China is the site of the greatest credit bubble and consequent construction boom in recorded history. Property prices have risen so persistently and so steeply for so long that hundreds of millions of Chinese believe they only go up, and that high rise luxury condos, which they buy and never intend to live in, are the best possible form of savings account.
No wonder there are an estimated 70 million empty apartment units—most of which are priced at 25-50X the average household income. Given such massive malinvesments and deformations, the mantra of Wall Street bulls that China’s vast and desperately poor rural population will eventually migrate to the cities and fill the empty towers was always non-sense. But now this fallacy is becoming blindly evident as the tottering credit pyramids which underlie China’s construction boom are beginning to rapidly falter.
For years, the building boom was funded by China’s big state banks, but when Beijing tried to cool the red hot expansion of credit to developers several years ago, the big banks took a lesson from Citibank. They just opened up off-balance sheet “trust” operations which sold short-term notes–often with double digit interest rates—-to tens of millions of newly flush Chinese speculators, and used the proceeds to make loans to developers at even higher yields. So the property lending spree just migrated over to what became an immense shadow banking system virtually overnight. Now estimated variously at $3-4 trillion it hardly even existed in 2008.
Needless to say, this kept the game going a bit longer. It did allow local officialdom which sold municipal land to the developers to meet their revenue targets and also their quotas for local “GDP growth”. All of these targets and quotas came down the chain of command form Beijing, and highlight why China is the opposite of an economic miracle. It is actually a pernicious brew of command-and-control economic statism, mindless expansion of fiat credit and a tissue of corruption, delusions and lies that tenuously and temporarily bind together what is actually a dangerously unstable system.
Among the legions of vulnerabilities underlying China’s great game of speculation and mass mania, is the naïve belief of millions of newly minted red speculators that property values can be propped up indefinitely and that the fat yields on their trust certificates are money good. But the recent collapse of property developer Zhejiang Xingrun Real Estate Co. underscored the immense default risk pyramided into the system—that is, in many cases newly minted trust loans were simply recycled back into repayment of balance sheet loans from the parent bank. Historically, it has always been a truism that when loans to payoff loans to payoff more loans reach an asymptote, even all-powerful state rulers can’t prevent an eventual collapse.
A current Bloomberg story highlights the danger. Even before a serious retail “run” on the trust operations has gotten started, these shadow banking agencies have already begun to drastically curtail the new advances that property developers desperately need to keep building game going, while also keeping existing property prices at nosebleed valuations:
Chinese developers raised 49 percent less through trusts in the first quarter as the collapse of Zhejiang Xingrun Real Estate Co. highlighted default risks….Issuance of property-related trusts, which target wealthy investors, slid to 50.7 billion yuan ($8.16 billion) from 99.7 billion yuan in the fourth quarter…
The relevant point here is not just the depth and speed of the adjustment, but that on the margin the flow of fresh credit from the shadow banking system has been the decisive factor propping up China’s property sector in the last 2-3 years. Already Chinese interest rates are beginning to rise reflecting the growing, if belated recognition of default risk by investors, while nation wide property sales have also begun to weaken:
The value of homes in China sold in January and February fell 5 percent to 598.5 billion yuan from the same two months a year earlier, the statistics bureau said last month.
It does not take much imagination or familiarity with the history of financial bubbles and manias to see where this is going. As credit-deprived developers are forced to disgorge the massive flow of newly constructed units in their pipelines at a discount in order to generate urgently needed cash, the price of existing units will also buckle.
This, in turn, will cause widespread revulsion among the newly minted red speculators who will be shocked to learn that prices do not grow to the sky, even in China. These newly chastened red speculators are likely to bring enormous pressure on the government to prop up the luxury apartment market, but also to sharply curtail placing any more “savings” deposits into apartment units. In turn, property developers will be squeezed even more, the sky-line of cranes will steadily go quiet, and the credit fueled GDP growth of China will head south.
As the Bloomberg article makes clear, even the sell-side market strategists are now recognizing that the jig may be up:
“The banking system and the shadow banking system are becoming concerned about exposure,” David Cui, China strategist at Bank of America said in an interview yesterday. “Once people refuse to provide credit to developers, their balance sheets will be under pressure, forcing them to cut prices. Once enough of them cut prices, fewer people would buy because most people buy property only when they think the price is going up. If this persists, it will turn into a vicious loop.”
