China's looming property bubble

The GFC was a shock for the Chinese Communist Party (CCP): to maintain the confidence of the population China must outperform its western counterparts and Beijing has no option but to produce high growth.

China’s US$586 billion stimulus package was 67 per cent bank lending motivated, intended to boost domestic demand. The central bank was satisfied that record lending would achieve the 8 per cent GDP growth target for 2009. Banks willingly accepted the challenge so successfully that lending jumped 150 per cent to US$757.2 billion in the January-April 2009 period, exceeding the Beijing's US$732 billion limit for all 2009.

By the end of 2009, banks had lent US$1.5 trillion, around 33 per cent of GDP, of which an estimated 33 per cent of loans went into speculation.

China’s domestic stock market capitalisation jumped US$743.1 billion immediately following the implementation of the stimulus package lending incentives. Not recorded however, is substantial local government debt in off balance sheet transactions via their financial management arms that bypass state policy.

Beijing had assumed an early recovery of the global economy and stimulus spending would produce a surge in consumer demand and a resurgence of exports, foreign direct investment, employment, demand for commercial and industrial floor space, and push property and stock market values higher. But slow global growth in China's major export consumer economies, combined with crises in the Euro zone suggest that business as usual with China could be a long way off, as will amortising China's massive infrastructure spending debt.

China's property boom relies on data showing strong demand, sales and rising prices.

Increasing references to a bubble in China's property market is fuelling speculation of threats to both China's and global economies. Comparing China's property market with those of developed nations risks serious miscalculations.

Assessing the risk of this boom-bust scenario is complex and challenging and requires an understanding of China's five-year plans, property market development, developers, state bank and local government involvement, land acquisition, role of the media, government driven background forces, widespread corruption, speculation, investors, and homebuyers.

Information quality

Regardless of reported market related events, it is wise to remember that all information classified as not being in the interest of the state, meets the criteria of state secrets. Beijing and state media effectively censor sensitive information.

Recent boom to bust history

Outside China, many nations gained valuable experience from the financial pain of several resource, property, and technology booms and busts over the past three decades. China was isolated from that learning curve, its population lacks exposure, education and comprehension of a capitalist society and related financial risks. China also lacked opportunities.

From 1949, China was a classless society and the CCP ruthlessly suppressed all symbols of personal achievement and contact with the outside world. Information was the exclusive domain of state controlled media mixing domestic issues with large doses of propaganda, information of the outside world restricted only to those events of use to Beijing for propaganda purposes.

New opportunities, new wealth

Decades of low expectations and despair suddenly changed under the leadership of Deng Xiao Peng and his proclamation of "Poverty is not socialism. To be rich is glorious."

Following the "opening up" and flood of foreign direct investment, farmers and rural workers migrated to the cities to work in new and varied industries. The majority lacked the crucial residency permits and became China's exploited low paid migrant labour force exceeding 230 million. Generations, driven by desperation to escape poverty now encountered a modern world of new technology, opportunity, work, hope and wealth.

For those with connections and university degrees, high incomes, "friendly" banks, property development, and the stock market provided opportunities to generate additional wealth on a scale undreamed of before the opening up. It was now possible to flaunt symbols of personal success and wealth. Luxury apartments, cars, clothes, and accessories became the visible evidence of success. For those lower down the scale, those symbols related to local circumstance.

Banks played a major role in the drive to boost earnings, and downplayed risk. Anyone could become eligible for loans. Those lacking assets to secure their loan goals, simply paid corrupt bank officials for the privilege and would recover the fee from their profits. Pooling of family savings boosted the investment pool to participate in the stock market, helped by loans from "friendly" bank officials.

Property market with Chinese characteristics

Like the economy, statistics on population, health, unemployment, GDP and environment are all considered statistics with "unique Chinese characteristics".

Property has emerged as another market with "unique Chinese characteristics" in which crucial factors that include actual demand, affordability and market sectors take second place. The property market is a major contributor to China's GDP, and as such is politically sensitive.

State media

State media plays a key role in boosting the population's confidence in the CCP, the economy, stock and property markets: and the continuous glowing reports on China's increasing importance as a major global economic and industrial power increases that confidence. State media hailed China’s new economic prominence as proof of national superiority:

The country’s economic miracle exists because its leaders, unlike those in other, unnamed nations, can make quick decisions and ensure underlings carry them out. The Great Recession, has laid bare cracks in plodding Western-style capitalism.

A further confidence booster is extensive media coverage of grandiose projects demonstrating China's architectural imagination, innovation, engineering and financial capability to undertake projects developed nations consider impossible.

Buyer profile

Rising incomes have seen China's urban sector vigorously embrace the western consumer's obsession with self-indulgence, credit cards, and debt.

Because of sheer numbers and naïvety of values, market risk and traps, plus total confidence in state media and government, China's buyers are very different, and more vulnerable than their western counterparts. This buyer also lacks protection and guidance from NGOs; legislation governing market and sales practices; misleading advertising; and any effective recourse against illegal and misleading practices.

Striving for this new wealth, buyer confidence is boosted by TV reports of peasants and urban workers in stock market viewing rooms, eagerly talking of their rapidly growing paper fortunes. It was now easier to make money in stocks than working, and the growing value of the investments made it easy to borrow more. Property sells off the plans, long before construction starts, and often before final approvals.

Average house prices in the low income sector can exceed 12 times average income and mortgage payments can consume 60 per cent or more of a buyer's income.

Like most property markets, China's market comprises speculators, a mix of speculation and genuine homebuyers, and the one-off homebuyer. These buyers are reliant on the claims of developers, media reporting and government statements.

Speculation is a major component of this market: the practice of placing deposits on multiple units for resale nearing completion was also rampant in Malaysia, Indonesia, and Thailand prior to the Asian crash that delivered devastating results. The majority of China's population cannot afford to buy their dream apartments, and turn, instead, to speculation to increase their funds base, aided by developers and corrupt bank officials to circumvent government anti-speculation legislation.

Savings, family support and bank loans provide deposits on multiple apartments intended for resale before construction is completed, gaining a profit and repaying debt.

Many however, enter the luxury market with enough funds for one apartment at a time aiming for a higher profit, leading to misleading statistics in actual demand for luxury apartments.

Hukou (household registration), is a problem when trying to offload apartments to those outside Beijing. This can take more than five years.

Round robins provide buyers with a profit and opportunity to transfer residual risk to the bank if things turn bad.

Developers and developer scams

Developers range from corporations with government connections, local and central government state-owned enterprises, and corporations masking government participation in various projects. Companies across China now incorporate property development divisions in their operations to exploit new profit opportunities.

Because of anticipated high profits, focus is on palatial commercial property, luxury apartments, villas, and elite recreation facilities. The lower level executive apartments for the middle class form the secondary market. But totally ignored, except when demanded by Beijing, is the very high density, small, low-cost high-rise apartments.

Taking multiple deposits on apartments at below market prices up to 18 months pre-construction is common. The developer then claims various causes to boost the price when construction is due to start and later repays deposits. The intention is not to defraud buyers of deposits, but to use the deposits as interest free working capital for up to 18 months. One developer is reputed to have earned US$106,000 per month in interest on deposits totalling US$30 million.

Deposits can count as sales, inflating asset values to support loans, creating a false impression of demand.

Banks

The banks benefit from both the developer and the buyer. More clients means increased numbers of loans and greater turnover for the bank. Fake mortgages and inflated numbers of sales inferred by multiple deposits support loan extensions or new loans for the developer.

Banks sell loans to financial institutions, including pension funds, or repackage them into wealth-management products in largely unreported transactions. December 2009, Fitch Ratings reported:

China's banks were creating a growing pool of hidden credit risk through financial moves that shift loans off balance sheets to comply with government capital requirements.

Permitting banks to transfer all of the credit risk to third parties shields them from the consequences of bad credit decisions, which over time could foster the same type of recklessness witnessed with the securitisation of subprime loans in the US.

State involvement

Recent transactions of two major state owned enterprises raised serious concern of state involvement, possibly to protect banks, "favoured" developers, and other SOEs facing serious risk in the property market.

A Sinopec subsidiary purchased a major complex comprising apartment blocks, office towers and underground car parks for less than 50 per cent market price sparking outrage from homeowners and developers fearing plunging asset values.

After several months of contradictory excuses, a statement claimed the transaction was a debt for asset transaction with the developer of the complex. That complex however, was reportedly substantially unoccupied, burdened by heavy debt and incurring serious holding charges. The explanation raised more questions than answers in respect to omissions, pricing, developer, bank and individuals involved. Further reporting ceased.

China's major construction and engineering company purchased an apartment development site, setting a new record price for the Shanghai property market. State media immediately trumpeted the record deal:

... as a clear sign that Shanghai property values were still rising and would have a positive impact on Shanghai's future property market.

... analysts speculate that the deal could singlehandedly underpin apartment prices in what is already one of the nation’s priciest and most closely watched real-estate markets.

The purchase was unusual in that it blatantly ignored Beijing's demands to cool home prices in the regional centres, there was no competition, and timing and location were unusual.

Developers were experiencing falling demand and values, and the land was in low priced Yangpu, well outside the price setting Shanghai CBD and Pudong district. Further reporting ceased.

State statistics and media

Knowledge of the five-year plans, bank lending, the stimulus package, relocations, ethnic policies and Beijing's projected image, is essential.

Breaking up the statistics into regions can reveal interesting facts in determining the real impact of overall housing in 2009-2010 economic growth. Property development is a major contributor to regional GDP growth. It also provides:

1. rural housing for millions who have been displaced by Beijing's mega projects;
2. apartments for Han Chinese migrants in ethnic majority regions; and
3. low cost ethnic housing resettlements.

The first relates to projects including the Three Gorges Dam (3GD), the Olympics, the South to North Water Diversion Project (SNWDP) and others.

Relocations from the 3GD greatly exceeded the original 1.3 million estimates. Poor soils and collapsing reservoir shorelines forced further relocations, many up to three times. The latest relocations total 300,000. US$7.03 billion of stimulus funds will move another 330,000 people from Henan and Hubei under the latest SNWDP relocations.

The second is not low cost, but more the executive and luxury apartments for Han Chinese entrepreneurs, business executives and professionals drawn to, or assigned to work in the ethnic sensitive regions of Tibet and Xinjiang to reduce the ethnic minority.

The third is a Beijing priority for Tibet and Xinjiang. The strategy is to relocate Tibetan nomad communities from traditional lands designated for resource, agricultural, industrial and infrastructure development, as well as Tibetan urban communities from city growth areas to dispersed relocation sites. Both strategies mean they can be easily monitored and controlled.

In Xinjiang, entire Uighur communities were forcibly removed from the old town that is now prime city real estate and relocated to isolated outer urban ghettos of hastily built tower blocks that are already showing signs of deterioration. Activities in these tower blocks are easier to monitor and control than the old narrow alleyways of the old town.

Low cost housing is not only about fulfilling the desire for a home for the low income Chinese. It is also about control of ethnic populations and protecting the CCP from criticism and separatism and boosting housing statistics.

Local government gone mad

Because of the manner in which China calculates its GDP, local governments construct grandiose mega projects to boost local GDP, regardless of potential for success. New Ordos City is just one example.

This gleaming new palatial seat of power of grand structures house the local government, CP headquarters and Grand Khan Square in landscaped parklands less than two kilometres south from old Ordos City, reached by high speed freeway. Palatial office blocks and thousands of luxury villas, apartments and leisure facilities in a landscaped countryside have also been constructed to meet the needs of the private sector.

Designed for a population of 1.3 million, the assumption is that luxury and extravagance will attract the wealthy corporate elite and entrepreneurs to live in luxury in this desert land of opportunity alongside the new centre of power in Inner Mongolia.

While workers are bussed in and out to the busy government sector every day, the same energy and dynamism is missing in the private sectors. Few occupants live in these forests of silent monuments to luxury private desert living. Despite this, construction continues, adding more accommodation and facilities every day while existing, unoccupied facilities deteriorate.

Ordos is in a billion-dollar cleft stick standing in line for occupants like Dubai’s Burj Khalifa, Astana, New Songdo City, and the tens of square kilometres of floor space in the gleaming empty, or near empty towers of Beijing and Shanghai.

Abandoning construction is not an option, since it would acknowledge failed policy, oversupply, and unrealistic prices. Lowering prices will push values below realisable levels, triggering a chain reaction that could engulf not only the developers and tenants, but also the banks and local government itself.

What of 2010

Inspecting Beijing and Shanghai apartments and office space reveals the sheer extent of vacant buildings, floor space, and that in turn, indicates massive outstanding debt that is accruing servicing and maintenance charges. Time spent checking Beijing hotels reveals serious oversupply and low average occupancy rates, reducing debt recovery dating back to pre Olympics.

Despite the efforts and claims by government, media and developers, property prices are in decline. Beijing is pressuring banks to meet new government requirements to cover loan/loss ratios, triggering a rush for additional funds from new offerings and bond issues. Banks face a growing NPL risk from lax credit control, questionable practices, concealed debt, and corrupt officials.

Speculators requiring high prices and quick turnover to cover their apartment investments face declining property values, falling demand and pressure from banks. Even a 10 per cent decline in property prices could raise defaults by 300 per cent triggering escalating default rates. A 30 per cent decline could raise defaults by 500 per cent.

Summary

1. The state of the market appears reliant on questionable information on actual sales, level of speculation, the real level of debt and actual level of vacant floor space.
2. The market is unbalanced, favouring the luxury sector while demand is in the mid and low income sectors.
3. Possible state involvement and related dubious practices question the basis for media claims of continuing rises in the property market.
4. Banks argue they face "minimal risk of losses from such deals" but reject the need of disclosure in their financial statements.
5. The property market is politically sensitive and all information can be classified under state secrets legislation.
6. State media reporting on the property market is controlled by the Central Propaganda Department and related Ministries.
7. The market comprises a market naiive generation with experience only in a rapidly growing economy, rising personal wealth, and confident of government support in time of crisis.
8. Because of scale and sheer numbers of small speculators, any hint of impending foreclosure would immediately hit cyberspace, creating havoc for banks, developers, local governments and the CCP.

The consequences of creating and trading in illusions are likely to surface later this year.