Boom, Gloom and the New Normal

Saturday’s blog post highlighted the risk of a hard landing in China.

This risk is very real, and is centred on the government’s need to achieve a difficult balance between reducing today’s high rate of food price inflation, whilst not collapsing the property market.

House prices are now falling in 60 Chinese cities. An excellent report by the Financial Times highlights the key issues, which are summarised in the chart above. As in the USA during the sub-prime bubble, we may well have reached the point where China’s credit bubble can expand no longer.

The key is the country’s relative poverty. It is only 90th in the world in terms of GDP/capita at just $5184. This is a long way from the USA at $48147 or Germany at $44558. Yet as the FT’s chart above shows:

• Beijing property prices average 17300 Rmb/sq metre ($2700)
• Shanghai property sells at 14300 Rmb/sq metre ($2200)

As a result, the house price to income ratio in China’s Tier 1 cities has reached 14:1. It is 10:1 in Tier 2 cities, and 8:1 even in Tier 3 cities. By comparison, the US ratio at the peak of its housing boom was only 5:1.

The problem is our old friend, unrealistic expectations. As the FT notes:

“It is easy to forget that the market is just over a decade old and, apart from a brief dip in the midst of the 2008 financial crisis when transactions dried up, most Chinese have only seen prices double every couple of years and never seen them fall.”

Before 1998, all urban housing was built and allocated by the state. There was no word even for ‘mortgage’, as there was no such thing as private residential property. Even in rural areas, peasants built their homes on land allocated by the state or the collective.

Another key factor behind the rise in prices has been China’s lack of a proper system of social security. As a result, most women believe owning a home is essential for any man wanting to get married.

Young bachelors have thus routinely turned to their extended families for help with raising the finance for a home. And as prices were doubling every 2 years over the past decade, the ‘bank of mum and dad, and grandparents, and cousins’ has always been happy to help.

Equally, the local provinces are dependent on property development for up to 40% of their income, according to the FT. And they quote Prof Yi Xianrong of China’s prestigious Academy of Social Sciences as warning

“Right now the high housing price is not due to limited supply – it is because of endemic speculation. But the government doesn’t combat speculation because high prices keep GDP growth and revenues high.”

Today. however, the government’s main concern is reducing the inflation caused by the credit bubble it unleashed in Q4 2008. It therefore has to reduce bank lending, even if this weakens property markets. Food price inflation is its key concern, and this rose again to 9.1% in December.

96% of China’s population earn less than $20/day according to the Asian Development Bank. So rising food prices inevitably lead to a risk of social unrest. In turn, this now makes it difficult for the government to support the property market.

Effectively, it may therefore be caught between a rock and a hard place.

Inflation and social unrest would increase if it launched another stimulus programme and allowed lending to boom again. But the current lending slowdown risks causing future unrest amongst all those who have bought into the market in the belief that prices would never fall.

The blog sees no easy way through this crisis. It can only repeat its warning of a year ago. We may be about to “discover, too late, we have simply been in the middle of yet another China ‘boom and bust’ scenario”.

This week’s news provided more evidence to support the blog’s fear that the global economy is close to recession:

• The German economy, Europe’s motor, saw negative growth in Q4
• US retail sales grew just 0.1% in December, despite good auto sales
• China’s auto sales fell in Q4, and house prices fell in 60 cities

Equally worrying is that many policymakers seem blind to the risks of recession. Germany’s Chancellor Merkel, for example, remarked as recently as August that “I don’t see anything which signals a recession in Germany”. Yet only a month later, growth had already stalled.

The reason for this myopia is probably fairly simple. The global economy grew more or less continuously during the 1982-2007 period, and so policymakers are making the fatal assumption that this is ‘normal’.

As a result, their wishful thinking is creating additional risks for the economy as we move into 2012:

• On the Downside lie the risks of a Eurozone break-up, a hard landing in China, and a further downturn in the US housing market
• None of these risks is minor from a chemical industry viewpoint. They all have destabilising potential, particularly in terms of political risk
• Protectionism would be a very strong possibility if any of these areas went seriously wrong
• On the Upside, policymakers might panic if these events occurred
• They might undertake further stimulus efforts, on a massive and perhaps co-ordinated scale
• In terms of scale, they might each do a minimum of $500bn, making $1.5trn in total

None of us can judge the likelihood of the above events. They are like leaving a series of banana skins at the top of the stairs, and wondering whether anyone will fall and break their leg as a result.

The best response is perhaps to continue with a Base Case scenario that is based on the arrival of recession. A Downside scenario would then reflect the risks above, just as would the Upside scenario.

It is all a very long way away from the comforting consistency of the Supercycle days. But to do nothing in the face of the banana skins around, could also prove to be wishful thinking as well.

China’s economy is slowing rather fast. That’s the only conclusion to be drawn from the above chart. It shows a major collapse in producer price inflation (PPI), from July’s 7.5% peak to just 2.7% in November.

The decline from September’s 6.5% level has been particularly dramatic, with the index down nearly 2/3rds in just 2 months.

Usually such declines are linked to major falls in commodity prices, as in 2008. But whilst some commodities have slipped in price, others such as crude oil are still at Q3 levels. So one has to conclude that producers have suffered a major loss in pricing power due to a downturn in demand.

Thus the PPI numbers are another sign that the ending of the credit bubble is having a major impact. And once bubbles burst, particularly those of China’s size, it usually takes a very long while for confidence to be restored.

Long-standing readers may remember the video posted in January 2010 showing ‘China’s empty city’.

This was the new city being built in Inner Mongolia, to help ensure local officials met China’s GDP growth target. Unlike the West, GDP in a communist country is a target, not a result. Thus East Germany under communism was alleged to have GDP equal to the UK. Reality was somewhat different, as was shown after the Berlin Wall fell in 1989.

Ordos was, and is, a great example of this policy inversion in practice. Since 1995, officials have been building a completely new city 30km from the old city of Ordos. It is meant to house 1.6 million people, and until recently speculators have ensured all the property has been sold.

The only downside is that the city is more or less empty.

Now the Wall Street Journal updates the story:

• 2 months ago, one of the main property developers committed suicide
• He left debts of Rmb 263m ($41m)
• He had borrowed at an interest rate of 3%/month

The boom was great whilst it lasted. As one saleswoman told the Journal, “everyone has at least two or three properties and lots of people have seven or eight.” Now, prices have stopped rising and sales have slowed, as bank lending has been cut.

Nationwide, China has 306 billion square meters (3294bn square feet) of property under construction. But sales to the end of October were just 709 million square meters. And prices have begun to fall, as the government moves to reduce inflation.

As the Journal notes, “speculators buy property because it is rising in value”. When prices stop rising, they often head for the exits. But as Hyman Minsky observed, they then find there is no way to sell.

China has an awful lot of empty property owned by speculators such as those in Ordos. Last year, for example, its Academy of Social Sciences estimated there were 64.5 million empty houses and apartments that were owned by somebody, but used no electricity.

The Minsky Moment for its banking system is probably now underway.

It seems increasingly clear that China’s economic policy took a wrong turning 10 years ago, when it joined the World Trade Organisation.

2001 was also the year when the Western BabyBoomers (those born between 1946-70), began to leave the peak consumption age group of 25-54 years. As they entered the 55+ age range, and the children left home, they began to spend less and save more.

China, however, decided to use its WTO membership to become the ‘manufacturing capital of the world’.

10 years later, the bill for this mistake is becoming very large indeed:

• China has $500bn invested in the US housing agencies, Fannie Mae and Freddie Mac. This was a form of vendor finance, to support its export drive. Unless the US housing markets stage a strong recovery, which looks increasingly unlikely, writedowns are inevitable.
• China’s personal consumption as a percentage of GDP has halved to just 35%. As we describe in chapter 6 of ‘Boom, Gloom and the New Normal’, the government instead sponsored the building of export-related factories and the infrastructure support they required.
• More recently, the Q4 2008 crash left many of these factories without work. So the government was forced to sponsor a domestic lending binge, as incomes were too low to support increased consumption.
• It doubled bank lending to $1.4trn, a third of GDP, and held it at this level in 2010. And it added a $580bn subsidy to support sales of cars and electrical goods, especially in the poorer rural areas.
• Its lending boom also encouraged speculative home purchases, as a ‘quick fix’ for employment. Prices are now 10 times average annual household incomes, double their peak during the US housing boom.

As one ‘quick fix’ led to another, so the government’s problems have multiplied. High house prices, for example, make it difficult for young men to marry. 70% of China’s women regard “housing, a stable income and some savings” as vital for any man wanting to get married.

Equally, current food price inflation at 11.9% is a major issue for a poor country like China. 96% of people earn less than $20/day, and so food costs are a major part of their budgets.

So over the past few months, the government has finally had to act. As the chart shows, bank lending is now down 29% (red square) versus the 2009 YTD total. And premier Wen has revealed the government is now targeting home price falls of 20% or more.

What happens next, is anyone’s guess. No country in history has ever lent out so much, so quickly, to so many people.

Credit bubbles need increasing amounts of debt to continue. China’s Minsky Moment is therefore approaching fast as lending gets cut back. Thus ratings agency Fitch worries that 30% of China’s loans could become non-performing.

This one statistic is alarming enough. It means $2.5trn of loans might not be repaid. Yet 2010′s GDP was only $5.9trn. Even if we halve Fitch’s estimate, this would still mean loans worth 21% of GDP will not be repaid. This is a big ‘haircut’, even by Eurozone standards.

And debt repayment is already becoming a major issue, as sources of new credit dry up.

• Operating cash flow at China’s listed firms fell 27% in the January-September period, despite 25% sales growth
• Whilst Bloomberg reports that loan sharks from China’s vast unofficial lending market cut off fingers if debts can’t be repaid.

China is thus paying an increasingly high price for its 2001 failure to recognise the importance of changing Western demographics. After all, if demographics don’t drive demand, it is hard to know what does.

Financial bubbles are like balloons. Only instead of air, they need to be constantly pumped up with new lending. Otherwise they begin to deflate, and the Minsky Moment occurs.

The above chart of China’s bank lending shows, as discussed last month, that the Minsky Moment is getting close. August’s lending (red square) was exactly the same as in 2010 at RMB548bn ($86bn). And so far this year, it is down 8% (RMB60bn) versus 2010.

Last year, lower official lending was supplemented by the ‘shadow banking’ system, as described by the blog’s co-author of the Boom, Gloom eBook, John Richardson in a 2-part July post. But that was when the authorities still believed they could contain inflation below 4%.

Today with inflation above 6% and food price inflation over 13%, they have tightened up considerably. 2 major plastics converters, who were also acting as traders, reportedly went bust in Guangdong recently with debts of Rmb100m each.

This leaves the problem of all the inventory, bought on borrowed money over the past 2 years, which is now filling warehouses down the value chain. Some of this is disappearing into exports, where it is depressing Asian and global prices.

For example, data from GTIS, the global trade data experts, shows polyethylene exports were:

• 350kt in January-July, double 2010 levels
• They were also more than 3 times 2009 levels

Of course, the government may panic, if growth really starts to slow sharply, and allow lending and inflation to rise again.

But if it doesn’t, then the owners of the inventory will eventually begin a rush for the exits. At this point, when distressed selling starts, the Minsky Moment will have arrived.

China’s growth in electricity consumption is a much better guide to its economic growth than the published GDP figures. This was confirmed by likely next premier, Li Keqiang. It has been a major reason for the blog’s long-standing focus on this key area.

The problem with GDP is that it is a target for local Party members, not an output. As Li noted, it is for “guidance” only.

Thus GDP has been reported at ~10% since the stimulus programmes went into effect from Q4 2008. But as the chart shows, electricity consumption (blue line) has far outpaced this level of growth:

• It reached a record 435 kWh in July
• The January – July total was 15% above the 2010 level
• Similarly, Jan-July 2010 was 15% about the 2009 level

15% GDP growth would ring warning bells in any country. It would highlight potential overheating, and a rising risk of a banking crisis.

Exactly on cue, such worries are now emerging. As the Wall Street Journal reports, local government has been the main driver of the lending:

• Loans to local government for highways and other infrastructure projects are estimated at RMB14.4trn ($2.25trn)
• They represent a third of all loans in China
• Banks often received land as collateral for these loans

But for the past year, the central bank has worried about whether these loans will be repaid. It has pushed up reserve ratios, causing China’s publicly traded banks to raise RMB 595bn ($93bn) of new capital.

But in turn, of course, this is making new loans harder to obtain, as the chart also shows (red column). So the credit bubble is beginning to burst. Bank of China, for example, recorded RMB 135bn of bad loans in H1, more than the RMB 123bn it reported for the whole of 2010.

Most analysts, of course, are convinced that China will avoid a banking crisis. But most analysts also failed to spot the US sub-prime crisis.

China’s credit bubble is one of the largest the world has ever seen. This is true not only of its total size, but also in relation to GDP.

The history of credit bubbles is very clear about what happens next. Anyone who has followed the US subprime lending disaster will know the script already. But the blog worries that too few companies seem to be learning from history, and making the necessary contingency plans.

The great analyst of credit bubbles is Hyman Minsky. We described his insights in Chapter 2 of ‘Boom, Gloom and the New Normal’:

• Long periods of stability lead to complacency
• Lenders no longer check whether borrowers can repay the loan
• They are instead convinced that capital values will always rise
• They therefore believe foreclosed assets can be sold at a profit

China is now going through the late stages of this cycle. The ‘Minsky Moment’ is therefore getting closer. This is when prices begin to fall, and lenders suddenly panic about the real value of their assets. Liquidity dries up, and there is a sudden rush for the exits.

The chart shows how monthly borrowing has grown since 2008. The big jump began in Q4 2008 when the government ordered banks to increase lending, to compensate for the loss of exports:

• Monthly lending averaged RMB 386bn ($57bn) in Q1-Q3 2008 (red line)
• It then jumped 24% to RMB 477bn in Q4
• 2009 saw it jump a further 67% to RMB 796bn (brown line)
• 2010 saw a small decline to RMB 660bn (green line)

Latest figures for July show very little change in 2011 (purple line). Monthly lending has so far averaged RMB 667bn.

The sums involved are huge. Lending doubled in 2009 to $1.4trn, around one third of total GDP. Most of this money went into housing, in the belief that ‘the government would never let property prices fall’.

The rise in lending was great news for the chemical industry. Demand for the most basic polymer, polyethylene, jumped 53% between 2008-10.

But just as Minsky would predict, the government is now worried about what happens next. Bloomberg reports it is introducing new restrictions “to guard against the risk of bad loans should property prices fall“.

Coincidentally, the Financial Times notes that “China’s debt burden is far higher than it likes to admit“. It adds that “people forget that it undertook its fiscal stimulus package through the banking system, rather than by issuing public debt“.

Credit bubbles are like balloons. They expand whilst more air, or debt, is pumped into them. But as soon as this stops, they begin to deflate.

Of course, ‘this time may be different’. But companies cannot afford to plan on the basis of wishful thinking.

China’s own central bank is now planning for a possible property market downturn. Prudent chemical company Boards would be wise to follow its example. The risk of a downturn in China’s chemical demand growth is becoming too great for comfort.