact in terms of first-time buyer affordability and mortgage payments. Payments were 40% of take-home pay until 1998, but then rose steadily to above 100% during the Subprime Bubble. After a brief downturn, the Quantitative Easing (QE) bubble then took them back over 100% in 2016
The paradigm shift was driven by policy changes after the 2000 dot-com crash. As in the USA, the Bank of England decided to support house prices via lower interest rates to avoid a downturn, and then doubled down on the policy after the financial crash – despite the Governor’s warning in 2007 that:
“We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession… That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”
- The 2000 stock market collapse and subprime’s low interest rates led many to see property as safer than shares. They created the buy-to-let trend and decided property would instead become their pension pot for the future
- The 2008 financial crisis, and upheavals in the Middle East, Russia, and parts of the Eurozone led many foreign buyers to join the buying trend, seeing London property as a “safe place” in a more uncertain investment world
- Asian buyers also flooded in to buy new property “off-plan”. As I noted in 2015, agents were describing the Nine Elms development as: ” ‘Singapore-on-Thames’. Buying off-plan was the ultimate option play for a lot of the buyers [who are] Asian. You only need to put down 10% and then see how the market goes. A lot of buyers are effectively taking a financial position rather than buying a property”“
But now all these factors are unraveling, leaving prices to be set by local supply/demand factors again. Recent governments have taken away the tax incentives behind buy-to-let, and have raised taxes for foreign buyers. As the top chart shows, this leave prices looking very exposed:
- They averaged 4.8x earnings from 1971 – 2000, but have since averaged 8.7x and are currently 11.8x
- Based on average London earnings of £39.5k, a return to the 4.8x ratio would leave prices at £190k
- That compares with actual average prices of £468k today
And, of course, there is the issue of exchange rates. Older house-owners will remember that the Bank of England would regularly have to raise interest rates to protect the value of the pound. In 1992, they rose to 15% at the height of the ERM crisis. But policy since then has been entirely in the other direction.
Nobody knows whether what will happen next to the value of the pound. But if interest rates do become more volatile again, as in 1971-2000, cyclicality might also return to the London housing market.
The post London house prices slip as supply/demand balances change appeared first on Chemicals & The Economy.
Last year it was the oil price fall. This year, there is no doubt that the US dollar has taken centre stage, alongside the major rise underway in benchmark 10-year interest rates. As 2016′s Chart of the Year shows:
The US$ Index (black) has risen 12% since May against other major currencies (euro, yen, pound, Canadian dollar, Swiss franc, Swedish krona), and is now at its highest level since 2003
Benchmark 10-year US interest rates (red) have almost doubled from 1.4% in July to 2.6% today. They are back to 2013-4 levels, when the Fed proposed “tapering” its stimulus policy
Clearly something quite dramatic is now underway.
In currency markets, investors are voting with their feet. It is hard to see much upside in the European, Japanese or Canadian economies in the next 12 – 18 months. Europe is going to be gripped by the unfolding crisis over the future of the euro and the EU itself, as it moves through elections in The Netherlands, France, Germany and probably Italy. By March, the UK will be on the Brexit path, and will leave the EU within 2 years. Japan is equally unattractive following the failure of Abenomics, whilst Canada’s reliance on commodity exports makes it very vulnerable to the downturn underway in the BRICs (Brazil, Russia, India, China).
Investors are also waking up to the uncomfortable fact that much of today’s borrowed money can never be repaid. McKinsey estimated global debt at $199tn and 3x global GDP at the start of 2015, and the total is even higher today.
As I warned a year ago in “World faces wave of epic debt defaults” – central bank veteran), there is no easy route to rescheduling or forgiving all this debt. Importantly, central banks are now starting to lose control of interest rates. They can no longer overcome the fundamentals of supply and demand by printing vast amounts of stimulus money.
This is the Great Reckoning for the failure of stimulus policies in action.
THE RISES WILL CREATE “UNEXPECTED CONSEQUENCES” FOR COMPANIES AND INVESTORS
These moves are critically important in themselves as the dollar is the world’s reserve currency, and US interest rates are its “risk-free” rates. Unsurprisingly, interest rates are already now rising in all the other ‘Top 15′ major economies – China, Japan, Germany, UK, France, India, Italy, Brazil, Canada, S Korea, Russia, Australia, Spain, Mexico. Together, these countries total 80% of the global economy.
The rises are also starting to create unexpected “second order impacts”. For example, many companies in the emerging economies have large US$ loans, which appeared to offer a cheaper interest rate than in their home country. Suddenly, they are finding that the cost of repayment has begun to rise quite rapidly.
This happens in almost every financial crisis:
People become excited by the short-term cost of borrowing – “Its so cheap, just $xxx/month”
They totally forget about the cost of repaying the capital -”I never thought the dollar would get that strong”
There were $9tn of these loans last year, according to the Bank for International Settlements. Many were to weak companies who are likely to default if the dollar keeps rising along with US interest rates.
In turn, these defaults will also have unexpected consequences. Lenders will suffer losses, and will be less able to lend even to stronger companies. Higher borrowing costs will force consumers to cut back their spending. This risks creating a vicious circle as corporate interest costs rise whilst revenues fall.
China is the obvious “canary in the coalmine” signalling that major problems lie ahead.
The Wall Street Journal chart shows 10-year rates have risen despite central bank support
Its total debt is around $27tn, or 2.6x its GDP, due to housing bubble and other speculation
The central bank now has to sell its US Treasury holdings to support the domestic economy
In turn, of course, this pushes US rates higher, as rates move inversely to bond prices
China used to hold around 10% of US debt, and was the largest foreign holder. Japan holds similar amounts, and is also stepping back from purchases due to the growing exchange rate volatility.
Nobody else has the financial firepower to take their place. The only possible replacements – Saudi Arabia and the Gulf countries – have seen their incomes fall with the oil price, whilst their domestic spending has been rising. This means interest rates and the US$ are likely to carry on rising.
Higher rates will further weaken the US economy itself, particularly if President Trump launches his expected trade war. In the important auto market, GM has just announced production cutbacks next month due to falling sales, despite the industry having raised incentives by 21% to nearly $4k/car. GM’s inventories are now 25% higher than normal at 86 days versus 69 days a year ago. Housing starts fell 7% last month, as mortgage rates began to rise.
And then there is India, the world’s 7th largest economy and a leading oil importer. Its rates are now rising as shocked investors suddenly realise recession is a real possibility, if the currency reform problems are not quickly resolved.
These risks are serious enough. But they are very worrying today, due to the steep learning curve that lies ahead of all those who began work after the start of the Boomer-led SuperCycle in 1983.
They assume that “recessions” are rare and last only a few months as central banks always rescue the economy.
Only those who can remember before the SuperCycle know that markets and companies should have long ago taken fright as these risks began to develop
This is why the rise in the US$ Index and US 10-year exchange rates is 2016′s Chart of the Year.
It is now just over a month since India introduced the biggest currency reform the world has ever seen. In a country of 1.3bn people, it abolished the 2 main banknotes (worth $207bn), that accounted for 86% of all cash in circulation.
At 20:15 hours on 8 November, the government announced that the 500 and 1,000 rupee banknotes (value $7.30 and $14.60) would become invalid at midnight. It had apparently begun planning for the reform last year, with the aim of:
Reducing the role of the black market (thought to be around 20% of GDP)
Expanding the number of taxpayers, as currently only 1% of the population pay tax
Cutting back the availability of funds for terrorists
Moving India towards a digital economy
The problem is that currency reforms are very complex. The euro changeover took 3 years to organise, and covered less than half of India’s population. It was also done publicly, so potential problems could be spotted and solved.
By contrast, India’s reform had to be done in secret. And unlike the euro area, India is a very poor country, with median income of just $616. Cash is therefore critically important to individuals, and accounts for 98% of all consumer transactions: 600m people have no access to bank accounts and there are just 18 ATMs per 100k people.
As the Governor of State Bank of India warned in a report when rumours of the plan began to circulate in April:
“If demonetization is being contemplated, a road map needs to be created. It needs to be done in steps and be balanced with creation of necessary electronic and digital infrastructure in the country, coupled with creating awareness and financial literacy for ensuring that the man on the street is not put to undue hardship,” the report said.
Going into the advantages of demonetization, the report said that demonetizing Rs 500 and Rs 1,000 currency notes will bring a huge amount of the funds kept in these denominations into the banking channels and will facilitate a reduction in domestic black money transactions. But this would also be a headache when it comes to logistics.
“At the branch level, the cost of handling cash would zoom and there would be complete chaos as the funds kept in these denominations will be flushed into the banking channels,” the report said. The report goes on to say that introduction of a Rs 5,000 note will also not solve the problem and would continue to result in ATMs running dry several times a day.”
Sadly, it seems that the Bank’s warnings have proved all too accurate:
As of yesterday, the amount of valid currency in circulation is only 42% of the pre-reform amount, as the printing presses only began rolling in late October
Tens of millions of Indians have been standing in bank lines to exchange old notes for new 500 or 2000 rupee notes
One problem is that the new notes are smaller, which means all ATMs have first to be reconfigured – which is estimated to take 45 days
Shortages have been widespread, with the Financial Times’ correspondent reporting a 3 week wait for her local ATMs to start issuing the new notes
The drive towards digitalisation is also hampered as India has just 1.5m point-of-sale (POS) terminals – 1 for every 1785 people, compared to 1 for every 60 people in China
The government has promised to supply 2 POS terminals to every village of 10k people – but there are 100k villages of this size and it will likely take up to 6 months for them to arrive as they will have to ordered from China
The shortage of cash has already forced the government to allow farmers (who are mostly very poor) to use the banned 500 rupee notes to buy seeds for the winter sowing season
Clearly ordinary Indians have suffered the most from the poor execution of the planned reform. But the economy must also be suffering, given that cash is around 12% – 14% of GDP (compared to just 5% in most large economies).
The Japan Times reports: “Consumer goods sales are reported to have dropped by one-third. Trucks are at a standstill. Farmers have difficulty buying seeds and fertilizer and selling crops and perishable produce. The fishing industry is close to collapse. Few villages have ATMs and having to trek into cities and wait in line for hours means the loss of daily wages — as it does for the rickshaw drivers, street vendors, domestic workers and daily laborers in the cities. The construction industry has been badly hit with significant wage implications for its casual workforce.”
The Financial Times reports: ”Gaurav Daga, owner of Oswal Cable Products, imports plastic polymers used to manufacture everything from industrial cables to shoes to automobile components. His clients run across the gamut of India’s manufacturing sector, from large national brands and their big suppliers to small industries.
“His sales have dropped by half since Mr Modi announced the ban on the use of high denomination banknotes, and imposed cash rationing. Several of his big customers — large, national shoe companies with bank accounts and big workforces — have been forced to suspend production, due to their inability to pay their workforce — rural migrants, with neither bank accounts nor smartphones.
“They don’t have money to give to their labourers,” Mr Daga said. “They have it in a bank but they don’t have currency. And you cannot open bank accounts for everyone overnight.”
The Economist reports that India’s rural economy is “seizing up“: “In the second week of the (cash) drought, deliveries of rice to rural wholesale markets were 61% below prior levels. Soyabeans were 77% down and maize 29%. Prices have also collapsed. In Bihar, Scroll’s reporters found desperate farmers selling cauliflower for 1 rupee ($0.01) a kilo, a twelfth of the prior price”.
Wood Mackenzie reports that in petrochemicals, “Several producers are exporting chemicals due to lack of domestic demand, and running out of storage/warehouse space. The cash crunch will hit India’s automotive and real estate markets hard….Even if everything goes according to plan and there is sufficient cash available by the end of 2016, we expect impact of demonetisation to be a slowdown for a few quarters, at least.”
India’s Automotive Association has reported: ”2016 Sales Temporarily Disrupted Due to Demonetization”. And oil demand is also being impacted. November volumes were strong, as the government issued a waiver to allow people to stock up using their old banknotes. But December and Q1 are likely to be weaker according to Essar Oil’s CEO. This is very bad news for OPEC, as India is key to global oil demand growth.
Premier Modi has promised the problems will start to be resolved by the end of December, 50 days after the reform began. We must all hope he is right.
Markets are becoming increasingly chaotic, as the world’s major central banks each try to devalue their currencies.
They have created a traders’ paradise, with oil on a particularly wild ride. But this has not been based on supply/demand fundamentals. Instead, it has been due to hedge funds jumping back into the commodities market. They don’t care about supply/demand balances – these are irrelevant for them.
They only care that the US Federal Reserve has again been trying to push down the value of the dollar against the Japanese yen and the euro – just as it did after the Crisis began in 2008:
- So they have rushed to buy globally traded commodities like oil and iron ore, traded in US$
- These are supposedly “stores of value” against a weaker dollar
- Natural gas isn’t globally traded, and so isn’t part of this revival of the “correlation trade“
- Therefore its price has stayed low, and in line with fundamentals
But the Fed is no longer alone in trying to push down the value of its currency.
- The Bank of Japan (BOJ) is desperate to devalue the yen, which has been surging since January – when the Fed backed off its promised interest rate rises and began to push the dollar lower. Friday saw Bloomberg report that the BOJ might offer negative interest rates on some bank loans. This caused the yen to have its biggest fall versus the US$ for 17 months. It was down nearly 3% during the week
- The European Central Bank (ECB) is also desperate to lower the value of the euro, and is now threatening to further reduce interest rates – which are already negative – in order to achieve this.
So the world’s 3 major currencies are on a collision course, and this is creating major volatility in commodities:
- The volumes traded in currency and interest rate markets dwarf commoditiy markets
- $5tn is traded every day in currencies. That isn’t a misprint – it is $5 trillion
- Only a small proportion needs to leak into commodity markets to destroy genuine price discovery
- $80bn found its way into commodity markets during the Fed’s last stimulus policy – and, of course, the growth of high-frequency trading multiplied its impact.
Oil markets are therefore acting as the proverbial “canary in the coalmine”. Their rising volatility (Brent prices fluctuated by an astonishing 13% last week) is warning that a new crisis may be on the way.
This creates great danger for chemical companies, as the major petrochemical products have more than a 95% correlation to oil
- When the Fed tries to devalue the US$, oil prices rise
- And when the BOJ and ECB try to devalue the yen and euro, they fall
The decline of the US$ has been the main reason why oil prices have risen 50% this year – even though oil inventories have reached record levels – as the central banks have destroyed true price discovery.
In turn, their current behaviour creates great risks. The IMF meeting earlier this month saw an open argument between the USA and Japan. And in Europe, German Finance Minister Wolfgang Schäuble has warned the ECB:
“There is a growing understanding that excessive liquidity has become more a cause than a solution to the problem.”
None of us can know how these arguments will end. But we do know that it would be very dangerous for the world economy if Japan continues to fight the USA, and the ECB continues to defy the Germans.
When elephants fight, those around risk being trampled.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 58%
Naphtha Europe, down 55%. “Sentiment is supported by renewed buying interest from West Africa, although sales are being hampered by Nigeria’s payment difficulties”
Benzene Europe, down 53%. “numbers saw some gradual upward movement over the course of the week, in tandem with some gains on crude oil”
PTA China, down 40%. “Liquidity has dipped slightly on vigorous buying in recent weeks. Most are covered for May-shipment cargoes.”
HDPE US export, down 31%. “China’s domestic PE prices were on the downward trend in the week mainly due to weak demand.”
¥:$, down 9%
S&P 500 stock market index, up 7%
What we “assume” can make an “ass of u and me“, as the proverb says. And that is certainly true of the way central banks have manipulated the major currencies since the financial crisis began in 2008, as the chart shows of the US$’s movements versus the Japanese yen and the euro:
- It shows the change relative to December 2007 values, before the central banks realised the crisis was underway
- All 3 currencies were relatively stable in early 2008, but then performed quite differently
- The dollar began a 30% fall against the yen, and became quite volatile against the euro
- But Premier Abe’s election in December 2012 then led to the dollar soaring against the yen
- 2014 saw the European Central Bank making a similar decision to devalue versus the dollar
These moves were all created by central bank policy. At first, Japan and the European Central Bank were happy to let the US Federal Reserve weaken the value of the US$. They believed that this would help the US economy to recover, and so rebuild momentum in the global economy. But then they had second thoughts.
They had slowly realised that the Fed’s policy hadn’t worked, and that their economies were not recovering back to pre-2008 levels. Instead they hoped that devaluation would enable them to boost exports at the expense of the US. But they failed to recognise that China’s policies were also changing:
- China began its New Normal policies in 2013, reducing its massive stimulus programmes
- Global growth, measured in current dollars, fell to just 2%/year between 2012 – 2014 and declined 4.9% in 2015
In due course, the Fed then realised the US economy was suffering. And so in Q1 this year, it decided to devalue again. The dollar has therefore weakened against both the yen and the euro since the start of the year.
The problem all comes back to false assumptions.
One core central bank assumption is that their computer models can forecast the economy. A second is that they can create demand by printing money. A third is that demographics change doesn’t matter – they really do believe that a world full of 80-year olds would grow as fast as a world full of 30-year olds.
Common sense, of course, tells us that all these assumptions are wrong. Inevitably, therefore, their policies of devaluation and money printing do not create the growth they expect. Instead, they make life even more complex and difficult for companies and investors – and end up helping to destroy growth rather than create it.
Ordinary people like ourselves then end up taking the pain from their mistakes – making an “ass of u and me“.