China: A Major Correction Ahead
Andy Xie (Hong Kong)
Summary and Investment Conclusion
From my two weeks of visiting investors in Japan and the US, the market consensus appears to be that China has tightened enough and its next move should be easing. Most investors judge the impact of the tightening from the decelerating growth rate of money supply. The still-high growth rate of investment is justified on the need to invest in the western or northeastern provinces.
I believe that China's tightening has had a limited impact so far, the investment cycle has so overshot that any additional tightening could trigger a major correction, and a major correction would happen anyway over time without additional tightening. The main reason for my view is that the profit expectation that drives the investment boom depends on property demand and the property demand is not sustainable.
The rhetoric at the fourth plenum of the Communist Party central committee was not hawkish on macro tightening. That may reinforce the easing expectation in the market. The risk of another wave of speculation in both property and stock market is quite high, but it would accelerate the onset of the correction, in my view.
The Euphoric Market Consensus
The market consensus believes that China's tightening has worked and the next move is likely to ease. The main evidence for the tightening effectiveness is the decelerating growth rate of money supply. The widespread anecdotes of credit scarcity are also viewed as a sign that the current macro conditions are too tight.
Most investors justify the rapid growth of fixed investment on the needs to house a vast population and to develop poor provinces in the western and northeastern regions. The needs-based argument is very popular among investors to justify the sustainability of the current investment boom. It ignores the affordability issue.
The Tightening Has Had Limited Impact
Evidences suggest that the tightening has had a limited impact so far.
The financial institutions’ loans to the non-financial sector increased by Rmb 200 billion/month between January-August 2004 compared to 231 in 2003, 158 in 2002, and 72 between 1999–2001. Loan growth is still substantially above trend one year after the tightening began.
Fixed investment is still growing at 30%, similar to 2003. China has roughly doubled fixed investment in three years. This increase is virtually identical to that between 1991–94 after adjusting for devaluation-induced inflation.
Energy consumption is still running at 16–17% annual growth, also similar to 2003. Crude oil imports rose by 39% in the first eight months of 2004, compared to 31% in 2003. The imports of refined products rose by 44% in the first seven months of 2004, compared to 38% in 2003.
The mild slowdown in loan growth is probably due to less speculation in renminbi appreciation than last year. Under a fixed-exchange-rate system, capital inflow, if unsterilized, leads to loan growth. But sterilization would lead to a rise in interest rates. China has not done this systemically due to the politicized process of interest-rate policy.
Financial and physical indicators do not suggest that China has tightened significantly, in my view.
Why Are Credit Conditions Tight?
There are considerable anecdotes that reflect tight credit conditions.
I have been receiving faxes requesting money to fund property projects from places that I have never been to. The main reason, I believe, is that the demand has risen faster with another 30% increase in fixed investment. Ceteris paribus, it would require an increase of Rmb 300 billion/month in loans to make the credit condition as loose as in last year.
Judging credit condition on satisfying demand alone is erroneous. The current level of loan growth is still 2.8 times the average between 1999-2001 when China was growing briskly. The absolute level of loan growth is still substantially above trend, in my view. China should reduce investment rather than increase credit growth.
Why Is the Demand Unsustainable?
Profit expectation drives investment. China's current boom is no exception. As retail sales grew at 30% as fast as investment in 2003 and 44% this year so far, meeting consumption demand could not be the main motivation for the current investment boom.
Exports are growing as fast as investment in this cycle. But the profits from this sector are concentrated among foreign capital-owned enterprises that do not have much to do with the current investment boom. The export boom helps fund the investment boom, as the income that Chinese workers earn turn into bank deposits.
Most profits in this boom appear to come from the property market. The bulk of the profit growth in the current boom comes from the materials, financial and property sectors. The growth and high margin for the first two sectors depends on the strong property demand. Hence, the profitability in this cycle depends on rapidly growing property demand and high prices.
Sales of new properties are running at a pace of 8.2% of GDP this year, up from 2% six years ago. The total amount of property under construction is likely to reach 1,460 million square meters, with a market value of about 30% of GDP by year-end. All the data are suggesting that the market is grossly overextended.
Four factors have exaggerated the current property demand, in my view.
First, a negative real interest rate is prompting Chinese households to advance demand for properties for wealth preservation. Ten years ago, Chinese people bought refrigerators and TVs to hedge against inflation.
Property is now the hedge. This type of demand borrows from the future.
The low mortgage rate also misleads, as all mortgages are on adjustable rates.
The devaluation in 1992 and 1993 caused the inflation in the previous boom. Food and oil are causing the current bout of inflation.
Second, pent-up demand phenomenon in a new market has also exaggerated demand. China introduced mortgage financing in 1998, which kicked off the private housing market. In a new market, the initial buyers have high income, which exaggerates the market's buying power. China's auto market has gone through the same process. The auto demand was growing rapidly despite prices that were higher than in rich countries in the previous two years.
As the pent-up demand from high-income population is met, the selling prices have to connect with average income. This is why auto prices are falling while the sales are stagnating. The average selling prices for properties in most cities I have visited are above ten times household annual income and are not sustainable, in my view.
Third, corruption has generated a significant chunk of property demand.
Many cities that I have visited benefit from strong demand from western and northeastern provinces. These regions are the poorest in the country and have received government-directed loans in the past few years. Part of the demand from these provinces could be due to laundering corruption-related money.
Property demand from non-residents is a major factor virtually in all major cities. A disproportionate share of such demand, I believe, comes from government officials and executives at state-owned enterprises.
Fourth, speculation is a major force in property demand. In the hottest markets, I believe speculative demand may constitute over 20% of the total demand.
As property prices have risen rapidly in an environment of negative real interest rate, speculative demand has jumped onto the bandwagon. The importance of this demand is limiting the will of local governments to crack down on speculation.
Chinese people need properties in large volumes but not at the current prices, in my view. The sustainable demand at the current prices could be only half as much as what we are seeing today.
What Could Trigger the Correction?
A property bubble could last long. Why should China's go on for a few years? The main reason for a correction soon, I believe, is that China's property market is a primary market and needs a huge amount of new money to fund it. The Fed tightening policy is making it more difficult for money to flow into China. The big picture does not suggest that China's property bubble could continue for long.
I see four scenarios for China's property bubble to burst. First, if China raises interest rates, it could scare away speculators and decrease the inflation fear among Chinese people. Because the property market is so overextended, a rate hike would have a dramatic impact.
This is why vested interest groups are so against raising interest rate.
The fourth plenum of the Communist Party central committee that just ended did not sound hawkish on tightening. It appears that a decision on interest rates is not imminent. However, I believe that a rate hike before year-end is quite likely.
China's inflation will not go away. Food and oil are long-term bottlenecks. The high prices of food and oil are yet to work into general prices. Even if inflation stabilizes at 3%, China has to raise interest rates by three percentage points to achieve financial stability.
This would happen regardless of the growth deceleration. The current interest-rate structure is not consistent with long-term inflation outlook.
Second, an export downturn would lead to a big trade deficit, declining foreign exchange reserves, and, hence, low money growth. China's investment demand drives its imports; global demand and manufacturing relocation drive China's exports. When exports grow, liquidity in the banking system builds up due to the income effect from exports, which causes bank lending to rise. The investment funded by bank loans then generates imports.
I see two reasons why China's exports have more than doubled in three years: the Fed has injected massive stimulus into the global economy by keeping the interest rate at 1% for so long, and China joining the WTO has triggered a wave of manufacturing relocation to China. The export boom triggered the initial wave of lending boom, as higher export income increased bank deposits. The capital inflow has amplified this lending boom.
While China gains market share in global trade and its exports grow twice as fast as global trade on average, its exports are still very cyclical due to the global economic cycles. The global economy is just beginning to turn down. If the patterns from the past cycles hold, China's exports could record zero annual growth at some point in the next 12 to 18 months.
Also, China's exports might have been exaggerated since the middle of last year. China's exports have risen by ten percentage points more in the past six quarters than what is reflected in the import data of the selected countries that account for two-thirds of China's exports. I suspect that many exporters have been exaggerating export values to bring in money for speculation in Renminbi appreciation. If China's exports were indeed exaggerated, its trade deficit would already be large, which would be exposed when the exporters undervalue their exports to take the money out.
Third, a rising dollar interest rate could divert money away from China.
China's foreign exchange reserves have risen at an average pace of $11 billion per month, which is the primary reason for the fast generation of credit. I believe a substantial chunk of the capital inflow is to speculate in Renminbi appreciation. Many overseas Chinese businessmen that I have met are convinced that the US pressure would eventually push China into appreciating its currency, as happened to Asian currencies in 1980s. This type of inflow could be a major factor in the rapid rise of enterprise Renminbi deposits.
However, the carrying cost on such positions is rising. China's short-term deposit rate is 1% versus 1.5% for dollar deposits. As the Fed raises interest rate further, the carrying cost keeps rising. At some point, overseas Chinese businesses may take the money out. When it happens, China's money supply would come under pressure, which would lead to the interest rate rising or credit rationing.
Fourth, property supply could overwhelm demand. The supply of new properties is rising at 20–30% per annum. Chinese household income is not rising nearly as fast. Hence, to meet the demand, the stock of savings has to be drawn down. This explains why household savings deposits are decelerating rapidly. As the deposit growth rate slows, there would be less money for mortgage loans or loans for property development. At some point, there would be insufficient money. As property development takes about three years, the market has a bias toward oversupply. When household demand slows due to a declining stock of savings, the supply would continue to rise. The combination would lead to a downturn in property price.
Basically, interest rates, foreign exchange reserves, and property prices are the best indicators to suggest a turning point approaching.
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