No one, not even China's leadership are exactly sure of what is going on. With the Chinese economy slowing, the situation will only get worse
For the past year, the International Monetary Fund (IMF) has been warning about the risks in China. Certainly the overcapacity and real estate are obvious risks. But what the IMF is missing and which is far more serious are two issues with China. The first is that the economic system in China is Chinese. Specifically it is capitalism with Chinese characteristics.
The second issue is information. It is far worse that the typical asymmetry issues: they have it and you do not. The Chinese government suppresses information. Worse, it has provided large incentives for distorting it. The result is that no one, not even China’s leadership are exactly sure of what is going on. Markets may think they understand the situation. They project their own experience on a reality that might be quite different.
Look for example at the numbers for China’s growth. The Chinese announced earlier this month that it had declined to 7%, its worst growth in six years. However, the reported statistic looks strong compared to other estimates. Research groups at Citibank estimated actual quarterly growth could be below 6%, Capital Economics estimated the quarter at 4.9%, the Conference Board’s China Centre thought 4% and finally Lombard Street Research had the lowest estimate at 3.8%.
It is not hard to point to the reason why China’s growth is slowing. It is slowing because of the same problem that the US had in 2007, the end of a housing boom. Real estate sales have been slowing for more than a year. Prices have fallen for the past six months. The decline has also been accelerating. Prices went down 4.3% in December, a further fall of 5.1% in January and 5.7% in February.
Falling real estate prices are a disaster for any country, but China is not just any country. Its real estate sector makes up 13% of GDP compared to just 3.2% in the US. If you include cement, steel, chemicals and furniture and other industries that affect real estate, the figure rises to 20% a full one fifth of GDP. In addition, prices are some of the highest in the world relative to household income and they have increased some 500% since 2008.
Slowing land sales of course have hit developers. The developer Kaisa defaulted $2.8 billion worth of offshore dollar bonds, a small part to the $65 billion dollar bonds loaned to Chinese real estate companies and an even smaller part of the over $5 trillion dollar denominated debt loaned to emerging markets.
The real impact will be on local governments in China. As of last count in 2013, Chinese local governments owed about 17 trillion yuan (about $3 trillion) up 67% since 2010. No doubt, it has been growing since then. Some recent estimates put it at 25 trillion yuan. However, local government bonds in China are just like American munis, right? They are backed by taxes. Nope. This is China. Real estate taxes are in the experimental stage. Even the real estate land titles are in doubt. Local governments raised 65% of revenues by selling land. But there is a slight problem, sales of land by local governments declined by 32% so far this year.
This bizarre state of affairs occurred because of the way China stimulated its economy. Some governments used taxpayer dollars. The cheapest and most politically palatable method was to get central banks to print vast sums of money. But the Chinese local governments borrowed it from their state owned banks.
This worked well until about 2012 when the bad debts started rising. To avoid the problems that occurred in the last recession, the central government allowed the rise of the shadow banking system. And rise it did. It quintupled since 2009.
Much of the money raised in the shadow banking system was invested in real estate. As the US Federal Reserve predicted during a meeting in 2008, much of it was wasted. In 2013, about 22.4 % of all homes in urban areas, or 48.98 million units, were lying vacant. But now that real estate is declining where are investors supposed to invest?
The stock market, of course. Much of the money printed by the central banks has found its way into equity markets. Margin lending in the US is at an all-time high, but it is nothing compared to China. Most of the stocks listed on Chinese exchanges are state owned companies. So, a large part of their shares are not available. The real margin-debt ratio in China is at 8.2%.
This is potentially an economic catastrophe for the world’s second largest economy, but western markets salivate like Pavlov’s dogs at the mere mention of stimulus. Recently, the People’s Bank of China suggested a program that was ostensibly similar to Europe’s long-term refinancing operation (LTRO) program. Western markets looked on this program along with a cut in reserves for the banks with favour as a form of monetary stimulus. It is not.
The reserve cuts most likely will not put any more money into the system. It will either be used to roll over old loans mostly to state owned banks or to make up for the flows of money that have now reversed and are leaving the country. Nor will an LTRO program help. First, banks are balking at buying any new bonds issued by local governments in exchange for debt. The reason is simple. Although the interest rates on the bonds might be lower, their quality is not any better. Recent bond auctions were ‘postponed’. Second, banks have problems finding any quality lenders to take the money. With the Chinese economy slowing, the situation will only get worse.
However, markets can react only to what is known and what is known is interpreted according to their own past experience. Although the reality has been quite obvious for some time for anyone interested in looking behind the numbers, when it does come to come to light it will be perceived as a bit of a surprise. Black Swans anyone?
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William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)
