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By admin, January 25, 2010 6:40 pm

Investment Bubble:

Steel prices in China, the world’s biggest producer of the metal, dropped the most in four months last week as inventories piled up and concerns grew that the government may curb lending.

Inventories of steel products, including holdings by traders, producers and end users, are estimated to exceed 50 million metric tons, setting a record, said Ma Haitian, an analyst with Beijing Antaike Information Development Co. That’s compared with an estimated 18 million tons a year ago, he said.

And the Real Estate Bubble:

China’s property-market data may be masking the degree that speculation is driving prices in some of the larger cities, Ardo Hansson, the World Bank’s chief economist for China, said today in an interview. Government data this month showed Chinese real- estate prices climbed the most in 18 months in December, highlighting a struggle to rein in speculation while sustaining an economic rebound.

Meanwhile, the Bank of China is planning a capital raise after extending massive amounts of loans in the past year.

Chinese banks are under pressure to raise money after a record 9.59 trillion yuan of new loans last year weakened their capital and the industry regulator imposed tougher guidelines for financial buffers. Bank of China, the nation’s third-largest lender by market value, needs to sell almost $12 billion of new equity to keep its so-called core capital adequacy ratio at 9 percent, according to Nomura.

…Bank of China’s capital adequacy ratio fell to 11.63 percent as of Sept. 30 after advancing 1.4 trillion yuan in new loans in the first nine months, the most among China’s lenders. Its core capital adequacy ratio was 9.4 percent as of Sept. 30.

The lender aims to maintain a capital ratio of 11.5 percent during 2010 and 2012, and increase its loans by about 16 percent this year, Guotai Junan Securities Co. wrote in a note today, citing the conference call.

The Bank of China can easily raise capital now, but what happens if the bubbles start bursting? Investors wont buy into Chinese banks when NPLs start building up…

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By admin, January 20, 2010 7:50 pm

China bull Jim Rogers seems to have backtracked a bit, now acknowledging that there probably is a bubble in the Chinese property market.

“Certainly, Shanghai real estate or Hong Kong real estate should decline,” said Rogers, 67. “My goodness, if anything’s in a bubble in the world, that and U.S. government bonds are certainly very overpriced.”

At the same time, Rogers believes that the rest of the economy is OK, and that problems in the property sector will not spread to the rest of the economy (sounds like the same thing they said about the US bubble…):

Efforts to restrain lending underscore the government’s attempt to take “some of the heat out of the economy,” he said in an interview in Bloomberg’s Singapore bureau today. The rest of the Chinese economy is “hardly in a bubble,” he said.

“China now realizes that they’ve created too much money, that prices are going up too much and they’re trying to slow things down,” Rogers said.

“These things are designed to take some of the heat out of the economy. Let’s hope it works.”

Meanwhile, Goldman Sachs’ chairman for Greater China is getting worried as well:

China, Singapore and Hong Kong need to be watched for asset bubbles, especially real estate prices, Hu told a conference in Taipei, yesterday. He also warned of inflationary pressures in China and said that China and India would lead the way in economic growth.

Again, the core problem is that with weak exports, real estate investment is needed to keep China’s economy growing. So unless the world gets out of its funk and starts buying Chinese products again, authorities in China will be inclined to keep applying stimulus to this sector.

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By admin, January 20, 2010 5:45 pm

Building on the last week’s export data: while the year-over-year figures surprised the market on the upside, the seasonally adjusted monthly figures show that China’s export recovery still has a bit to go.

Based on the seasonally adjusted numbers, the gradual recovery of 2009 brought China’s exports halfway back to their previous peak. From peak to trough, China’s exports fell by 35%. By December 2009, they had recovered by 26%, but we have another 21% to climb from the December level before we match the previous peak. (In non-seasonally-adjusted terms, it was almost reached in December 2009, but the monthly effects are misleading.)

The point here is that China’s export recovery isn’t as dramatic as the market thinks: foreign demand for Chinese products is still weak, and that’s despite the yuan weakening against all non-USD currencies (as a consequence of the peg to the dollar).

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By admin, January 19, 2010 6:08 pm

After a quiet weekend, we get a batch of news from China:

China property sales jumped 75.5 percent to 4.4 trillion yuan ($644 billion) last year, led by the eastern cities of Zhejiang and Shanghai, as record new loans boosted buying.

… Zhejiang topped the increase in sales value, with a 130 percent gain, the statistics bureau said today. In Shanghai, the gain was 126 percent.
Investment in property development in 2009 rose 16.1 percent to 3.62 trillion yuan, the statistics bureau said.

Meanwhile, the Chinese central bank raised rates on the one-year bill:

China’s central bank guided its benchmark one-year bill yield to the highest level in 14 months to curb record loan growth and prevent bubbles in the nation’s property and stock markets.

The People’s Bank of China sold the bills at a rate of 1.9264 percent in open-market operations, according to data compiled by Bloomberg. The yield increased eight basis points, the same as last week, after five months during which the benchmark was left unchanged.

China’s government will manage the pace of loan growth and maintain “reasonable and sufficient” lending, the State Council said in a statement today after a meeting chaired by Premier Wen Jiabao. The central bank on Jan. 12 increased the amount of funds banks must set aside as reserves.

Although the central bank is removing some of the excess liquidity in the system, it is doubtful that the measures taken are enough. The 8 basis point increase still leaves the yield below that of one-year bills in the secondary market. As I have stated before, I believe the moves by the Chinese authorities are aimed more at reassuring investors rather than actually slowing down the economy and controlling inflation. As long as a global recovery is on shaky ground, expect the Chinese monetary and fiscal spigots to remain open.

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By admin, January 15, 2010 6:42 pm

Bloomberg reports:

Banks extended 379.8 billion yuan ($55.6 billion) of new loans, taking the annual total to an unprecedented 9.59 trillion yuan, the PBOC reported.

New lending was more than the 310 billion yuan median estimate in a Bloomberg News survey and higher than in the previous two months. M2 money supply jumped 27.7 percent in December from a year earlier, after a record 29.7 percent gain in November.

Now we know new loans picked up in December and surged in early January – meaning China is getting hit by a wall of liquidity.

Meanwhile, the Business Insider has a nice slideshow with some arguments for a real estate bubble.

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By admin, January 14, 2010 8:50 pm

One of the unique aspects of China’s miraculous growth over the past decade has been the large share of investment and conversely, the low share of consumption. Consumption accounts for about 37% of GDP in China, compared with about 70% in the United States and 55-57% in Japan, India, Germany, and South Korea. Meanwhile, gross fixed capital formation has consistently been above 30% of Chinese GDP, and has recently surged to almost 50%. Most of the commentary on Chinese growth has focused on “global imbalances” and the need for the Chinese to consume more and export less. While this is certainly an important topic, today I want to discuss another important issue: overinvestment and overcapacity.

There is nothing wrong in principle with investment constituting a large share of GDP; in order to “catch-up” to developed nations, many emerging economies have gone through investment booms. However, the length and magnitude of China’s boom creates cause for concern. Consider the charts below from Pivot Capital Management (HT: Money Supply Blog):

The trouble with such an enormous investment boom is revealed in chart 4: diminishing efficiency of investments. The Incremental Capital Output Ratio (Incremental Capital Output Ratio is the ratio of Gross Fixed Capital Formation to GDP divided by real GDP growth) measures how much investment is needed to produce GDP growth – the higher the ratio, the more inefficient the investment. As you can see, the efficiency of Chinese investment has deteriorated in the past decade and was particularly wasteful in 2009.

But why is all this inefficient investment being undertaken? If the return on such investment is so low, how does it continue to attract the necessary capital? The answer is China’s command-and-control economy – although China has somewhat liberalized its economy, the government remains heavily involved in crucial economic decisions.

As a communist country, China faces the risk of political unrest among its population. In order to ensure the government remains in power, it is therefore necessary to generate enough growth to provide employment for the growing labor force. Estimates peg 8% GDP growth as the magic number that must be maintained (this is also the growth target the government has set for 2010). In order to meet this target, the national and local governments have actively pursued policies aimed at stimulating investment:

1) Maintaining an undervalued yuan, which increases profitability of export-related investments
2) Issuing a large volume of loans through state-owned banks
3) Creating artificially low interest rates by capping deposit rates and implicitly and explicitly guaranteeing loans
4) Aid from local governments due to regional protectionism
5) Low input prices due to government subsidies

Furthermore, the fiscal stimulus package enacted in response to the global financial crisis emphasizes investment as the engine of growth. With domestic consumption and foreign demand weak, investment is the only way the government can ensure strong growth in 2009 and possibly 2010.

Now let’s turn to the consequences of the investment boom: overcapacity. A report released in late November by the European Chamber exposes the problem:

Because of the sluggish nature of the global recovery, demand for Chinese products is expected to recover only gradually. In spite of this, and the enormous spare capacity already evident, investment in these sectors continues! This is not only an issue for China but for the global economy – as the charts below show, China’s production and excess capacity in these sectors is huge relative to overall global production. China is the world’s largest producer of steel, producing more than the US, EU, Russia, and Japan combined. Meanwhile, China’s excess cement capacity is greater than the consumption of the US, Japan and India combined. The scope of the problem is immense: there is enough capacity in China to handle a recovery in foreign demand, but there is already more capacity in the pipeline!

While incoming capacity may serve Beijing’s goals of growing employment, the profitability of such ventures must be questioned. At such low utilization rates, how can we expect these factories and businesses to pay back their loans? European Chamber:

The extremely low utilisation rates in industries producing at overcapacity go hand-in-glove with resource waste. Companies are cutting corners, often disregarding environmental as well as health and safety standards and circumventing labour and social laws. Companies in overcapacity industries suffer from low profits and lack sufficient cash for R&D projects, leading to less innovation. Meanwhile, as banks bankroll the addition of unnecessary capacity in certain industries, the threat from non-performing loans (NPLs) is growing.

The threat from NPLs is serious and understated. Although the Chinese government has a small amount of explicit debt (23% of GDP), the implicit debt is much higher. Pivot:

Not included in the public debt figures are the liabilities of the local governments, which the Ministry of Finance estimated at $680bn as of the end of 2008. In addition to that, a large part of the loans extended this year (estimated at $350bn) went to finance public infrastructure projects guaranteed by local governments. Furthermore, when the Chinese government bailed out its banking system in 2003, it set up Asset Management Companies that issued bonds to the banks at par for the non-performing loans that were transferred to them. These bonds, worth about $260bn, are explicitly guaranteed by the Ministry of Finance and the Central Bank and sit on the balance sheets of the big four banks. The Chinese government also explicitly guarantees $400bn worth of debt of the three “policy banks”. In total, these off-balance sheet liabilities are equal to $1.7tn, which would bring China’s public debt to GDP ratio up to 62%, a level that is comparable to the Western European average.

Bringing it all together: In order to prevent political unrest under a communist government, China must meet certain growth targets to maintain employment. To accomplish this, both the national and local governments have provided a wide variety of subsidies to promote investment growth. These subsidies include but are not limited to: an undervalued yuan, stimulus funds, weak lending standards, strong loan growth, and implicit and explicit loan guarantees. These subsidies have over-stimulated investment, leading to projects that are wasteful and in many cases, most likely not profitable. This creates a significant downside risk in the form of non-performing loans. Should these investments not realize the rate-of-return required to pay back their loans, we may see a surge in non-performing loans. Moreover, the government of China, with large amounts of implicit debt, is in a much more fragile position than investors assume.

The reports by Pivot Capital Management and the European Chamber can be found on my Documents page.

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By admin, January 14, 2010 7:33 pm

Via Bloomberg:

China’s property prices rose at the fastest pace in 18 months in December, highlighting the government’s struggle to rein in speculation while maintaining economic growth.

Residential and commercial real-estate prices in 70 cities climbed 7.8 percent from a year earlier, the National Development and Reform Commission said on its Web site today. That topped a 5.7 percent gain in November.

But wait, you say, won’t the government act to stop the developing bubble?

…“The government is likely to issue more verbal warnings,” said David Ng, a Hong Kong-based property analyst at Royal Bank of Scotland Plc. “If they really cool the market to the extent that no-one’s buying land, then their 2010 economic growth target will be in jeopardy.”

…Policy makers will let construction “boom” at least through June because exports are weak and consumer spending is insufficient to be the main driver of growth, according to Mark Williams, a London-based economist for Capital Economics Ltd.

Meanwhile, in the World Economic Forum’s annual risk report, the organization highlighted China’s economy as one of the major risks in 2010:

China’s economy is overheating as asset bubbles and inflation pressures build, posing a “major risk” to global growth, the World Economic Forum said.
A drop in momentum in the world’s fastest-growing major economy “could adversely affect global capital and commodity markets,” the group said in a report issued before this year’s Jan. 27-31 annual meeting in Davos, Switzerland.

“The Chinese economy is in the process of overheating,” Hofmann said. “The result of the monetary stimulus was a credit expansion of 30 percent in a year alone,” and “large cities like Shanghai and Beijing saw houses price increase more than 60 percent in 2009 alone.”

As long as external demand remains weak (which could be a while), the Chinese government will keep the fiscal and monetary spigots open to promote growth, even in the face of a property bubble. The key question is: how long is this sustainable? The World Economic Forum’s risk report has mentioned China as a major risk for the past 5 years, will this year be the one?

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By admin, January 12, 2010 5:28 pm

From CNBC:

The People’s Bank of China (PBOC) raised the yield on its 20 billion yuan ($2.9 billion) in one-year bills by about 8 basis points (bps) to 1.8434 percent after holding it steady in the previous 20 auctions, compared with a median forecast among traders that it would go up by just 4 bps.

It also drained a record 200 billion yuan via 28-day bond repurchase agreements, ensuring it will draw net funds from the market this week.

The steps come after reports that bank lending surged in the first week of the year to 600 billion yuan, adding to concerns fuelled by blockbuster trade data for December that the world’s third-largest economy is overheating.

…However, long-term bond yields were mostly steady since traders still doubt the central bank will raise benchmark lending and deposit rates by more than 54 bps this year, as is already priced into that part of the yield curve.

It’s good that the Central Bank is taking some liquidity out of the system, but I find it hard to believe that the government will tighten substantially and risk hurting growth. Furthermore, 54 bps of tightening this year is not going to be enough to prevent the economy from overheating.

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By admin, January 12, 2010 5:25 pm

The Washington Post on the real estate bubble in China (HT: Marginal Revolution):

For investors, many of the usual bubble warning signs are flashing. Fueled by low interest rates, prices in Shanghai and Beijing doubled in less than four years, then doubled again. Most Chinese home buyers expect that today’s high prices will climb even higher tomorrow, so they are stretching to pay prices at the edge of their means or beyond. Brokers say it is common for buyers to falsely inflate income statements for bank loans.

… For many people — especially the young or people moving to the cities from rural areas — the dream of owning a home is more and more difficult to attain. The Xinhua news agency quoted Goldman Sachs as saying that housing price increases had outpaced wage hikes by 30 percent in Shanghai and 80 percent in Beijing in recent years.

The article makes a few reasonable arguments why the price increases aren’t a bubble, mainly that the mortgages being taken out are a much smaller fraction (about 40% from 2002 to 2008) of the price of the house than say, in the United States. While that may have been true from 2002 to 2008, one has to wonder whether the use of leverage has increased. Moreover, when it becomes “common for buyers to falsely inflate income statements”, it gets a bit hard to deny the existence of irrational exuberance.

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By admin, January 11, 2010 9:31 pm

An economic trifecta today that gives us a good look at whats going on in China: State researchers warned the government that China GDP may grow up to 16% with risk of accelerating inflation and a property bubble unless the authorities reduce stimulus measures.

“If the government continues with the same strength of macro-economic stimulus as in 2009, there will be notable economic overheating in 2010,” Yao Zhizhong and He Fan, economists with the Chinese Academy of Social Sciences, said in an article published in the official China Securities Journal.

Also, exports came in strong for the month of December, reflecting stronger foreign demand. Imports were at a record high, narrowing the trade surplus.

China’s exports grew 17.7 percent last month from a year earlier, the first increase in more than a year, and imports rose to a record, customs data showed yesterday. Gains were boosted by a low base for comparison in 2008.
“The export rebound will add significant momentum to China’s growth, contributing about 7.5 percentage points to growth in gross domestic product,” Yao and He said.

But, the biggest news of the day was the surge in Chinese bank lending:

New loans amounted to about 600 billion yuan ($88 billion) in the first week of January, nearly twice as much as the monthly average in the second half of 2009, banking sources said, confirming a media report earlier.
…
In 2010, active fiscal policies will continue, and this means we cannot weaken the intensity of fiscal support for economic development, avoiding the losses to our achievements that would come from an excessively early exit”, Finance Minister Xie was quoted as saying by the official Xinhua news agency.
…
The government should be relatively tolerant in its response to the current credit surge to avoid the situation of ‘the more the fear of tightening, the stronger the lending’,” said Ba, who is also chief economist for the China Banking Association.

So lets recap: Foreign demand is snapping back, driving up exports which should contribute 7.5 points to GDP (keep in mind, the government is targeting 8% growth in 2010). Meanwhile the government holds the yuan fixed against the dollar (weakening its currency against everyone else as the dollar tumbles) and keeps applying fiscal stimulus. On top of that, lending continues to surge as people snap up stores of value (gold, copper, real estate, equities). Sound like the right conditions for an asset bubble?