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It Doesn't Take a Genius to Figure Out How This Will End

Reggie Middleton's picture




 

For all of those who feel China is going to take over the free
world, just remember that when you blow a bubble (particularly a
balance sheet bubble) it is bound to pop. The damage from the pop
invariably does more harm than the boost from the bubble. It has always
been the case, particularly when leverage is involved - which makes the
impact that much more devastating. If anybody can attest to this, it
should be us Americans (British, Spanish, Irish, those from Dubai,
Japanese...).

Methinks that before China gets a chance to
become a preeminent world power, their profusely blown asset bubble (by
way of a most accomadating fiscal policy) will blow up in their face
and they will go through what the US, Japan and UK just (is still) went
through, exacerbated by the fact that they are still a net export
reliant economy when the bubble blowing is removed. With the developed
world in sluggish mode, they will have very little to fall back on as
their asset prices collapse to equilibrium and debt from their
steriodal lending system is left under or uncollateralized and unable
to be serviced.

Why does everybody confuse bubbles with economic progress?

From Bloomberg:

Dec. 31 (Bloomberg) -- Li Nan has real estate fever. A 27- year-old
steel trader at China Minmetals, a state-owned commodities company, Li
lives with his parents in a cramped 700- square-foot apartment in west Beijing.

Li originally planned to buy his own place when he got married, but after watching Beijing real estate prices soar,
he has been spending all his free time searching for an apartment. If
he finds the right place -- preferably a two-bedroom in the historic
Dongcheng quarter, near the city center -- he hopes to buy immediately.
Act now, he figures, or live with Mom and Dad forever. In the last 12
months such apartments have doubled or tripled in price, to about $400
per square foot.

“This year they’ll be even higher,” says Li in the Jan. 11 issue of Bloomberg BusinessWeek.Does this scenario sound even remotely familiar???

Millions
of Chinese are pursuing property with a zeal once typical of
house-happy Americans. Some Chinese are plunking down wads of cash for
homes. Others are taking out mortgages at record levels. Developers are
snapping up land for luxury high- rises and villas, and the banks are
eagerly funding them. Some local officials are even building towns from
scratch in the desert, certain that demand won’t flag. Straight out of the Dubai make money now and pay for it later handbook of bubblistic speculation! And if families can swing it, they buy two apartments: one to live in, one to flip when prices jump further. Imported speculators from Miami, LA and downtown Brooklyn!

And jump they have. In Shanghai, prices
for high-end real estate were up 54 percent through September, to $500
per square foot. In November alone, housing prices in 70 major cities
rose 5.7 percent, while housing starts nationwide rose a staggering 194
percent. The real estate rush is fueling fears of a bubble that could
burst later in 2010, devastating homeowners, banks, developers, stock markets, and local governments.
Let's get this straight. "Fears of a bubble"!!! A 54% gain in 9 months
does not confirm a bubble???!! What is the long term historical average
in China. Probably 2% to 4% annually, or on pace with inflation, give
or take. So, if pundits are not sure a 25x increase is a bubble, what
would it take to convince them?

High-End Bubble

“Once the bubble pops, our economic growth will stop,” warns Yi Xianrong, a researcher at the Chinese Academy of Social Sciences’ Finance Research Center. On Dec. 27, China Premier Wen Jiabao told news agency Xinhua that “property prices have risen too quickly.” He pledged a crackdown on speculators.
Actually, once the bubble pops, their economic growth will collapse,
and trend in reverse. That's what happens when bubbles pop. If the
growth just stopped, then it would make sense to encourage bubbles,
wouldn't it? You can just reignite another bubble when the previous one
pops and start the cycle over again. It appears as if this is the
playbook some of our central bankers are following. Unfortunately, they
are called boom/bust cycles, not boom/stop cycles. Bubbles are not
indicative or true organic growth, they are a sign of growth borrowed
from future time periods that MUST be paid back with hard money
interest. The bigger the bubble, the bigger the "vig".

Although
parallels with other bubble markets, the China bubble is not quite so
easy to understand. In some places, demand for upper middle class
housing is so hot it can’t be satisfied. In others, speculators keep
driving up prices for land, luxury apartments, and villas even though
local rents are actually dropping because tenants are scarce. What’s
clear is that the bubble is inflating at the rich end, while little
low- cost housing gets built for middle and low-income Chinese.This is not hard to parallel. This is exactly what happened in NYC, particularly Manhattan and Downtown Brooklyn. See  "Who are ya gonna believe, the pundits or your lying eyes?" (for pictures) and "Who are you going to believe, the pundits or your lying eyes, part 2" (for numbers and a very shaky video),
I illustrated a trip from Chelsea Piers in Manhattan to Prospect Park
in Brooklyn, capturing the rampant supply of residential, office and
commercial space that is STILL being put up despite the extreme glut
currently in this rapidly declining market. As you look through all of
this visual material, remember banks have supplied the capital for
building all of these empty edifices, at no less than 10x leverage.
None of this inventory was targeted at the middle and lower classes. As
ironic as it may sound, this activity ultimately ends up causing
downward social mobility as asset values collapse under mounting debt.
See Super Brokers form to push Super Broken products to make those with High Net Worth Super Broke for my take on social mobility, downwards style).

In
Beijing’s Chaoyang district, which represents a third of all
residential property deals in the capital, homes now sell for an
average of almost $300 per square foot. That means a typical 1,000-square-foot apartment costs about 80 times the average annual income of the city’s residents. I'll give this until the end of 2010 to blow up!

Table Talk

Koyo Ozeki,
an analyst at U.S. investment manager Pimco, estimates that only 10
percent of residential sales in China are for the mass market.
Developers find the margins in high-end housing much fatter than
returns from building ordinary homes.

How did this
bubble get going? Low interest rates, official encouragement of bank
lending, and then Beijing’s half-trillion- dollar stimulus plan all
made funds readily available. City and provincial governments have been
gladly cooperating with developers: Economists estimate that half of
all local government revenue comes from selling state-owned land. "Nuff said!

Chinese consumers, fearing inflation
will return and outstrip the tiny interest they earn on their savings,
have pursued property ever more aggressively. Companies in the
chemical, steel, textile, and shoe industries have started up property
divisions too: The chance of a quick return is much higher than in
their primary business. Oh my!

Built on Sand

“When you sit down with a table of businessmen, the story is usually how they got lucky from a piece of land,” says Andy Xie,
an independent economist who once worked in Hong Kong as Morgan
Stanley’s top Asia analyst. “No one talks about their factories making
money these days.”

I am leaving out significant
parts of the article, so as not to excerpt too much. I suggest you
follow the link to read it in its entirety. The following portions do
support my suspicions of where all of the alleged consumer activity in
China is coming from, though:

Key to Growth

...
The government is reluctant to crack down too hard because
construction, steel, cement, furniture, and other sectors are directly
tied to growth in real estate. In November, for example, retail sales
of furniture and construction materials jumped more than 40 percent. At
the December Central Economic Work Conference, an annual policy-setting
confab, officials said real estate would continue to be a key driver of
growth.

The worst scenario is that the central
authorities let the party go on too long, then suddenly ramp up
interest rates to stop the inflationary spiral. Without cheap credit,
developers won’t be able to refinance their loans, consumers will no
longer take out mortgages, local banks’ property portfolios will sour,
and industrial companies that relied on real estate for a chunk of
profits will suffer. Nahhh! Really!

...
One difficulty in handicapping the likelihood of a nasty pullback is
the opacity of the data. As long as property prices stay high, the
balance sheets of the developers look strong. And no one knows for sure
how much of the more than $1.3 trillion in last year’s bank loans
funded real estate ventures.

...

Analysts figure
a substantial portion of that sum went into property, much of it
indirectly. Banks often lend to state-owned companies for industrial
purposes. But the state companies can then divert the funds to their
own real estate businesses or relend the money to an outside developer. Enter the domino/daisy chain effect in case of collapse...

Meanwhile,
the big banks may be cutting back on their real estate risk by selling
loans to smaller local banks and credit co-ops...

I explored these possibilities about a year and a half ago. See China Macro Update, (also of interest is the HSBC opinion and 2H08 update).Then My view of the China hype bears additional fruit and All of my warnings about China are starting to look rather prescient.

 

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Thu, 12/31/2009 - 23:15 | 179625 Anonymous
Anonymous's picture

bubbles do not exist based upon the merits or
demerits of the capital allocation....they do
exist when prices rise out of proportion to
demand and ultimately that is driven by income...

there is no economic situation which justifies
the torrid pace of real estate prices increases
reported in the article or in these postings...

the rapid and extreme re price rises have
absolutely no correlation with rises in income -
just as happened in the usa....

it is a shame that observors of your ilk do not
understand what sustainable or healthy growth is...
they are the cheer leaders for bubbles...

and anyone who thinks that vancouver re prices
c. 1990 are a useful yardstick for assessing chinese
re prices c. 2010 has no perspective of income
vs price levels. 400 usd per sf is even expensive
in the usa for residential property except for
manhattan and other select markets...but then again
most manhattan incomes are in the stratosphere...
is the average chinese buyer really making 100-125k
per year?

looks like a bubble to me....

Thu, 12/31/2009 - 20:06 | 179506 Anonymous
Anonymous's picture

You may have noticed Flaherty the other day talking about people rushing in to buy houses they can barely afford at today's rates who will be in trouble when rates inevitably rise. The bubble factor will become apparent when Toronto housing prices drop as a result of rising rates. Our rates are being suppressed in sympathy with BB's desperate ZIRP strategy.

Thu, 12/31/2009 - 14:29 | 179144 Ripped Chunk
Ripped Chunk's picture

+10

Thu, 12/31/2009 - 13:05 | 179015 Anonymous
Anonymous's picture

You rock Reggie. In my head, I am thinking this will be just like the great depression only this time China is America and America is Europe. America got hurt way worse in the depression than Europe did. I think the same will be true with China this time around.

Thu, 12/31/2009 - 12:54 | 178992 Leo Kolivakis
Leo Kolivakis's picture

Reggie,

I had read somewhere that Chinese banks are in much better shape than critics claim. This just out, China will stick to loose monetary policy in 2010:

China's central bank said on Thursday that it will stick to its loose monetary stance next year and at the same time be more flexible in implementing policies.

 

People's Bank of China governor Zhou Xiaochuan said in a new year's address that the PBOC would urge banks to lend more to new industries, employment-friendly sectors and agricultural production.

 

Many analysts view Chinese officials' repeated pledges to maintain "appropriately loose" monetary policy while enhancing flexibility as a sign of its plan to step up mild tightening.

Looks like Chimerica will let the bubble blow.

Thu, 12/31/2009 - 14:20 | 179120 RagnarDanneskjold
RagnarDanneskjold's picture

For the record, I do believe the Chinese have bubbles because they're still centrally directing the economy and running a loose monetary policy, and local government revenue comes from landsales, etc. Whether these offset in some sense is an open question, but there's definitely some malinvestment going on.

That said, having lived in China, Leo has a point. I've seen whole new developments spring up and sit empty for a year or two (sometimes more), and then they're suddenly filled. The empty city of Ordos may be a ghost town, but so was Pudong back in 2004. 

The Chinese are running a few years ahead of demand with infrastructure and real estate. At some point, they are going to be a few years ahead of demand, but it will never arrive. Based on demographics, that is likely to be closer to 2020 than 2010. 

Fri, 01/01/2010 - 05:22 | 179737 bokapita
bokapita's picture

Not so. China has an effectively limitless pool of un-activated demand. The vast majority of the country live in terrible conditions by western standards, and thousands of empty cities could be filled up if the price was right (near zero) and there was some sort of job there.

At some point the chinese will figure out that selling to their own horde of disposessed is better than selling to the USA. Then, they will figure out how to make the transition - just like the UK and the USA did about 150 years ago.

 

their banks will go bust? So have ours but the world still turns. they will find a way.

Thu, 12/31/2009 - 12:40 | 178966 Daedal
Daedal's picture

Reggie,

One of my co-workers has an apartment in China which he purchased about 1 year ago. A few months ago he received an offer that was 60% above his purchase price. At the time his ownership was not even 9 months in length! Have my pleadings resulted in a sale? I'll give you 2 guesses, but you'll only need 1.

Thu, 12/31/2009 - 12:31 | 178952 Cursive
Cursive's picture

@RM

The ChiComs built an entire city that is uninhabited.  China is a polluted wasteland.  Chinese unemployment is rising.  But don't worry, they're firing on all cylinders...

Thu, 12/31/2009 - 16:42 | 179318 Bill - Yes That Bill
Bill - Yes That Bill's picture

There's a big difference between a paper tiger and a tiger with cancer. Uninhabited city... polluted wasteland... throw in social and political instability... you're still left with a powerful totalitarian state with powerful military and economic resources behind it.

Oh, sure... we could "take" China today in a shooting war. (At least I think we still could.) But consider... five years ago "the experts" were talking of us being anywhere from 20-35 years ahead of China in terms of their being able to legitimately challenge our military superiority; now it's 10-15 years based upon authoritative analysis.

Right now... TODAY... let alone in five years assuming an Obama second term... what do you suppose we'd do if China were to take back Taiwan by force?

Command economies have many weaknesses, but let's face it, when we're talking "competition" against "a foe" a nation such as China holds huge advantages over the United States.

China seeks natural resources... she goes to the source and either buys or via political (backed by potential military) action "takes" control of foreign mining, oil, forestry, and food producing centers - be they in Asia or in Africa or South America.

Pay attention to what the Chinese have been doing.

Might China collapse upon itself due to internal stresses...? Oh, sure... anything's possible. (And China has PLENTY of internal stresses!) But give me a viable scenario where the repercussions to the world as a whole and the U.S. in particular shouldn't scare the crap out of all of us.

China is dangerous. China is not our friend.

BILL

 

Sat, 01/02/2010 - 14:06 | 180647 Anonymous
Anonymous's picture

Shooting war? How do you get within range? Ever looked up "Sunburst Missle"?

Thu, 12/31/2009 - 17:26 | 179369 Anonymous
Anonymous's picture

So...five years ago they were "experts" for predicting the Chinese will be a threat in 20-25 years. Now authoritative analysis warns us against danger in 10-15 years. That happens in another 5 years, will this authoritative analysis also be downgraded to the inglorious field of "expert" analysis. [incidentally, a little math observation here. If 5 years ago the 'experts' predicted that China would be a threat in 20-35 years, then today this threat is within 15-30 years. Which in part falls into the authoritative prediction of the Chinese threat in 15 years]

Anyway, the big scary Russians were about to overrun Christiandom in 1979. And then that kind of faltered. As all things in this universe, everything turns on the price of oil. For the Russians, the higher it is the better. For the Chinese, the lower it is the better. As we are scared relentlessly about peak oil, in the long run we might be ok.

If the Chinese want to expand all over the world, the better for the West, as our navies are mighty, and can comftorably hangout in the Indian Ocean to intredict the resource supplies to scary China if need be.

As a generall note -- all totalitarian states are inherently weak in the long run. Too much bureacracy, too much corruption, and the all seeing and all powerful chief becomes blinded by yesmen. If Hitler hadnt started World War 2 in 1939, hell if he hadnt annexed Austrian gold supplies in 1938, the 3rd Reich would have gone broke in 40. The only reason the Soviets didnt go broke in the 70s was the oil embargo, and when prices collapsed so did their economy.

The only successful authoritarian state in the world is Singapore. All other, former succesful authoritarian states, eventually converted into quasi-democracies. [Korea/Japan/Taiwan]

Thu, 12/31/2009 - 21:33 | 179563 WaterWings
WaterWings's picture

The only successful authoritarian state in the world is Singapore. All other, former succesful authoritarian states, eventually converted into quasi-democracies. [Korea/Japan/Taiwan]

Is a foreign military base in a given country the chicken or the egg for quasi-democracy?

China is ready to take advantage of our weaknesses - and our military is stretched thin and exhausted. I'm surprised we haven't reinstated the draft. As a nation we are too decadent to even realize how sickly and feeble we are. What if China detonated a few nukes over CONUS? I'm just sayin', what if they did? Damn the torpedoes, we're going to EMP blast the American homeland. Many of their officials talk openly of how they had discovered America before Columbus. It's insane to imagine but Hitler also needed 'breeding ground' and invaded East. He felt the Slavs were inferior. The Chinese think the same way.

Their system is fragile, like ours, but they will reveal their talons if they see an opportunity. 

Thu, 12/31/2009 - 23:07 | 179621 Anonymous
Anonymous's picture

Well, that is a pretty sweet rant. Chinese need liebensraum so they will invade continental USA. Manages to combine the 1930s with the 19th century.

But no, we are not stretched thin. Why? Because the USN is fucking sweet. And in any conflict it will demonstrate that he who rules the waves, rules the world.

Dunno about the quasi-democracy thing. US had bases in Philippines, Japan and Korea. Of these 3, only the later two became normal. I dont think Americans ever had military bases in Taiwan, but they also became normal.

Fri, 01/01/2010 - 04:18 | 179734 WaterWings
WaterWings's picture

Ja! Philippines and Greece have the same problem: too many goddamn hills and islands to maintain rule. 

And how long can the USN survive without regular shipments once (if? I'm not qualified to make qualified statements) international trade goes FUBAR? An isolated Navy is a rubber ducky after a few months.

Thu, 12/31/2009 - 17:15 | 179356 Anonymous
Anonymous's picture

"Oh, sure... we could "take" China today in a shooting war. (At least I think we still could.)"

ROFLMAO.

Thu, 12/31/2009 - 15:33 | 179241 Anonymous
Anonymous's picture

There's always been an element in the West that admired totalitarian regimes. Hitler, Stalin, the Chicoms, it does not matter. Thomas Friedman is a good example currently. He gushes about the Chinese. He does throw in a reference to their human rights issues now and then to keep it semi-legit.

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