Last week, China announced a number of moves to ease the stress in the real estate market. Down payments have been lowered, interest rates on first home mortgage cut and tax exemption extended. Although these policies should improve home sales in the coming months, they betray the overdependence of the Chinese economy on the government’s continued support for the real estate bubble.
URBANIZATION WITH CHINESE CHARACTERISTICS
The extraordinary expansion of real estate investment in China created a self-reinforcing loop with accelerated urbanization patterns. Migrations have taken people from Western provinces to Central provinces, from Central provinces to Coastal regions, from Coastal regions to Beijing and Shanghai, and from Beijing and Shanghai to America. Some reverse movement of talent (from US to China’s main cities) and low cost labor (from coastal areas to home provinces) has already begun, but does not yet reverse the overall trend.
The official urbanization rate has reached 43%, growing at 1% every 2 years. The unofficial “target” is 65%, but it could be affected by further trends in FAI and migration policies. Key to understanding the nature of China’s vertiginous growth is not migration, but physical expansion of the cities’ outer rings; much of the statistical “urbanization” took place not through immigration and birth rates, but by swallowing the land around the municipal boundaries, along with the local population. As much as 40% of increase in urban population (120m) has been achieved this way since 1990. In theory, assuming a 2% population growth, the cities could expand by another 350m people (including 240m migrants) by 2025. But that would assume a rate of growth even faster than over the last 18 years, would require funding for health and education services for the migrants who would constitute as much as 40% of urban population.
The population density and wide dispersion of incomes invites comparisons between EU and China. Europe’s 550m inhabitants are but a little less than a third of China’s, but Chinese urbanization plans saw 221 cities of at least 1m population, almost seven times as many as in Europe. However, the same plans see only 170 mass transit systems in China, as compared to 85 in Europe. Clearly, something is just not right.
URBAN GORILLA
This process allowed for an unprecedented expansion of wealth in the provinces. Contrary to common misperceptions, it is the local government that retains taxes, subsidizes local industry and licenses retail. Theoretically, during the last four years all the land sales were supposed to proceed through auctions, but in practice much real estate investment was done in hand-to-hand deals (“want to build a clinic in the 4th ringroad? I’ll do it for you. 1m renminbi, please”).
Land in China belongs to “the state”. In rural areas farmers are allowed to own a house, but not their land, which is leased out for 30 years from the state. But in urban areas, leases are for 70 years and people are allowed to “sell” on their apartments as if they owned them. This dichotomy leads to instant profits from land reclassification from “rural” – where no value transfer is possible to “urban” or “industrial”, where long term leases allow the land to accrue commercial value. Since the budgetary de-centralization earlier this decade, such land “reclassification” has constituted an important source of provincial income, ranging from 10% to as much as 40% of the budget, second only to VAT.
Realtors realize that there always is an official and an unofficial price for the land. Although in theory land auctions have been mandatory, there are many ways to go around it. Unlike in Singapore, Chinese bureaucrats are routinely underpaid and this form of ‘urbanization’ has been a very important source of grey income. The worst corruption occurs at the lowest level, where the officials are very poorly paid. It is among this group that one finds full size replicas of the White House and entire Audi fleets. In practice, passive corruption is punishable, but active corruption is not and investors may $cement their guanxi with impunity.
The other main driver of urbanization has been the Dong Qian process of inner city rehabilitation (2004-08). This process has now come to an end in the largest urban centers.
REAL ESTATE MARKET
The real estate market is not entirely dependent on immigration as there is still potential demand for housing among existing urbanites, over at least 4 years, should the market conditions remain healthy. Prior to 2006, supply of residential units outstripped demand. The market shot up in 2007, with the average price running up 50%, with some cities registering even higher jumps. So far this year we have seen an average of 60% drop in transaction volume, and 40% fall in price in the main cities. Floor area sales usually improve in summer (Jul-Aug), which was not the case this year.
China’s downcycles usually last between 12 and 18 months, but could last longer if purchasing power deteriorates for some reason. That could be the case if GDP growth contracts considerably. Although household incomes still rose faster in 2007 than house prices, this reflected mean incomes, not median incomes.
Beijing has currently 15 months’ worth of inventory, so it could be surprising that price per sq meter is not falling yet. But the capital is home to an estimated army of 400000 bureaucrats from the central government many of whom are literally maintained by private entrepreneurs in order to keep up good guanxi. Nor is there any other reason for the $1000/night rooms at Ritz Carlton with herds of available girls always ready for the hot shots. The three Chinese status symbols (apartment, car, prostitutes) find a well structured demand in Beijing, making this market less volatile than the coastal areas.
The other reason why Beijing market will hold up better is the prestige and social standing accruing from a family member who moved to the capital and owns an apartment there. Many cousins in the countryside will scrap funds together to be linked, by extension, to such a status symbol. Over the past 7 years, some 0.5m people immigrated into Beijing every year (including the above-mentioned graduates). There is no consensus to what extent this trend may be sustained, but the only natural boundary is formed by the mountain range in Hebei, to the north of the capital.
In Beijing, on the 5th ringroad, a 90 sq m apartment costs around $175k. Usually property developers would target a 6/1 annual income ratio, so a two-person family with an income of $29k pa qualifies easily. That translates into 8300 renminbi per month – right in the middle of the urban middle class bracket. Statistically, some 15 - 20% of Beijing’s population within the 5th ringroad makes this amount of money.
The above figure of 20% would, on paper, clash with the current ownership rate of 80% (in Beijing). However, 80% of available units are purchased by the companies and allocated to their employees (similar to the now defunct Japanese kaisha system). Among the owners, 30% are first time buyers, a further 40% upgrade to larger units (or more appropriate location) and 30% are well-off investors who upgrade even further or hold multiple residences. Although many hold speculative property in expectation of higher prices (apartments are empty, not rented), some are suffering wealth effects (cash is tied up in the stock market and won’t realize losses and are priced out of the market due to liquidity problems).
A 120 sq m (2 bedroom) apartment in central Shanghai costs around $730k. This could appear pricey, but Shanghai and Beijing dominate China in the war for talent. 150’000 graduates from Beijing universities end up staying there after graduation. 28% of Shanghai’s workforce has tertiary education, but there are not enough graduates for 2nd tier cities.
The impact of the US credit crisis has been limited on the big four (state owned) banks as most of them trade only RMB-denominated debt. FX bonds are a tiny (and highly regulated) part of their business.
BANKING
China’s property bubble should not be understood as a fallout from past credit excesses. In fact, if China does experience an increase in non-performing loans, it will probably be on the manufacturing side, rather than in real estate. Loans to realtors and loans to property owners have been a relatively small portion of banks’ portfolios. Overall, developers’ loans account for only 7% of bank assets and real estate companies’ liability to asset ratio is 73%. This is why the impact from the property slump on overall consumption will be limited (no home equity loans here).
The bubble was pricked by two regulatory moves initiated as far back as September 2007, when the government banned lending for land purchase purposes and land hoarding period was shortened through revised land auction rules. However, due to the huge fiscal boost injected on the occasion of the new 5-year plan, the effects were not immediately apparent in the market. Not surprisingly, after years of heady growth, the realtors were still very cash-rich.
Banks are under guidelines that limit lending to property developers who wish to build profitable (i.e. larger units). However, if the realtor complies with the 70/90 rule and agrees to build smaller units, the bank will release the loan immediately. For all other types of residential property, the realtor will have to be 1 year advanced into the development and post a 30%-40% margin (“equity”, not necessarily cash), which severely limits leverage. Importantly, the recent relaxation of lending quota did not apply to property development.
In the absence of bank lending for property development, realtors turn to wealthy backers. But here the lending costs are very onerous. The bill comes with a 20% interest, plus the cost of protection from renminbi appreciation, and access to 60% of value of the property. Such a “loan” is only extended to those who hold all the 5 property certificates (land, ownership, construction, inspections and – most coveted – sale permit).
DEBT AVERSION LIMITS THE BUBBLE’S TOXICITY
The second reason why Chinese property bubble will not transform into a severe credit crunch lies in the economic behavior of investors. The population is generally risk and debt averse. Consumer loan to savings ratio is 24% and 80% of banks’ funding comes from retail deposits. Still, some youngsters who use corporate credit cards are beginning to apply for revolving credit. Remarkably, there has been a credit growth expansion this year (up 5% year on year), with expected loan growth of $0.5tr this year, with total loan portfolio of $4.18tr. The government does not encourage revolving credit. As usual, the expectation is that if something goes wrong, the government will ‘save’ them.
A sizable 3 bedroom house in suburban Shanghai may cost as much as $430k. Debt aversion is so high among Chinese homeowners that when uncertainty grows his/her economic behavior will be exactly the opposite to the American model. Rather than refinancing the mortgage, the Chinese homeowner will accelerate the repayment schedule. Until last week, with a 35% down payment and 5.4% interest rate, it was not uncommon to see these mortgages repaid within 4 or 5 years. Importantly, the price of such a piece of property is still up 80% over the last 5 years, which not only increases labor mobility but also leads to wealth concentration high net worth in the areas determined by school quality, where “emperor moms” tend to congregate.
The buyers of a second unit face steeper hurdles. It is very difficult to obtain a loan for the second apartment. Such buyers need to put 40% down payment and have to pay higher interest premium (7.7%).
The subprime problem is a distant abstraction for the Chinese. Buyers of their first apartment pay a 30% down payment and mortgage is only offered to clients whose income is above $10.5k pa per person (one needs to earn at least 6000 renminbi per month in order to service repayments of 3000 renminbi per month). These figures apply to second tier cities.
Although interest rates were cut by 0.27% in early September and again a month later, the transmission of this measure makes it little more than a symbolic measure and no impact on residential investment. The recent relaxation of lending applies only to a 10bp reduction in reserve requirement among the smaller banks (which account for 40% of the market). Lending quotas were increased by 5%, applying to all state-owned banks and their JVs. The government’s priority is to target small and mid sized enterprises, energy saving businesses, green technology and Sichuan rebuilding, not the property market. The government dissects the prospective loan recipients into 3 categories: “actively promoted” (renewable energy, transportation, grid, rail, ports), “prudently promoted” (health care, power generation), and “restricted” (highly polluting, energy-intensive, overcapacity – like glass, steel, aluminum, cement).
Capital growth could even become negative. Although loan to retail deposit ratio is 57%, as profits are fall and unemployment rises, non performing loans (NPLs) would return as a feature of China’s financial system. An 8% GDP growth (official) translates into 4% NPL. A 6% GDP growth (official) would lead to NPL expansion to 6.8%. Disposable income growth trails GDP growth by 2%, so losses could be made worse.
With asset prices falling (depressing artificial price earnings ratios), price competition will intensify again in the conditions of overcapacity (assuming continued slow demand overseas). Production costs may appear less flexible than in the past (labor, energy, quality control, environmental costs) and capacity utilization rates are bound to fall. Production scale-backs are possible and bankruptcies would spread among small and midsize enterprises with low working capital.
No comments:
Post a Comment