By Walter KurtzSober Look

To understand the issues faced by China and the steps the nation is planning to take, one needs to look no further than the country’s official press. It’s a bit like corporate press releases – one should read them with a healthy level of skepticism, yet the tone, the timing, and some of the content can provide good insight.

We start with the following quote from Wei Jianguo, secretary-general, Center for International Economic Exchanges:

Xinhua:  For China, the year of 2012 will be the most “unpredictable, complicated, grim and difficult” year since the financial crisis three years ago… “We should get ready for trade deficit next year…”

China should also prepare for trade wars, as many countries are working to boost exports to protect themselves amid the dim global economy, he added.

China’s officials certainly had made downbeat statements about the economy before, but for a statement to be this negative, the Party is trying to get a message out. The bosses are starting to get quite concerned about the state of China’s economy. This statement says: get ready for hard times ahead, but know they are all caused by external factors, such as “dim global economy” and “trade wars”. What may prompt the Chinese leadership to turn so negative on China’s growth?

There are multiple and complex issues facing China, but one of the most troubling is a potentially unprecedented correction in the real estate market.

Council on Foreign Relations: According to the property agency Homelink, new home prices in Beijing dropped 35 percent in November alone. And the free fall may continue for some time. Centaline, another leading property agency, estimates that developers have built up 22 months’ worth of unsold inventory in Beijing and 21 months’ worth in Shanghai.

A crash of this magnitude is clearly an unwelcome event for Party officials as they begin to prepare to deal with this issue. A 35% correction in a month feels like a panic, but this event has been in the making for some time. A glut of development projects and easy money available for developers (both debt and equity) had been widely discussed over two years ago. In fact this may not be unique to China, with “bubble” property and other asset markets correcting across several nations of Asia (again discussed over two years ago).

The economic numbers coming out of China, though sometimes suspect, clearly show signs of deceleration. It started with a fairly rapid monetary policy tightening to fight inflation resulting in the M1 money supply growth dropping recently below 8%.

China M1 Growth (Bloomberg)

Now we also see signs of a decline in growth of credit, particularly loans for fixed asset development. It’s interesting to note that both the money supply measure and the fixed asset loan growth peaked around the same time – in late 2009 to early 2010.

Growth in Loans for Fixed Asset Development (Bloomberg)

In the last two years, as banks have tightened credit to China’s property developers (chart above), these firms tapped the capital markets in order to raise debt capital via bond issuance. But recently, particularly in the wake of the Sino Forest fiasco, investors are beginning to demand unsustainably high premium to own Chinese developers’ debt. As an example consider the Evergrande Group, one of China’s largest and and “asset rich” developers. A newly issued bond by Evergrande, the 9.25%, 5-year note now trades at 70 cents on the dollar with an over 20% yield.  In fact the yield spiked above 26% during the Sino Forest scare, as investors were dumping all Chinese bonds, but had since recovered.  The yield however continues to climb with uncertainty about property markets escalating.

Evergrande 9.25%, 5-year bond yield (Bloomberg)

This is by no means unique as can be seen in another example – Greentown, also a large and well known property developer.  The 9% bonds maturing in just two years are extremely volatile, currently trading at 71 cents on the dollar with a yield of over 30%.

Greentown 9% bonds maturing 11/2013 – yield (Bloomberg)

This means that these developers are now not only cut off from significant new lending, but also effectively shut out of the capital markets and new bond issuance.  It is unclear how these developers will be able to pay back their debt, if the property markets seize up.  This will not only hurt the bond holders, many of whom are outside of China, but may deal a severe blow to China’s banking sector that is awash with debt to property developers.

As developers begin to struggle, the property markets are having a knock-on effect on the broader economy.  As an example, the steel production industry is beginning to slow markedly (the bulk of steel produced in China is used in construction).  The chart below shows pig iron output dropping off at the rate similar to 2008.  Note that pig iron is the raw (carbon rich) iron that is in the earliest stage of refining.  Reduced orders/demand would first show up in the earliest stages of production. Prices on pig iron also declined rapidly, from 3900 to 3200-3500 CNY/metric tonne in a matter of two months.

China’s total pig iron output monthly, 10000 tons (Bloomberg, Antaike Information Development)

Other areas of the economy are showing signs of strain as well.

Council on Foreign Relations: Chinese steel production — driven in large part by construction — is down 15 percent from June, and nearly one-third of Chinese steelmakers are now losing money. Chinese radio reports that half of all real estate agents in the southern city of Shenzhen have closed up shop. According to Centaline, more than 100 local government land auctions failed last month, and land sale revenues in Beijing are down 15 percent this year. Without them, local governments have no way to repay the heavy loans they have taken out to fund ambitious infrastructure projects, or the additional loans they will need to keep driving GDP growth next year.

In a few cities, such as coastal Wenzhou and coal-rich Ordos, the collapse in property prices has sparked a full-blown credit crisis, with reports of ruined businessmen leaping off building rooftops; some are fleeing the country.

As the “Dutch tulip” style property correction is making its way through the broader economy, China’s leaders are looking to implement solutions to address this economic downturn. Their ultimate concern continues to be the risk of social unrest.

Council on Foreign Relations: Crowds of owners who had recently bought apartments at full price converged on sales offices throughout the city, demanding refunds. Some angry investors went on a rampage, breaking windows and smashing showrooms.

Here are some of the government’s initiatives aimed at heading off the effects of this economic downturn – directly from China’s official media:

1. Rapidly expand credit to medium and small businesses.

Xinhua: The Chinese government should especially give support to medium and small businesses as they would go through a hard time when the E.U. market starts to shrink, leaving them no time for a business transformation.

2. Improve domestic demand and increase incomes – particularly for the poor.

Xinhua (a different article): With the external demand waned, the Chinese government has attempted to turn to domestic consumers to take up the slack. The country vows to expand domestic demand next year and increase residents’ income, especially for disadvantaged groups.

3. Improve social security and affordable housing.

Xinhua…the government also needs to improve its social security system as well as increase construction of affordable houses and public rental houses.

The dirty secret of China’s property development boom has been the fact that these were largely luxury investment properties, homes that most ordinary Chinese could not afford.  It is not surprising therefore that the focus shifted to affordable housing.  China’s government currently has enormous financial resources at its disposal (such as tax cuts, monetary easing which has already started, etc.), that will allow the nation to soften some of the blow from this inevitable economic downturn.  But it’s unclear just how severe the downturn will turn out to be and the support for the economy would only be possible if social unrest does not become a problem. 2012 will be a decisive year for China and many of its trading partners.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.
Sober Look

Sober Look

Sober Look was founded by Walter Kurtz, a New York based hedge fund manager and credit markets specialist.

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  • Bond Vigilante/Willy2

    Ouch. Thanks for the graphs.

  • http://. Octavio Richetta

    After laying all the hard facts, the author, like most no cojones analysts, covers his back by ending with a sissy mild prognosis. No one has the guts to say, even if attaching a probability it, that the mess in China can end up very badly as soon as 2012. Anyone with an 80 IQ can see that their extremely unbalanced GDP with construction accounting for more than 60% of GDP, and a lot of it useless and nonproductive can not easily lead to a soft landing


    It is worth noticing that unlike, for example Argentina where a big chink of the RE development is 100% equity financed; in China they frequently go the “Italian way”, i.e., close to infinite leverage: financing with virtually 100% leverage.

    The Chinese government is gonna have to drop not yuan but US dollars frome helicopters to keep the rioters at bay.

  • http://. Octavio Richetta

    It doesn’t seem to me that they have the soft landing figured out: http://english.caixin.cn/2011-12-22/100341340.html

  • Jack

    Though I tend to agree your outlook, your inflated sense of conviction seems foolish.

  • Jack

    …Octavio’s that is.

  • perpetual neophyte

    “It is worth noticing that unlike, for example Argentina where a big chink of the RE development is 100% equity financed; in China they frequently go the “Italian way”, i.e., close to infinite leverage: financing with virtually 100% leverage.”

    Can you expound on that? It was my understanding that most Chinese residential property (including those purchased as investments) were done so with high down payments, typically around 30 – 50%.

  • asha101

    Chinese residents have 33 trillion in savings, total residential housing value is around 170 trillion, less than 30% of the houses have mortgages on them, the official total mortgage size is only 6 trillion, the estimated size is 10 – 15 trillion. Even if you use the 15 trillion number, mortgage value/housing value = 10%
    In U.S., this number is 60% I believe.

    For the market, the volume is certainly down, but the 20%-35% drop in price only represents the price movement of the new developments in suburban area. The price has not dropped for existing home sales in the urban area.

    I don’t know how people read these numbers. To me the RE market downturn does not signal a collapse in the financial system. Even if the price does drop 50% (in urban existing home sales, I think it’s a nearly impossible scenario), it will not have a major compact to 90% of the chinese families since most of them don’t even have a mortgage.

    It only means that the chinese can no longer use houses as store of their future savings, they need to find new ways to invest their gigantic savings. It could be gold, or some other stuff.

  • spragus

    Developers use the Italian approach, end buyers make a big downpayment

  • Hangemhi

    I’ve been wondering if there is a bet against the aussie dollar AUD from this and Australia’s housing bubble. If australias bubble finally pops, while exports to china take a hit, that would surely throw them into a recession that they’ve largely escaped so far. So does AUD collapse with it too?

  • http://. Octavio Richetta

    I meant exactly what I wrote RE development (I.e., the developers including government enterprises) not RE purchases. I am aware the Chinese use little leverage when buying residential property. More or less the same as here.

  • http://. Octavio Richetta

    U R Rite in one thing, I am not putting my money where my mouth is. I have not done any homework to see ow one my profit low risk from a China not very soft landing. The first thing that comes to mind would be short Australia currency and equities via puts.

  • http://. Octavio Richetta

    Agree that is what I meant, and despite my sloppy writing I thought it was clear I was referring to leverage by developers. Even though, thank god, consumers are not leveraged as much as in the USA, one cannot say the same for private and public enterprises. Despite the fact that mortgage levels are low, the Chinese really overdid it. People may have no debt but they are loosing a HUGE percent of their savings.

  • http://. Octavio Richetta

    Shilling has been recommending this. As usual, way too early but the time may have come. Need to look at Australian equities too see how much of the CHina slowdown is already priced in.

  • Texan

    Just as developers in the US have switched to multifamily housing vs commercial and office construction, developers in China can move toward affordable housing vs luxury. I’m not sure what demand is currently in affordable housing but the potential demand is huge with so many people moving into the middle class!

    The US single family housing boom in the 40’s and 50’s was a very prosperous time.

  • mike


    You may want to look at the distribution of the savings. Just like in the US I would say that the top 5-10% control a vast majority of that savings. Unlike the prosperous times in the US where labor was contributed a a significant amount of savings which propel the working class to middle class, the Chinese do not have that luxury. They cannot demand too much labor concession else the manufacturing base will move to cheaper locales. Even with the government investing in affordable housing, I would still say that most of it will be out of reach of most workers. It is just the way it is

  • asha101

    Cities like Shanghai has annual population growth near 3%. Majority of the residents still live in very crowded areas. There’s for sure a lot of demand for affordable housing. The biggest problem is that the local government is not willing to lower the cost. The combined cost (including land, tax, and other fees) is very high in China. Developers will be forced to not build.

    It is just my guess that the government officials own a lot of residential properties personally. They do not want the price to drop. They control the cost for new development that forces developers to reduce supply. With strong demand and reduced supply, the housing market will quickly turn into supply deficit in a few years that will keep the housing price high.

    Only government official numbers have a lot of affordable housing “in construction”, both the developers and residents do not see a lot of such units come in based on real life observation.

  • Bond Vigilante/Willy2

    1. “”Get ready for a Trade Deficit””. That’s bad for a number of countries that are running trade deficits as well. Does any one think about the US ?

    “”Chinese purchases of T-bonds are the function of their Trade Deficit””.
    Source: Cullen Roche.
    2. Japan has been a steel exporter since the early 1990s. South korea has become a steel exporter this (last ?) year and China keeps adding new capacity since 2000 (??). So, the price of steel is about to implode in the Far East. Not a pretty picture.
    3. The way to sterilize inflows of money into China is actually very straight forward: Issue short term debt. That sucks up any excess money supply. It’s precisely what the FED does/tries to do with the 3 month T-bill rate.

  • Bond Vigilante/Willy2

    Made an error. It should have been “”….. of their trade surplus”.

  • Old Dog

    Cullen – Times are tough all around but do you really have to take money from BAC?

    They truly are the scum of the earth!

  • Joe Consumer

    RE prices in China are as out of whack as in Australia when you measure them by almost any ratio such as median income/median house price…or house price/rental value.

    If I remember correctly, Bill Bonner at The Daily Reckoning blog wrote the median house price in Ozland is over $650,000. Incomes are barely a tenth of that. The “normal” or “safe” ratio should be below 4 from what I read.

    Same for price/rental value. This ratio should be about 12; it is now running over 22 in many cities in China and Australia from what I read. If others have different knowledge please comment so we can all learn.

    Stagnant wages and high unemployment intensify the RE problems.

    For the same reasons the RE Bubble Burst in the USA and other places, the same most likely will happen in any area where this disparity/instability exists. The market usually wins in the long run despite temporary support, although this support may help (hopefully) a softer landing.

    Good article on China RE and very thought provoking. Thank you.