The blog’s new Research Note in the ‘Your Compass on China’ series highlights the way that China’s commodity imports have been used to finance its housing bubble. This is clearly a shock for investors, who have till now believed the imports were a sign of its superior economic policies and long-term growth prospects.
The Qingdao probe could thus become the straw that breaks the camel’s back for world markets. There are two reasons to believe this is a serious threat:
- Investors have assumed that China’s vast share of global commodity demand was due to its economic growth. Now they will slowly wake up to find it was more about supporting a housing bubble
- Similarly, they have assumed that China had become ‘middle class’ with Western living standards and incomes. Now they will be forced to realise that consumer spending has been driven by the ‘wealth effect’
The worry is that the global financial system is currently priced for perfection. and may not be resilient enough to cope with this shock. Investors, companies and individuals have been lulled into believing that central banks’ experience with the Lehman Bros collapse means they will never let markets suffer a major downturn:
- Borrowing to buy stocks in New York is at record levels
- Investors Intelligence US sentiment index at 62.2% is at danger level, above August 1987 and October 2007
- American investors so-called ‘fear index’, the VIX, is at its lowest level since 2007
The best view is always from the top of the mountain, and thus it is no surprise to see Goldman Sachs still bullish:
“If nothing unexpected upsets the stock market’s delicate balance at these lofty heights, VIX could fall to record lows.”
The Qingdao probe is exactly the type of ”unexpected” event to reveal this as simply wishful thinking. The key issue is that a large part (we don’t yet know how much), of China’s vast purchases of commodities since 2009 has not been used to build the economy. Instead, it has been used as collateral to finance a huge property bubble.
China’s new leadership clearly understand this. As the blog discussed in its February Research Note, they are now implementing a series of well-designed policies with the help of the World Bank to limit the damage from the bubble’s collapse. We can only hope they are successful.
Now, however, the rest of the world is about to discover what they already know. The blog’s fear is that this discovery will prove extremely painful, because of being so “unexpected”.
A core reason for concern is the total size of China’s corporate debt. It overtook the US in 2013 at $14.2tn, according to ratings agency S&P:
“China’s corporate issuers account for about 30% of global corporate debt, with one-quarter to one-third of it sourced from China’s shadow banking sector. That means as much as 10% of global corporate debt, about $4tn to $5tn, is exposed to the risk of a contraction in China’s informal banking sector.”
China’s ‘collateral trade’ is at the heart of the issue. This is why the Qingdao probe is potentially so earth-shaking:
- Already some lenders are withdrawing from commodity financing in China as the risks rise
- Global market prices for copper and iron ore are declining, as informed players exit the market while they can
- The Economist notes that China’s banks are starting to become more reluctant to grant letters of credit
An investigation by the Wall Street Journal (WSJ) makes the link between the ‘collateral trade’ and housing very clear,. It appears the owner of the company at the centre of the Qingdao probe was heavily involved in real estate development:.
“In 2008, China’s government unleashed a $4 trillion stimulus package aimed at helping the economy withstand the global financial crisis. The stimulus drove a wave of credit through China’s financial system that launched a building boom in cities like Qingdao.
A real-estate company controlled by Mr. Chen currently is developing at least four projects in Qingdao, including a residential project called “Brocade City” and a large mixed-use development in the city center, according to the firm’s website.”
The WSJ adds that Mr Chen was not unique:
“Just about every trader who does collateral financing is also likely to have a real-estate development on the side, because the property sector gives higher returns,” said Jerry Chen, a metals trader at Shanghai-based Star Futures.”
It is already clear that China’s property market is entering a major slowdown, with Beijing sales down 35% so far this year. This will itself prove an enormous shock as property has been a money-making machine till now, with prices doubling every 2 to 3 years since urban property was privatised in 1998.
As property prices now fall, the ‘collateral trade’ will come to an end. In turn, investors will slowly realise that China’s economic growth has indeed been tied to a property bubble which is now beginning to burst.
There is thus a serious risk that today’s warning tremors in Qingdao will become a serious earthquake, and open fault-lines across the global financial system. Investors may now find out the hard way that central banks have instead created a debt-fuelled ‘ring of fire’, with China’s property bubble at its epicentre.
Today, the blog launches a major new Research Note in the ‘Your Compass on China’ series, produced in association with leading Hong Kong-based financial advisory firm Polarwide.
Titled ‘Here today and gone tomorrow – a simple guide to China’s world of trade finance’, it is probably the single most important paper it will publish all year – please click here to download a free copy.
The bottom line – China’s vast imports of commodities such as iron and copper have, in reality, often been used to finance today’s property bubble. This is how it worked:
Sardine tins were scarce during World War 2 in the UK, and often became tradable items in their own right. Then one day, a company decided to open some for a celebratory lunch, only to find that the sardines had decayed, and were uneatable. On complaining to their supplier they were told – “That’s not our fault. Those sardines were for buying and selling, not for eating.”
This is perhaps the best analogy to explain what has been happening in China with its so-called ‘collateral trade’ since 2009. The world wanted to believe that China’s rise to consume two-thirds of the world’s iron ore, and 40% of its copper, was due to its superior economic policies and long-term growth prospects. But the truth is somewhat different. A major part of these imports have instead been used as collateral for loans to support its housing bubble.
News agency Reuters has suggested, for example, that 100 million tonnes of iron ore are currently tied up in such financing deals. This would be enough to build 1200 buildings the size of New York’s Empire State building. A wide range of other commodities have also become involved more recently, including polymers such as polyethylene and polypropylene. As the Wall Street Journal reports:
“In mid-2013, authorities limited how much traders could borrow against commodities like iron ore and copper. But that only pushed investors to start using a wider range of collateral, including soybeans and palm oil”.
The concept behind the ‘collateral trade’ was simple, though its various mechanisms are complex. Its aim was to finance speculation in China’s property sector as it reached bubble-like proportions, with central Beijing apartments selling for 34 times average earnings. This is four times the ratio seen at the height of the US sub-prime boom.
Property developers have been offering sky-high returns for short-term loans. And one easy way to participate has been to use imported commodities as collateral for letters of credit issued offshore – often in Hong Kong. Investment bank Goldman Sachs estimate that up to $160bn may have been involved in such schemes.
Now, however, China’s new leadership has begun to steer a new course with the economy. The $10tn lending programme developed since the Crisis began in 2009 is being wound down. Property development, currently almost a quarter of the economy, is being drastically scaled back. As state-owned China Daily has highlighted:
“If the country is to eliminate up to half of its industrial base to make way for business based on the mobile Internet, it will have to keep the credit line really tight for local development projects.”
Thus the ‘collateral trade’ is fighting for survival as China’s government and central bank clamp down. China’s 3rd largest port, Qingdao, was closed in early June, with news reports suggesting that up to $1.6bn of allegedly fraudulent deals were under investigation. Qingdao had already started to see property price declines of 20%-30%, as the government’s new policies hit home. Now, as The Diplomat notes:
Qingdao’s commodity and asset market troubles offer an example of how the decline in the shadow banking and real estate markets is playing out in China. It reveals that interconnected degradation is eminently possible and potentially circular, as one shock reinforces another in turn. It is likely that we will see other similar situations emerge in the near future. Qingdao also shows that after-the-fact policies such as loosening mortgage lending are too small to combat full-on market retrenchment. It is hoped that larger reform policies will stimulate economic growth where defensive economic policies cannot. Much is likely to play out through the end of this year.
Investors and companies are now discovering, the hard way, that a large part of China’s commodity imports have not been used for their proper purpose. Instead, like wartime sardines, they have simply been collateral for buying and selling – this time, in support of a gigantic property bubble.
China’s property market is the epicentre of the global debt bubble discussed yesterday. It has been red-hot since urban residents became free to buy their own home in 1998. Before then, they lived where the state told them. With interest rates held low to boost state-funded infrastructure spending, people had few options for investing their money.
The result is that prices have become totally unaffordable for new buyers. Beijing house prices average 34 times average earnings, and Shanghai sells at 29 times average earnings. Even worse is that property has provided massive opportunity for corrupt officials to feather their nest. 30% of all property is owned by just 1% of the population, and around 2.1 million households own between 40% – 50% of China’s $10.5tn real estate and financial assets.
Now these same officials are selling in a frenzy, panicked by the thought that their property holdings will soon have to be published on the internet, for anyone to see. As China Daily reports:
“Once sky-high priced houses in Hua Qing Jia Yuan, a famous residential district near a key primary school, are witnessing a decline in prices to less than 60,000 yuan per square meter. A homebuyer said properties in that district were being sold at 100,000 yuan per square meter just six months ago, but recently she was shown a 106–square-meter house priced at 6.2 million yuan.”
The downturn is also now beginning to widen, as the government’s efforts to control shadow bank lending have led house prices across China to start falling. Thus the research unit of real estate developer Soufun reported:
“Rising market supply and sharp falls in transactions have put relatively heavy pressure on property developers’ sales, leading some to beef up promotions and adjust their pricing strategy.”
And there will likely be more falls to come, as the government wins its battles with local authorities who have been keen to support prices in order to boost their income from land sales – often their major revenue source.
The size of the earthquake now underway is highlighted in private remarks by Mao Daqing, vice chairman of China’s largest developer, China Vanke. Leaked online, they apparently suggested that China’s land bubble now parallels that of Japan before its crash in 1990:
“Tokyo’s total land value in 1990, prior to the property bust there, was equal to 63% of U.S. GDP in 1990, he said. During the Hong Kong bubble in 1997, land values there reached 66% of U.S. GDP. In 2012, the total land value in Beijing was 62% of U.S. GDP, “which is a scary number”, Mr Mao said”.
An unofficial report of the speech by JL Warren Capital highlights the core problems:
“Mao singles out three major trends in the Chinese real estate sector in 2014:
- Tier 2 and Tier 3 cities: Supply exceeds demand, by a lot
- Tier 1 cities: Continue to see robust demand; however, land prices have gone up more than Actual Selling Price for projects
- Credit has tightened.
“China’s anti-corruption campaign has had a greater impact on high-end property projects than most have realized. Investigations are ongoing into owners of property priced around 40K-50K RMB/sqm, ($6.5 – $8k/sq metre) not to mention more expensive properties. The increased scrutiny surrounding the anti-corruption campaign has caused demand to fall off in the high-end property market.
“The second-hand housing market has been even more impacted by the anti-corruption campaign. New listings for sale surged to 10-12 units per day, twice as many as before.
“Many owners are trying to get rid of high-priced houses as soon as possible, even at the cost of deep discount, because many corrupted officers have illegally accumulated several or more houses through bribery or embezzlement. As a result, ordinary people who want to sell homes in the secondary market must face deep price cuts….
“Most cities have witnessed an increase in inventory-sale ratios for residential buildings. Among the 27 key cities we surveyed, more than 21 cities have Days Sale of Inventory (DSI) exceeding 12 months, among which 9 have DSI greater than 24 months….
“The second critical issue is the demographics in China. Our research shows that by 2033, the total population aged 60 and above will reach 400 million, as well as an additional 270 million people living on social welfare. That is, by the end of 2033, there will be approximately 670 million people, or 50% of the Chinese population, will be living on social welfare”.
The detail behind the remarks makes it clear this was not a ‘top of the head’ speech, but carefully considered. Mao, along with China’s leadership, seems to recognise that there comes a point where the can cannot be kicked down the road any more, as it is likely instead to end up over a cliff.
Total housing activity totalled nearly a quarter of China’s GDP last year, according to Moody’s. So as China’s Academy of Social Sciences has warned, “we’ve got to let the growth rate go down”.
The fault lines from this earthquake thus run very deep indeed.
To assume, as they say is “to make an ass out of u and me”. That was certainly the case last week, when financial markets assumed that China’s slightly better PMI index was a sign that its domestic economy was stabilising. They had temporarily forgotten the key message of February’s Research Note, namely that the government would aim to preserve growth levels and jobs by boosting exports.
This is a critical distinction. The leadership is giving no sign of intending to do any kind of major stimulus programme. It knows that domestic growth will inevitably head towards zero as it tackles the property bubble. But at the same time, China does need to preserve jobs. And the only possible means, on the scale required, is via exports.
China’s PTA market provides a good example of what is happening, as the chart of the blog’s benchmark prices shows:
- Slowing domestic demand combined with increasing capacity has taken prices down 12% this year (red line)
- ICIS suggests that June’s operating rates will be a further 10% below today’s 76% level as demand slows
- This slowdown is destroying import demand – yet until recently China was the world’s largest PTA importer
- Imports were just 500kt in January-April versus 2MT in 2012, according to Global Trade Information Services data
- Instead an export surge is underway, with 127kt exported in the same period – the first time this has ever happened
This change of strategy is most advanced in PVC. China used to be a major importer when its construction boom was at its peak, buying 255kt in January-April 2012. This year, its trade is balanced, with exports matching imports at 300kt.
China’s new strategy makes great sense – it aims to close down low-margin polluting businesses and instead expand higher-value exports. Thus it is investing heavily to create a technologically sophisticated auto industry, and car exports are poised to take off as the domestic market weakens:
- China’s gas deal with Russia rightly grabbed the headlines last week
- But Russia’s railway is now also ramping up its connections between China and Germany/Central Europe
- Links to India, Thailand, Vietnam and Indonesia are also planned for the next 2 – 3 years
- The aim is to create a ‘through route’ for China’s cars to key export markets
And whilst it is fashionable to mock the quality of China’s domestic car production, JD Power analysis shows manufacturers moving rapidly up the learning curve:
“Chinese domestic brands achieved tremendous improvement in vehicle quality in 2013, with four domestic brands—GAC Motor, Venucia, Roewe and Luxgen —performing above industry average. We have seen the gap with international brands continually narrow during the past 14 years.”
Meanwhile, as the chart also shows, an ominous calm has fallen in other Benchmark product markets. They have hardly moved in months.
But the blog is keeping a close eye on benzene, its favourite indicator (green line). its prices have suddenly weakened, as Asian demand disappoints. As we move into the seasonally weak Q3 period, this could prove an early warning sign that a new downturn lies ahead.
Certainly performance since New Year supports the blog’s own argument that the Demographic Scenario is far more likely to occur than policymakers’ Recovery Scenario. And even they are now warning of potential trouble ahead. Germany’s chancellor Merkel warned of “deceptive calm”, whilst as Bloomberg reports:
“24 hours of warnings where led by New York Fed chairman William Dudley’s acknowledgement that the slide in market volatility “makes me a little nervous”. Bank of England deputy governor Charles Bean said conditions were eerily reminiscent of the pre-Crisis era, whilst Bundesbank borad member Anreas Dombret said “we do see risks despite the fact the markets are calm“.
The blog’s weekly round-up of Benchmark price movements since January 2014 is below, with ICIS pricing comments:
PTA China, down 12%. “Several producers are planning to shut their units in June because of squeezed margins, and slower off-take in the downstream markets”
Benzene, Europe, down 4%. “Ample import volumes arriving in Europe.”
US$: yen, down 3%
Brent crude oil, flat
S&P 500 stock market index, up 4%
Naphtha Europe, up 5%. “A recent spike in exports to Asia has been followed by a sharp drop”
HDPE US export, up 7%. “Globally, buyers are buying mostly on an as-needed basis, not wanting to build inventories on the assumption that prices will decline”
The above chart is the blog’s simple guide to forecasting China’s auto sales. We know from all the data that most Chinese are far too poor to afford to buy a car out of their income. Average per capita consumer spending in the towns is just $2600/year, after all. While rural incomes are only a third of urban ones.
Thus money spent on cars normally has to come from loans. And cars are quite expensive. So the loans depend on the wealth effect created by China’s property bubble. The chart highlights how it works:
- In 2008, before the crisis, lending averaged Rmb 400bn/month ($65bn) and car sales averaged 560k/month (purple number)
- In 2009, lending doubled to Rmb 800bn/month and car sales to 850k/month (blue)
- Then 2010-12′s red-hot property market meant car sales averaged 1150/month, even with lending lower at Rmb 650bn/month, as players used the windfall house price gains to finance high-value purchases (black)
- But 2013 saw lending’s role return, as loans jumped to Rmb 750bn/month and car sales to 1300/month (green)
So far in 2014, lending has averaged Rmb 950bn and car sales 1500/month (brown).
But Q1 is always somewhat special, as the banks like to lend as much of their quota as early as possible in the year. And in recent weeks, there have been clear signs that they government is turning off the loan tap, with new rules to restrict lending being introduced all the time.
Of course, the government may change its mind and allow lending to jump again. This is what most analysts still expect. But this would make solving China’s debt burden even worse, and it would also increase pollution in the major cities to even more dangerous levels.
And lets not forget that President Xi opened November’s economic policy conference, the 3rd Plenum, by announcing:
“The good meat is all gone; all that is left are hard bones to chew”
These do not sound like the words of a man who intends to maintain ‘business as usual’ in terms of China’s economic policy. The bad loan ratio of China’s banks is already rising, as the squeeze continues on the property sector.
Equally important is that sentiment is turning against property developers in financial markets – the junk bond market is now effectively closed to them, and shadow banking rates have reached 10% – 12%.
A prudent Base Case Scenario for the rest of the year would therefore be:
- Once the government has the shadow banking sector under control, it will no doubt feel confident enough to cut official lending quite sharply
- This could be as early as H2, given that the leadership needs to resolve its problem before 2017, before its reappointment is due in March 2018.
We could therefore start to see China’s car sales fall quite sharply later in the year, as the lending and housing bubbles start to be burst.
The UK no longer leads the world in soccer, as next month’s World Cup will confirm. But it can still hold its own when it comes to creating house price bubbles.
China would be the obvious winner of the World Bubble Championship, with Shanghai prices at an eye-watering 29 times average earnings. But London would have a good chance to reach at least the semi-finals, as the above chart shows (based on data from the UK’s largest lender, and National Statistics):
- It shows prices adjusted for inflation, to enable comparison over the period since 1971 when records began
- Today’s nominal price of £362k ($615k) becomes £29k in £1971
- London house prices have risen four-fold over this period, from £7k ($11.2k) to £29k today (blue line)
- Even more importantly, London prices are now at 10 times median London earnings, an all-time record
- This is also double the long-term average between 1971 – 2000, highlighting current unaffordability
Of course, policymakers deny there is any sign of a bubble. Their predecessors have built up a global reputation for only shutting stable doors after the horse has bolted. Clearly, they wouldn’t want to spoil this record by recognising the obvious signs of a bubble today, before it bursts:
- The first bubble took place between 1971-3, when prices rose 51% in real terms, before falling 31% by 1977
- The next bubble took prices up 37% by 1979, before they then fell 15% by 1982
- The third bubble was a real winner, doubling prices by 1989, before they then almost halved by 1995
- At this point, one in seven home-owners owed more on their mortgage than the house was worth
The next bubble was the one that future historians will research with wonder. By 2007 it had trebled prices in just 12 years. This was exceptional even by comparison with the US subprime bubble. And unlike 1989, prices then only fell a modest 10%, before rebounding to reach today’s new record level.
Yet unlike the early 1970s, when large numbers of BabyBoomers searched desperately for somewhere to live, there are few signs of a real shortage of accommodation. Instead affordability is the key concern for many UK homebuyers, with 1 in 8 borrowers (and 1 in 4 first time buyers). forced to take on mortgages with up to 40 year terms:
“As the Financial Times has reported, “whole sections of London have become completely unaffordable” for even solidly professional middle class families, whilst “34% of resale transactions in prime locations now involve international buyers, who also account for almost three out of four sales of new-build homes in prime central London.”
These international buyers don’t normally even live in their homes, as their aim is simply to move money out of unstable areas such as Russia, the Middle East and Asia. Instead of discouraging such capital flight, the UK’s finance minister has chosen to further inflate the bubble. His Help to Buy scheme allows people to buy with just a 5% deposit.
A sign we are probably near the peak of the bubble has come from 3 former finance ministers, and the OECD. They have broken with tradition and warned that a house price bubble may be underway. Similarly, the Governor of the Bank of England has warned that “the biggest risk to financial stability…centre(s) in the housing market“.
But for the moment, the current policies remain. Their attraction is obvious to a government seeking votes in the short-term:
- Higher house prices create a ‘wealth effect’, and so encourage consumption
- Consumption is 60% of UK GDP, and so economic growth is artificially increased
- Higher prices also disguise the fact that UK real incomes have fallen since 2010 in every income bracket
There seems little now to do, but wait for the inevitable crash. Experienced players, such as the Duke of Westminster’s property company, have stopped building new homes for sale as they believe “the prospect of a correction is becoming more likely”.
Young people who recently bought their first homes will as always be the major losers. Like their predecessors in 1973, they may have to wait decades for prices to fully recover (if they ever do).
The blog’s fear is simple. This bubble has effectively run for 20 years, with just a minor correction after 2010. It has been so vast, and so extended, that the crash may also be on an epic scale.