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“All war is based on deception.”
                                          Sun Tzu

Commentary & Analysis
Risk off the Charts: China’s Investment Dependence and Real Estate

I am going to start off today with something I have shared here before–the China Treadmill: Virtuous to Vicious? I want you concentrate on that highlighted in red, where it says “Investment Dependence.” It is an interesting area as it weaves in the key source of China’s growth (now through the property market) which drives the demand for commodities, which is leading to financial speculation and laying the foundation for a major debt overhang in China and massive non-performing bank loans. That’s all! Nothing much to worry about…

One of the questions I ask myself (yes, sometimes I even answer myself) is if there is so much internal opportunity in China, why are companies resorting to good old financial engineering al la the Japanese "zaitech.” I guess, as the Chinese apologists love to say–it is financial engineering with Chinese characteristics. But either way you slice it, it represents good old speculation of the first order.

The conduit for this game has been copper, according to Professor Michael Pettis. It is a summary of a conversation with a commodities trader he knows indirectly [my emphasis]:

He [the trader] said that on March, clothes makers, food manufacturers, and others who have never bought copper before were massively buying copper from the tariff-protected warehouses, in Guangdong for example. The warehouses are in China, but tariffs on the goods there haven’t been paid yet, and any purchase from one of these warehouses is regarded as an import.

These enterprises purchased copper just to get L/C financing, in which banks finance the purchase of the imports for 90 days. This costs the buyer 30 bps. If they defer repayment to 180 days, they pay an additional 40 bps. The import is settled in dollars, which means that the buyer has a dollar liability due in 180 days, but can sell copper today for RMB. The interest cost for the L/C is around 1.4% annualized, so that even when LME copper trades at a premium to Shanghai copper, the all-in borrowing cost is greatly mitigated by the low cost of L/C and any RMB appreciation.

In other words, your average clothing manufacture buys copper, resells it in the open market for RMB immediately, then pays his bill later in dollars. Thus, this game of speculative profit is predicated on the RMB appreciating against the dollar and also copper prices remaining firm between the time you buy it from the tariff-protected warehouse and re-sell it on the open market.

Copper versus RMB-US dollar Daily: Only one side of the equation is working now…RMB appreciation.

One only need look to the excellent article in the Financial Times today that suggest the Chinese property market is the primary demand driver for all things commodities and the driver of continued Chinese growth, i.e. investment inside China [our Investment Dependence box in the flow chart above]. From the FT [my emphasis]:

Since last year the Chinese government has been trying to rein in soaring real estate prices and limit overinvestment in the middle- and high-end residential developments that have proliferated across the country.

At the same time, Beijing has launched an unprecedented campaign to build tens of millions of state-subsidized apartments to provide housing for the majority of Chinese citizens who can no longer afford to buy or rent their own home in the cities.

This plan is intended to continue the investment and construction boom even as the commercial housing sector slows, but it is also an attempt to address the widening disparities in Chinese society that have partly emerged as result of such rapid growth.

…Local governments rely heavily on land sales to real estate developers for a huge portion of their revenues and the requisition of land belonging to ordinary citizens is probably the biggest single source of serious social unrest in the country.

A recent story carried by confirms the rising social unrest related to land grabs by local governments:

On May 26, a 52-year-old unemployed man named Qian Mingqi reportedly set off improvised explosive devices outside three government buildings in Fuzhou, Jiangxi province, killing himself and one other person and wounding at least 10 others. According to Chinese media reports, the man had posted statements to his microblog accusing a local government official of failing to compensate him fairly for the seizure of his property. Though not all the details of the case are available, the man claimed the government had appropriated 10 million yuan ($1.5 million) for land belonging to him and seven other people, but the local official had cheated him out of about 2 million yuan he believed he was owed. In the microblog post, he claimed to have appealed the case for 10 years without any progress due to opposition from the local government and judicial bureau, which he said presented false evidence in court.

Grievances against local governments over land seizures and compulsory demolitions are a long-running and widespread issue in China — an issue that has been exacerbated by the rapid economic growth and urbanization since the 1990s. Local governments are given a great deal of autonomy over land sales and collaborate with developers, investors or other interest groups in pursuing financial interests, shaping a process that is easily manipulated by local officials and developers.

The local governments may be the Achilles heel in this investment-cum-growth-cum-investment speculation game. Rising debt among the local governments and rising tensions created by them don’t bode well for the smooth transition of buildable land:

From [my emphasis]:

China’s central government is preparing a plan to manage massive local government debt problems, according to a May 31 Reuters report. Though the plan and its details remain unconfirmed — even Chinese language reports are citing Reuters as the sole source — the report suggests that a major attempt is under way to address the greatest immediate challenge to China’s financial stability. In March 2010, China’s Ministry of Finance announced a plan to overhaul local government finances. Little progress has been reported since, but the details from Reuters correspond closely to the overhaul plan and suggest it is nearing implementation.

The report cites unnamed sources with direct knowledge of the plan, claiming that Beijing will adopt a range of measures to clean up local governments’ financial books, which have become overburdened with debt since the massive nationwide credit binge launched to combat the global financial crisis in 2008. Local governments set up local government financial vehicles (LGFVs) to borrow from banks and manage development projects because the governments themselves, with very few exceptions, are not allowed to issue bonds and finance projects in such a manner.

In mid-2010, the China Banking Regulatory Commission (CBRC) revealed that of about 8 trillion yuan (about $1.23 trillion) in loans to LGFVs, an anticipated 25 percent would go bad, while another 50 percent was tied to projects that were unprofitable but were supported by local governments’ regular revenues. In May 2011, a Chinese news report cited the Ministry of Finance as saying that by 2009, local debt had reached 2.79 trillion yuan and that outstanding local loans had reached 7.38 trillion yuan, or about 226.4 percent of total local government revenue. After the local debt problem ballooned in 2009-2010, Beijing revealed that it would conduct investigations into local government finances to determine the scope of the problem.

Maybe it’s not a house of cards. But given the amount of global money predicated on China keeping this game going, the risk for all those buoyant risk assets across every major asset class is off the charts.