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Rodney Dickens thinks the risk of a hard landing in China is real this year. Your view?
By Rodney Dickens
The long, long signalled Chinese housing collapse may finally be underway.
Some people have been barking up this tree so long they have got tired and stopped barking.
The earliest record we have of someone predicting a collapse in the Chinese housing market was April 2009 when a Chinese professor predicted that property prices would half over the next two years.
In 2010 and 2011 more commentators joined the ranks of China doomsayers.
The following links are to a selection of related articles from mainly reputable sources as opposed to conspiracy theorists, including some that document the scale of speculative apartment and mega-city building.
The earliest stories are first. I checked that the first several links were still working, but I can’t guarantee that they are all still live. The words in the links give an indication of what the articles cover.
Reflecting the Chinese way of dealing with a problem, here is a story about the government stopping publishing a house price index that was adding to the negative press on house prices. It also highlights concern about the quality of Chinese economic data more generally.
Last year the government responded to the challenge of unaffordable housing by planning to build lots more affordable dwellings, which may have delayed the unfolding downturn.
Incomes of state governments are closely tied to development activity, so falling demand for land for development and falling land prices will be hitting a number of state governments hard, with this discussed in the article covered by the first link below. The second link below is to a related story about the massive debt burden facing numerous Chinese cities.
This link is to a YouTube video on ghost cities in China that starts with the announcement that China has surpassed the US in manufacturing sales. This is definitely worth a look.
This link presents a comprehensive view on why China is heading for a hand landing.
The links above only take us from mid-2010 to mid-2011, with lots more doomsayer articles since then.
The lesson is that housing bubbles take much longer to burst than seems sensible
In my considerable experience of analysing property market bubbles, a key lesson is that the boom phase goes on for much longer than seems reasonable.
In New Zealand this was the case with the commercial property bubble prior to the 1987 share market crash, the Auckland apartment market bubble in the 2000s, the coastal property market bubble in the 2000s and more generally with the national housing and section market bubbles last decade.
This is because gullible investors keep pilling in when smart investors are starting to take profits.
This has been the case more so in China than was the case in NZ because Chinese have limited investment options and limited experience with investment bubbles.
A story in the New York Times last year about Chinese investors camping in tents to get into the queue for presales of condominiums. But having held off joining the doomsayers, the time now looks ripe for ringing warning bells about a housing downturn in China delivering a “hard landing” for the economy.
On some measures things still seem fine on the Chinese residential building front. The Chinese National Bureau of Statistics reported recently that real estate investment in the March quarter was up 23.5% on a year ago in dollar terms.
But this is a classic example of developers rushing to finish buildings because of concern about falling sales.
This link is to a good article by a Chinese professor that puts the last housing market data and the behaviour of developers in perspective.
The worry is that sales of new residential buildings, measured by floor space sold in the left chart, have fallen significantly over the last several months, although it may not be going into free fall with March delivering some improvement. And while building activity is still growing the floor area of residential buildings started has also fallen significantly over the last several months, as shown in the right chart, although the fall has been reserved somewhat in the last couple of months.
The sheer scale of the numbers is staggering (e.g. at the peak over 150,000,000 sqm of floor area started per month).
The charts show how much higher the floor area of building started has been relative to the floor area sold since 2009.
On average since January 2009 11,470,000 sqm has started construction each month while 8,569,000 sqm has sold per month. We assume these data are on a comparable basis. This means starts have been running 34% ahead of sales each month on average for over three years, which fits with there being reported to be something like 64m vacant new apartments.
China is a bit of a mystery but if it follows the normal experience after massive and sustained speculative bubbles in residential building activity the level of building activity will fall back to around previous trough levels.
In the context of the floor area of residential building started this implies a fall to around 6,000,000 sqm per month from the peak of over 15,000,000 sqm. This implies that only around half of the fall has occurred so far (right chart).
However, the floor area of sales will probably fall back to around past trough level, which means a fall from the recent 8,000,000+ sqm per month to around 5,000,000 sqm (left chart).
But if sales fall to 5,000,000 sqm per month and there is a large oversupply of vacant dwellings it implies that starts could fall below 5,000,000 per month. This is playing with numbers and I have no way of estimating accurately how much more downside there will be, but the outlook appears to be ominous.
There is a strong link between housing activity and GDP growth
In NZ residential building activity has on average been around 5% of total GDP/economic activity, but even with this relatively small share it has played a major part in driving economic cycles as discussed in past reports.
Chapter Two of the How the Economy Works booklet highlights the pivotal role of housing in economic cycles, while Chapter Three looks at how the upturns and downturns that start in the housing market filter around the economy to other sectors and industries.
In China residential building is reported to make up 10-12% of economic activity, making housing upturns and downturns of even greater importance to cycles in Chinese economic growth than is the case in NZ.
The left chart confirms the significant role housing plays in Chinese economic upturns and downturns.
The black line shows annual GDP growth (left scale), with growth slowing to just over 6% in the 2008-09 “hard landing”. In the March quarter GDP was up “only” 8.1% on a year ago, so Chinese economic growth has already slowed quite a bit.
But the fall in the sale of residential buildings points to more downside risk to annual GDP growth over the next two quarters. The red line shows the annual % change in the floor area of residential building sold (right scale), with the rolling three month average number of sales down 13% most recently on the same three months a year earlier.
The best fit is with sales leading GDP growth by four months, with the red line advanced or shifted to the right by four months.
Overall there is a good fit with a correlation of 0.84 compared to maximum possible positive correlation of 1.0 (i.e. it is a bit like getting an A in old school marking). However, housing isn’t the be all of GDP growth, with growth being quite a bit stronger than predicted by sales between late 2010 and late 2011.
But the prospect that annual GDP growth will slow more in the June quarter is supported by the NMI Business Conditions survey that also has a good track record at predicting the near-term outlook for annual GDP growth (right chart).
So the odds that growth will slow more in the near-term seem to be high, but these leading indicators are not yet predicting that annual growth will slow below 7% (i.e. a “hard landing” isn’t imminent).
However, if our speculation about how much residential building activity could fall is vaguely in the right ballpark then the downside risk to economic growth is much larger than currently predicted by the leading indicator charts below.
And there are some more warning signs for near-term Chinese economic growth prospects.
Capital is reported to have started to flee China while growth in bank lending is reported to be weak recently. Bloomberg reports that the Chinese car industry is heading into a crunch with oversupply and downside risk to production and prices.
Chinese steel production is reported to be at risk of falling, which would hurt thermal coal and iron ore. There were reports today that some Chinese buyers are deferring delivery of shipments or defaulting on bulk contracts for thermal coal and iron ore.
China has a debt problem although this probably won’t result in a banking crisis because of where the debt resides. Some of the massive property development projects, like a full scale replica of Manhattan near Beijing are reported to be struggling under mountains of debt much larger than suggested by official debt figures.
State governments are hugely reliant on income from property development that is tumbling and are at risk because they borrowed heavily to finance infrastructure and property development.
The Chinese authorities might pull a rabbit out of the hat and if they do the conspiracy theorists will be beating the drum about dubious Chinese economic data. We expect the authorities to re-stimulate economic growth, while there are still lots of positive growth stories going on in China (see below),. But a relatively short-lived “hard landing” appears to on the cards this year.
China is also at risk to developments in Europe, especially with the new French PM planning an “assault on Beijing”, but also possibly because of Germany’s growing link with Eastern Europe. The left chart shows how much weaker annual growth in Chinese exports and imports have been in recent months – abstracting from the huge monthly volatility – with China particularly reliant on European demand. The falls in business and consumer confidence surveys are also of concern (right chart).
There are many faces to Chinese growth story
I don’t pretend to be able to forecast Chinese economic growth with any degree of accuracy because it is a much more dynamic growth story than is the case in a developed country like NZ.
However, when there are major, short-term upturns or downturns in housing market activity these will generally swamp the other growth-drivers that don’t have such a large impact on near-term outcomes (i.e. I still think the risk of a “hard landing” in China is real this year). But when I review the other growth stories going on I can’t get bearish about Chinese growth prospects in general.
The following provides some insights in the myriad of things unfolding in China.
Strong growth in real incomes
In 2011, 24 provinces and municipalities raised minimum wages by an average of 22 percent, according to the Ministry of Human Resources and Social Security. Shanghai’s rose by 14 percent. Compared to consumer price inflation of just over 4% in 2011 this means large increases in real or purchasing price terms. This is helping fuel consumer spending although it is also undermining China’s comparative advantage of cheap labour.
China benefiting from the recycling of petro-dollars
Countries made wealthy by the high oil prices are reported to be buying up Chinese goods big time. “But, more importantly for the economy, they are buying the value-added products that Beijing wants its oriented factories to focus on - construction equipment, heavy infrastructure goods and telecom network equipment, for instance.”
A move into high-valued manufactured goods
China has effectively achieved a monopoly in the production of solar panels aided by government subsidies, which the US is responding to by imposing tariffs that aren’t high enough to restore the competitiveness of local producers, with three reported to have gone bankrupt last August. It is moving into the likes of high-end equipment manufacturing and biotechnology more generally. The Economist Intelligence Unit wrote an interesting article covering these and other issues recently.
The evolving face of innovation in China
McKinsey wrote a fascinating report titled “A CEO’s guide to innovation in China” that gives some understanding of the dynamics going on in China, with innovation being at the heart of economic growth.
Financial sector reforms
Reform in the financial sector could have a significant impact, especially in terms of funding for private SMEs that struggle on this front because the large banks focus on funding government-owned businesses.
Pilot schemes are underway as the following extract from an Economist Intelligence Unit article shows:
“The shape of the private sector's role may be evident from a pilot scheme in Wenzhou, Zhejiang province that the State Council announced in March. This will permit the establishment of private financial-services companies, including village banks and rural financial houses, effectively legalising the region's substantial grey financing market. The government is also allowing smaller institutions more room to expand their lending activity. In April, for example, the authorities reduced reserve requirements for some smaller, county-level banks. The bigger banks, by contrast, are currently bumping up against prudential ceilings that limit the pace at which they can expand their loan books. The underlying goal of these and many other recent reforms in the banking sector - some of which are also being piloted in Wenzhou—is to improve the flow of capital to small and medium-sized enterprises (SMEs).”
Chinese consumers will be a major force in the future
China has surpassed the US as the world largest grocery market at US$972 bln in 2011 versus USS844 bln for the US, while the Chinese market is expected to grow a spectacular 51% by 2015 to US$1,470 bln.
A McKinsey report picks that the government will introduce a range of measures to fuel consumer spending this year (e.g. tax breaks/rebates, increased wages and rebates on the purchase of electronics and appliances), will offer incentives for manufacturers to move inland, will continue with pilots to drive rural land amalgamation and increased living standards for rural people, and will introduce reforms in the health system that include the construction of private hospitals.
Another McKinsey report provides some useful insights into how dramatically income levels are likely to change in China this decade, with the following excerpt from that report:
“At present, the great majority of the population consists of “value” consumers - those living in households with annual disposable incomes between US$6,000 and $16,000, just enough to cover basic needs.
“Mainstream” consumers, relatively well-to-do households with annual disposable income of between $16,000 and $34,000, form a very small group by comparison. China has fewer than 14 million such households, representing only 6 percent of the urban population.
This situation is changing. Because the wealth of so many consumers is rising so rapidly, many people in the value category will have joined the mainstream one by 2020.
Indeed, mainstream consumers will then account for 51 percent of the urban population. Their absolute level of wealth will remain quite low compared with that of consumers in developed countries. Yet this group, comprising 167 million households (close to 400 million people), will become the standard setters for consumption, capable of affording family cars and small luxury items.
Nevertheless, value consumers, whose ranks will fall to 36 percent of urban households in 2020, from 82 percent in 2010, will still represent an enormous market for cheaper products: 116 million households, or 307 million consumers.
Affluent consumers will remain an elite minority, making up only 6 percent of the population in 2020. (In the United States in 2010, more than half of the population earned at least $34,000.) But that 6 percent will translate into about 21 million affluent households, with 60 million consumers.”
Chinese consumer are impacting on the UK antique furniture market
The growing wealthy group of Chinese, while small compared to the Chinese population is still a large group in absolute terms and they are starting to have an impact on some niche markets, like the Japanese did before them. One example that was interesting was the impact on the UK antique furniture market where Chinese buyers were reported to be bidding up some prices dramatically based on a CNN story.
China is making friends with selected parts of the under-developed world
China is extending its reach all over the developing and under-developed world, with the recent USD$8n loan to South Sudan, where the prize is oil, being an example of the scale of this sort of activity. A BBC article on this makes for some interesting reading.
Foreign investment in China is moving inland, with major implications
The Economist Intelligence Unit has written a good article giving some insights into the changing face of foreign direct investment in China with it moving inland to take advantage of cheaper labour etc. (Link requires login.)
Growth in the Chinese service sector
Much of Chinese growth story in the last decade has been about bulk manufacturing. As covered above this is evolving into higher valued-added manufacturing. But possibly of even more ultimate importance is the move to promote the service sector. I read a great article about this last year but unfortunately I have lost the reference to it. But to put this in context, in a modern economy the services sector is dramatically larger than the manufacturing sector, which provides a basis for assessing relative growth prospects for the manufacturing versus services sectors in China over the next few decades.
* Rodney Dickens is the Managing Director Strategic Risk Analysis. See more detail here.