Economy on the Edge of a Nervous Breakdown

I just returned from a trip to New York, where earlier last week I gave a talk at the Council on Foreign Relations. The topic was the question on everyone’s mind these days: the outlook for China’s economy.

Over the past several weeks, a number of news reports and market figures have caught my attention, which appear to indicate that China’s economy may be approaching a crisis. I use the word “crisis” in the traditional (or medical) sense, meaning a critical turning point when tensions or contradictions are resolved, for better or worse — sometimes in unexpected ways. One potential interpretation of this crisis is that China is entering the terminal stage of a bubble, and that what we are seeing are the early signs of a much broader collapse. But it may not be that simple. I have been saying since the year began that China is due for a correction, and just last week I told the Globe and Mail that such a correction could be a lot worse than most people expect. How exactly the situation will unfold, though, and whether we’ve already reached a tipping point or not, remains to be seen. For the moment, I’m reminded of that song: Something’s happening here; what it is ain’t exactly clear. But — and this is the real point — something is happening, and people both inside and outside of China are right to be nervous.

Let’s start with real estate. For the past several months, China’s official media have been touting official data indicating that while most Chinese cities are still seeing housing prices rise, a growing number of cities are starting to see a plateau or even decline in prices — evidence, they say, that the central government’s cooling measures are finally working. More significant, in my eyes, are reports — which began emerging in late August — that in several cities across China, prices in primary housing markets (developers selling to homeowners) have begun falling away from those in secondary markets (homeowners selling to other homeowners). The effected markets include not only 1st tier metropolises (Beijing, Shanghai, Guangzhou, and Shenzhen) , but also 2nd tier (Chongqing, Wuhan, Tianjin, Zhenghou) and 3rd tier (Ningbo, Foshan, Wuxi) ones as well. In late August, reports had secondary market prices for many downtown properties in Chongqing at 4-10% higher than primary prices. Last week, another report put the price gap in 1st tier cities like Beijing and Shanghai much higher, at 20%.

What could explain the growing price gap? Back in April 2010, when the central government first announced its intention to “cool” the real estate market, property developers were skeptical. They’d seen this movie before: the market, they figured, might stall for a while, but as soon as policymakers saw the negative impact on investment-led GDP growth, they’d rush back in to support the sector. Six months, tops, they would be right back to business as usual. In the meantime, savvy developers better get ready for the next round by continuing to borrow and build. That’s precisely what they did, which is why, despite jittery buyers and slumping transaction volumes, investment in real estate (in yuan) rose 33% and new construction (in square meters) climbed 26% in the first eight months of 2011, compared to the same period last year — data that China’s National Statistics Bureau touts, by the way, as proof that the Chinese economy is still going strong.

All of this continued building was predicated on the assumption that China’s cooling policies could not last. In fact, since developers kept building, there was no negative impact on GDP, and no reason for policymakers to pull back. To the contrary, inflation rose, and the cooling measures targeted at real estate were broadened into a more general credit tightening policy aimed at reining in lending. As developers piled up more and more inventory — the primary market inventory in Shanghai, for instance, now starts at an all-time high, 12.5% higher than in December 2008 — they had to borrow to stay in business. With credit conditions tightening, they systematically ran through the credit lines available: first the banks, then high-yield bonds in Hong Kong, then the private wealth management vehicles that have been popping up all over China, then the loan sharks. Finally, they ran out of options, and had no choice but to start selling some of their inventory at whatever price they could get.

That’s why primary prices are dropping: hard-pressed developers offering steep discounts on property they’ve been holding out on, in order to get cash. Investors who already purchased homes, often as a place to stash large amounts of cash, don’t face the same pressure and so you don’t see the same price drop in secondary markets. However, it’s important to note how small and illiquid those secondary markets are. In the U.S. and Europe, the ratio of existing homes to new homes sold (in normal, non-crisis times) is something like 13 to 1. In China, it’s more like 1:1, or 2:1 at most. The price gap may be less of a real “gap” than a “lag.”

Frustrated by their inability to cool the property market, China’s bank regulators say they are intentionally trying to squeeze developers to force a correction. The thing is, they may get more than they bargained for. Consider what might happen if a lot of developers hit the wall at the same time, and start dumping their inventories. Sizeable discounts would have to be offered, and prices in the primary market would crater. True, investors who have already bought — in many cases — multiple properties might not face the same cash pressures, but absent a liquid secondary market they have been marking their investment to primary market prices, and looking to them for assurance that their properties are a reliable “store of value.” If primary prices collapse, that assurance is gone. And if they decide to cash out, even in part, they will find — as they might have known all along, had they cared — that there is no secondary market to cash into. The result could be a panicked rush to the exits. Even if just the primary market crashes, the rationale for the supposed solvency of a whole host of Local Government Financing Vehicle (LGFV) bank loans and bonds — that local authorities can always sell land to pay them back — falls apart.

To be clear, this chain of events has not unfolded — yet. But there’s mounting evidence that it could, that the fabric of China’s investment-led growth is starting to fray and unravel. In Shanghai, primary market property sales for Sept. 1-18 were down more than 50% year-on-year (contrasted with the all-time high inventories I mentioned earlier). In Beijing, nearly 5% of the city’s property agents have shut down in the past two months. The global price of copper, 40% of which is driven by Chinese demand, including wiring for all those new homes and office buildings, is down almost 25% since the beginning of August. But more dramatic, and worrisome, is what is happening in Wenzhou.

Wenzhou is a city on the southeast coast that is well-known as the center of free-wheeling entrepreneurship in China. Plenty of those entrepreneurs operate businesses and factories in Wenzhou itself, but others scatter themselves far and wide across China, forming networks of trade and commerce. With a reputation for getting by on their wits and the skin of their teeth, Wenzhou merchants have long relied on — and sponsored — informal methods of financing. So it’s no surprise that, as formal credit conditions tightened this year, they were front and center in providing alternatives. The fact that credit tightening has fallen disproportionately on China’s private sector presented them with both opportunity and risk.

For a while, I’m sure the opportunity was highly rewarding, with informal interest charges soaring to monthly rates of 4-10%. But eventually the risk caught up. Shanghai Daily reported on Sept. 23 that, in the previous ten days, at least seven local Wenzhou business owners had fled after defaulting on millions of yuan they had borrowed from banks and private creditors, which they in turn lent or invested in real estate and other speculative ventures. Take one example:

Hu Fulin, whose Zhejiang Center Group was one of China’s biggest eyeglasses maker, is one of the runaway bosses. He said he was unable to bankroll this company’s operation any more, the newspaper said. Hu ran a company with 3,000 employees in Wenzhou and used to be one of the city’s high-profile gurus. His company owns the best-selling sunglass brand in China and produces 20 million pairs a year, according to the company’s website. Hu also expanded into the real estate and solar energy industries. Sources close to him said Hu called them on Wednesday morning, admitting he is now broke. The news of Hu’s disappearance triggered a panic among his suppliers who gathered in his factory demanding payments. National Business Daily said Hu also owed about 10 million yuan of salary to his employees for the months of August and September.

On Sept. 25, three more entrepreneurs — the owners of copper, steel, and shoe manufacturing firms — disappeared. On Sept. 27, the owner of another Wenzhou shoe company killed himself by jumping from his 22-story apartment.

The meltdown is not limited to Wenzhou. Malcolm Moore of the Telegraph relates the fascinating tale of Shiji, a small crab-fishing village which suddenly saw itself transformed, overnight, into a speculative boom town:

“It all began when a man named Shi Guobao returned to Shiji after working in Beijing,” said Zhu Yi, the head official in the village. “He became a property developer, but he wanted to make a bigger fortune so he decided to also become a loan shark.” Together with 17 of his friends, Shi began tapping the villagers for their savings, promising to pay them 10 per cent interest each month. The gang quickly raised 350million yuan, (£35.5million) which they then lent out at rates of 30 per cent or more each month to borrowers including local property developers. Shi became known as “King Claw”, the man at the head of the pyramid. For a while, the scheme worked well. Other property developers borrowed from Shi in order to begin construction and the local government, which earned income from every acre sold to the developers, also prospered. During the boom, the villagers reported fireworks being lit in celebration almost every night.

And for good reason:

“We have become a BMW town!” wrote one shocked villager on a local internet forum. “In our county, there are now 800 BMWs and 600 Mercedes, 500 Audis, 50 Porsches, 30 Jaguars, one Ferrari, one Lamborghini and one Maserati,” he added. A forest of cranes had also sprung up around the village, constructing large apartment blocks which advertised themselves with pictures of English butlers and sumptuous, chandelier–lit dining rooms.

Then suddenly, in early September, the whole thing came crashing to the ground: But there was little demand in the end for the huge apartment blocks, which today stand empty and half–finished. And when the borrowers started defaulting on King Claw’s loans, the pyramid collapsed. Around 1,700 villagers have complained to the police, some having lost their entire life savings. Two villagers were killed in a mysterious car crash after trying to reclaim their money from one of the loan sharks. As one junior official who intercepted Malcolm cautioned as he was hustling the reporter into the back of a black sedan, “It is not worth looking into too deeply.” Maybe not, but it’s certainly worth paying attention to. What’s happening in Wenzhou and Shiji is not an isolated exception. With CPI rising at 6.2-6.5%, and the regulated deposit rate at banks at 3.5%, China’s banks have recently seen a rush of withdrawals by savers seeking higher yields elsewhere. According to China Securities Journal, outstanding deposits at China’s “big four” banks fell by RMB 420 billion (US$ 65.7 billion) in the first 15 days of September. Most of that money, it reports, is being channeled straight into speculative assets, either directly or via “shadow” lending arrangements. I was asked by a reporter the other day what I thought about a Hong Kong-listed baby formula producer that was loading up on loans and relending the money to non-ferrous metals, tungsten, and highway companies. I replied: When companies neglect their core business and start speculating in “hot” sectors they know nothing about, especially with borrowed money, it’s a sure sign the market is out of whack. Sometimes it’s because companies themselves are caught up in the “irrational exuberance” of a speculative bubble. Other times, it’s because inflation, price controls, credit controls, or other factors are distorting normal incentives. In any case, it’s a big red flag that something is seriously wrong. I have a hard time believing, though, that the underlying credit quality of these “shadow” loans is substantially worse than the loans that the formal Chinese banking system has been making. The only differences, in my eyes, are that (a) the borrowers, being politically marginal, are more exposed to disruptions in credit availability and therefore more likely to encounter immediate cash flow problems, and (b) the lenders, being entrepreneurs, are less likely to have the financial resources to be able to roll over bad loans indefinitely, without running out of cash themselves. They’re less liquid, but not necessarily any less solvent, than the banks. Nevertheless, it’s starting to become clear, to private investors at least, that the actual yields being generated in China are not living up to what was promised. The high-yield debt issued in Hong Kong by Chinese developers is now trading at a steep discount. Mainland banks, despite reporting record earnings, are seeing their stocks valued in Hong Kong at price-to-book ratios that imply looming large-scale losses and recapitalization. Neither of these developments actually threatens China’s domestic financial stability, although they do close off valuable options. In recent days, however, something else has happened that potentially has far more serious implications. For the past decade, China has run surpluses on both its current and capital account. When it comes to both trade and investment, China is a net importer of foreign currency, which places pressure on its own currency to appreciate in order to resolve the imbalance. China has prevented the RMB from appreciating more rapidly than it desires by fixing a price at which it buys dollars (and other foreign currency) and stockpiles them as official reserves. Because that price has always been fixed below the market equilibrium point (the RMB has been kept undervalued), whatever limited trading band was set, the RMB tended to bump up against the upper limit. In other words, the RMB was a one-way bet, always under pressure to appreciate against the dollar. Until this week, that is, when it started to bump up against the bottom of the trading band, implying that the RMB wanted to depreciate against the dollar. Why? Presumably because the capital account had flipped, and speculators were now rushing to turn their RMB into dollars in order to take their money out of China. It’s important to clarify what this does and does not mean. It does not mean that the RMB is now suddenly going to collapse in value. China holds US$3 trillion in currency reserves, and can deploy those reserves to support any exchange rate it wishes. Even if China were tempted to devalue (at the cost, it should be noted, of fanning inflation), the mounting political pressure in the U.S. Senate to take action against China for its undervalued currency would pose an obstacle to pursuing that path. What the new downward market pressure on the RMB does indicate, however, is that China — for so long a no-brainer destination for investment — has turned into a big question mark. And it suggests that at least some domestic Chinese investors who have been inclined to sock their money into empty villas and condos — or big stockpiles of raw materials — are now looking for a way out. The easiest solution to all of this — and one that Chinese policymakers will be sorely tempted to try — would be simply to relax the “tightening” policy on money and lending. Let the money keep flowing and, for the moment at least, developers and speculators will have ready cash to pay their bills without selling off properties or jumping out windows. But China’s latest PMI (Purchasing Manager Index) numbers, released on Friday, indicate why that would be a mistake. According to Reuters, “factory inflation in China quickened markedly in September, with the sub-index for input prices climbing to a four-month high of 59.5 in September from 55.9 in August.” Despite the risk of a slowdown, all the money that has been pumped into the Chinese economy — expanding M2 by 2/3 since the start of the global financing crisis — in order to engineer an investment boom is still putting upward pressure on prices. China’s central bank knows that what might be good for speculators and developers — more money — could be disastrous for economic and social stability. Most economists saw the latest headline PMI numbers as good news, indicating that China is on the path for a “soft landing” and strong continuing growth. The HSBC index came in at 49.9 (implying a very very slight contraction) and the official figure came in at 51.2 (implying fairly resilient growth). “This implies that although the lagged effects of credit tightening will continue to cool industrial activity in the months ahead, there is little need to worry about a sharp slowdown,” said Qu Hongbin, China economist at HSBC. To me, the PMI numbers provoke two thoughts. First, I’m told that HSBC’s survey has a higher SME weighting, while the official index has a higher SOE weighting. It’s interesting to consider whether the “gap” between them reflects what I was mentioning earlier, the fact that tightening is falling disproportionately on the private sector, while SOEs are being given a freer ride. If so, it would offer a vivid example of “guo jin min tui” (the state advances, the private sector retreats). Second, the latest PMI figures suggest that, whatever cracks may be emerging — and I’ve pointed out several — China’s economy has not yet turned any corners or entered a “crisis” moment. The Chinese economy is still circling, sustained by a combination of formal and informal credit, and has not yet come in for a landing, hard or soft. The tensions and contradictions remain unresolved. But they lurk below the surface, and are more and more visible to those who look. On Thursday, Bloomberg published a poll it took of global investors, gauging their attitudes towards China’s economy: Fifty-nine percent of respondents said China’s gross domestic product, which rose 9.5 percent last quarter, will gain less than 5 percent annually by 2016. Twelve percent see such a slowdown within a year, and 47 percent said it will occur in two to five years . . . Investors labeled the Chinese economy as “deteriorating” rather than “improving” by a nearly three-to-one margin, 38 percent to 13 percent. A plurality of 47 percent called it “stable.” The placid PMI and other economic data coming out of China clearly mask some rather serious market concerns. My experience, talking to numerous investors and economists, is as follows: the closer you are to running an econometric model, the better you feel about the Chinese economy; sure, there may be bumps along the road, the models tell us, but fundamentally the momentum is so strong that growth will stay on track. The more you go out and look around, and listen to your gut, the more worried you become. Something’s happening here, what it is ain’t exactly clear … but it feels bad, very bad. The problem with models, and the reason I’m inclined to stick with my eyes and my gut, is that models work very well when prior patterns of perception and behavior remain constant, but are very poor at noticing inflection points where the way people think and act undergo a shift. In other words, they are very poor at identifying moments of crisis. One last thought I’d like to leave. Notice that, throughout the above discussion, I never once mentioned the impact of a renewed global downturn on the Chinese economy. That seems to be the focus of much media discussion these days, but from my perspective, it is only a complicating factor. China’s economy is still based on an export-led growth model, and therefore ultimately derives much of its growth from external demand. But China’s accumulation and sterilization of foreign currency reserves, over the past decade, meant that when that external demand evaporated in late 2008, it could inject previous export earnings into its economy in order to finance a purely domestic investment boom. When it did so, China — for a time at least — was able to de-couple its fate from the rest of the global economy, tracing a story arc involving high levels of growth, bad debt, and inflation that has followed its own separate logic to their resolution — not unlike how Japan’s response to the Plaza Accord propelled it along a similar “bubble” trajectory in the 1980s. External factors, like a fall-off in exports, the fate of the dollar, or the volatile attitudes of foreign investors, may either intensify the forces at work or mitigate them, may accelerate or delay the moment of truth, but the primary forces at work and the primary choices to be made rest with the Chinese and the structure of their own economy, not with factors that have been imposed on China from outside.