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“And I say also this. I do not think the forest would be so bright, nor the water so warm, nor love so sweet, if there were no danger in the lakes.”

C.S. Lewis

Commentary & Analysis
The Case for a Chinese Real Estate Crisis – It could crush the Aussie

I think it is fair to say the Aussie is in trouble if China continues to slow its own demand for resources. And I think it is fair to say the Aussie gets crushed should China experience a crisis triggered by the feedback loop between real estate and shadow banking.

I hope you took advantage of the chart I posted at our blog and Twitter account @bswancap yesterday, because today the Aussie broke what was solid support near 0.9330 and looks headed for its next key support level, daily basis, at 0.9200. Our forex service and options service subscribers are short the Aussie and have been patiently waiting for this break. Maybe this is the big one?

Why might this be the big one? As I said above, a crisis, or even mini-crisis, in China would do the trick. And the probability of such an event, though hard to handicap, seems to be growing when you consider the high degree of inside China. Below is an excerpt from a piece examine the potential for crisis I recently sent to our subscribers:


1. China needs to transition to a more balanced economy

2. Long-term success depends on the ability of China to utilize capital more efficiently

3. All bets on reform are off if China experiences a real financial crisis

There are many forecasts of where China is headed; some bearish, some bullish, and many somewhere in between. China’s current leadership agrees with most analysts’ assessments the country is at the tail end of a growth model that served the country very well for the last 20 years, but now needs to make the painful transition to a more balanced economy. If this is achieved, China’s leaders expect the country will soon take its rightful place as the world’s largest and most vibrant economy and challenge the US as the supreme economic and global power.

The transition to a new growth model rests on one major element: real reform, and especially reform of the financial system.

The key questions for us as investors are these: 1) Does the current leadership have the both the will and ability to institute necessary reform, and 2) How does one measure over the intermediate-term whether the leadership is making progress?

China’s need to move away from the lopsided export/investment model to a more balanced economy; summarized well by Professor Michael Pettis:

[I]n at least two decades of solid and healthy growth, the state sector and the economic elite benefited disproportionately from the combination of rapid growth and implicit transfers from the household sector. In fact, GDP retained by ordinary Chinese households shrank dramatically over the past three decades, while the share retained by the state grew commensurately, of course, and income inequality widened. This has nearly always been the case in the early stages of the investment-led growth model—the state and the elite benefit disproportionately.

Anecdotal fact to bring some perspective on the level of Chinese infrastructure investment: In just two years, from 2011 to 2012, China produced more cement than the US did in the entire 20th century, according to historical data from the US Geological Survey and China’s National Bureau of Statistics.

So in order for a more balanced Chinese economy to evolve:

1) A much larger share of GDP must flow from domestic consumption

2) Households must capture a greater share of the country’s wealth

Why is reform so critical? It is because China must utilize its capital more efficiently in order to create sustainable long-term growth. That can only come from system-wide reform of the massive corruption (government elites and oligarchs), widespread pollution and waste of natural resources, and inefficient financial markets.

China will not be able to make the same level of capital investments as it did in the past given the structural changes within the global economy triggered by the credit crunch, China must achieve a greater return on both human and financial capital.

I would like to investigate two scenarios in this piece – rising probability financial crisis and reasons why reform will succeed and is already underway in the key areas:

Financial crisis leading to Japanese style stagnation – Many believe a crisis is unlikely because of China’s closed capital account, i.e. money can enter China but it is hard to get it out. Therefore, a massive liquidity rush out of China, similar to the run which doomed the emerging markets during the Asian Crisis back in the late eighties, seems difficult to imagine say the optimists. In addition, Chinese leadership places extreme value on social stability and would most likely take measures to assure the same near-term even if it endangers its longer term reform plans. But the wild card is the massive debt in China.

The potential for a daisy chain of default because of risky lending in the shadow banking system; plus the very real slowdown in the real estate market, has the potential to trigger a vicious downward self-feeding spiral and crush growth despite liquidity injections from the government. It is a bet China isn’t really different from other growth miracle countries which ended badly after.

Debt troubles

The debt concern is real and scary. The massive government stimulus from 2009 in an effort to neutralize the impact of the credit crunch—falling global demand for Chinese exports—may be coming back to haunt Beijing.

“Once China reaches debt capacity constraints, like nearly all of its predecessors did after many years of high growth, the country runs the risk of a sudden and disorderly disruption of growth,” says Prof. Michael Pettis.

Source: Business Insider

According to an estimate from K. Philippa Malmgren, appearing in the winter edition of The International Economy, “China Under Attack,” she writes:

o China’s shadow banking system seems to have grown by the size of the entire U.S. financial system in the last year [2013] alone.

o Some 43 percent of all of China’s trust products come due in 2014 and 80 percent mature before 2016. Most are collateralized by property or raw materials such as iron ore or copper. It has been said that at least 40 percent of the iron ore and a similar amount of the copper in storage within China’s ports serves as collateral for these trusts. Obviously, the collateral is not worth what it was during the boom, so cash calls are in play. The next spot of trouble came on February 7, 2014, when “Songhua River #77 Shanxi Opulent Blessing Project,” which was backed by iron ore, failed to repay investors the nearly ¥300 million it had raised from them. There will be more such problems given that China’s shadow banking system seems to have grown by the size of the entire U.S. financial system in last year alone. In the main, the fast-growing, highly leveraged financial system has been used to fund more and more building and infrastructure projects with dubious cash flow-generating ability.

And I noticed this little story from Reuters which indicates the slowdown in growth is starting to bite at a time when debt is at an all-time high [my emphasis]:

BEIJING/BANGALORE, May 15 (Reuters) – As China’s economy continues to cool, companies are waiting longer and finding it harder to get paid for goods and services they’ve already sold, leading to record amounts of receivables – and potential write-offs – on corporate balance sheets.

At Longyuan Construction Group Co 600491.SS, an east China builder of high-rise offices, apartments and highways, receivables last year inched up 4.9 percent to 4.1 billion yuan ($657.3 million), while on average collection times extended to 95.2 days, compared with 76.3 days for 2011.

Slow collection of money owed is causing Longyuan to delay its own payments to steel and cement suppliers, Zhang Li, the company’s board secretary, told Reuters, in a ripple effect that is being repeated across the economy.

Real Estate Troubles

China’s real estate bubble is deflating. This could morph into a bust. A bust in real estate would devastate Chinese growth when you consider “that the building, sale and outfitting of apartments accounted for 23 per cent of Chinese gross domestic product in 2013,” according to Moody’s Analytics.

Ghost cities are proliferating across the country [this video from The Sydney Morning Herald highlights one startling example: ]

Property sales fell 7.8 per cent over the first four months of 2014 compared to the same period last year. Yet more floor space is coming on line (it rose 25 per cent y-o-y in the 14 cities monitored by China Confidential; and in the second and third tier cities floor space grew even faster, up 31 per cent, confirming the video above from The Sydney Morning News), pressure builds on developers as profits are falling and smaller (weaker) players are increasingly in distress.

What makes this situation increasingly dangerous is the fact much of the growth in floor space was financed by shadow banking trusts. Keep in mind it isn’t just well heeled speculators who get hurt as real estate deflates; many regular Chinese citizens have pooled money to buy properties as a place to earn a decent return on their savings given their investment choices are limited (this highlights another reason why financial market reform is critical for the efficient allocation of capital).

Some are not alarmed and suggest deflating real estate prices is a good thing; it means China is cracking down on speculation and leverage. In addition, the Chinese government expects about 100 million people to migrate from rural areas into the cities by 2020. But history has shown it is never easy for governments to manage down a bubble—Japan wasn’t able to do it too well.

According to The Sydney Morning Herald:

Wang Shi, the chairman of China’s largest property developer, Vanke, said in September that property prices in China were ”strikingly similar” to what Japan experienced in its dark economic period in the late-1980s. In February, he said that while he was sure the property bubble would not burst in 2012 and 2013, he was not so sure about this year.

And the richest man in Asia, the legendary Hong Kong tycoon ”Superman” Li Kashing, has been busy dumping 20 billion yuan ($7 billion) of Chinese property from his portfolio.

”This is a signal worth attention,” Wang says.

The Financial Times reported this week that China’s central bank and one of its largest state lenders held emergency talks over whether to bail out failing Zhejiang property developer Xingrun Real Estate and help repay the company’s 3.5 billion yuan debts. It came quickly after Chaori Solar became China’s first bond default this month.

It came just a week after Premier Li Keqiang warned that defaults in China’s financial system were proving ”hardly avoidable” – highlighting the tightrope authorities tread between courting moral hazard and undermining confidence in the country’s debt-laden financial sector.

In a rare move highlighting the sensitivity of the situation, the People’s Bank of China denied it had sought to intervene.

This supports the contention of the bears: real trouble is brewing and the Chinese government will not have the ability to stem the impact of large scale default in shadow banking while at the same time insure the real estate market’s deflation doesn’t turn into a bust.