Braking China …Without Breakingthe WorldBlackRock Investment InstituteApril 2012
[ 2 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d What Is Inside Joel Kim Head of BlackRock Asia-Pacific First Words and Summary 3 Fixed Income China Inc: Bull, Bear and Bottom Line 4 Introduction: Why China Matters 6 – A Matter of Timing Credit: Too Much, Too Quickly 8 Mark McCombe – The Great Credit Leap Forward Chairman, BlackRock Asia-Pacific – Bad Debt? Just Roll It Over – No Banker Will Come Clean This Year – A Less Offensive Four-Letter Word Neeraj Seth Real Estate: Can a Bubble Be Deflated? 13 Head of Asian Credit, BlackRock – Something’s Got to Give Fundamental Fixed Income Group – A Men’s Shirtmaker Diversifies – A Quiet New Year for Realtors – Breaking a Vicious Circle Jeff Shen, PhD Head of Asia-Pacific and Emerging Investment and Consumption: Market Equity, BlackRock Scientific Looking for Balance 17 Active Equity Group – A Case of Diminishing Returns – Go Buy a Refrigerator! – A Blueprint for Rebalancing Success Ewen Cameron Watt – Bankers Are Shooting Fish in a Barrel Chief Investment Strategist, – Wanted: Carefree Spenders BlackRock Investment Institute – In Search of Luxury Goods Politics: Change Is Hard 23 BlackRock’s China Forum – The Emperor Is Far Away About 50 leading BlackRock portfolio managers and external – Vested Interests and Paralysis experts from around the globe recently exchanged views on China’s – 300 Million Publishers economic trajectory at the BlackRock Investment Institute’s China Forum. Many went in bullish and came out still bullish— – From Small Piles of Rocks to Oil Shock but with much less complacency and certainty. This publication – Tit for Tat in Trade Wars summarizes their ideas. Competiveness: Beyond Cheap Labor 27 The BlackRock Investment Institute leverages the firm’s – Of Robots and Old People expertise across asset classes, client groups and regions. Markets: Counting on China 29 The Institute’s goal is to produce information that makes – Equities and Corporate Bonds: BlackRock’s portfolio managers better investors and helps A Growing Addiction deliver positive investment results for clients. – Commodities: An Outsized Influence Lee Kempler Executive Director – overnment Bonds: A Big Overhang G Ewen Cameron Watt Chief Investment Strategist Jack Reerink Executive EditorThe opinions expressed are as of April 2012, and may change as subsequent conditions vary.
Blackrock investment institute First Words and SummaryChina is at a crossroads. Investment-driven growth has spun manufacturers. Domestic savers financed China Inc.’s masteran economic success story without equal since the country plan by accepting savings rates below inflation, wage increasesopened for business in 1978. This has come at a cost: Unbridled that lagged economic growth and a minimal social safety net.credit growth, overbuilding, environmental damage and a widening This is changing, but powerful interests are stacked againstdivide between the haves and have-nots. a true shift to a consumption economy: exporters, state enterprises and local governments.It has become clear China’s old playbook of “invest and grow” nolonger works so well. But a shift to a consumption-driven society } hina’s new leadership could take the tough measures needed to Cis tough for a command economy and wrought with pitfalls. The engineer a shift—liberalizing interest rates, opening capitalcountry’s upcoming once-a-decade leadership change brings markets, market pricing of resources, and building out socialboth opportunity and uncertainty. The downfall of “princeling” services. But Beijing is not almighty; local governments tendBo Xilai, the former charis-matic leader of Chongqing, shows to go their own way and a desire for consensus has often resultedtumult below the surface. This changing of the guard will in political paralysis. Risks of a popular revolt or foreign conflictsreverberate well beyond its own population, as China has are low as the one-party state has kept a tight lid on dissentbecome the globe’s growth engine. and is focused on fulfilling its domestic social contract.We are optimistic on China’s economic trajectory in the short term. } eal wage growth, rising materials costs and environmental RA nagging worry: Markets already factor in a “soft landing” this restrictions are changing the workshop of the world—for theyear, leaving potential downside risk. The leaders walk a tightrope, better. Some labor-intensive industries are moving elsewhereand have lowered the official growth target to 7.5% for 2012. We and automation is increasing. There is room for more productivityare concerned about China’s ability to keep up its economic march growth even as the easy gains have been harvested. Protectionin the long run. Challenges are big and solutions are not easy. of intellectual property is still weak and global brands have yet to emerge, but we believe chances are China will remainThis publication discusses key factors driving China’s economy competitive and confound the doomsayers.this year and beyond, signposts for change and implications forinvestors. Examining the financial system, the deflating realestate bubble, the tricky shift to a consumption economy, So What Do I Do With My Money?TMpolitics and competitiveness, our main findings are: } lobal consumer companies and high-end machinery G} n explosion in credit growth resulting from Beijing’s 2009 A makers are likely to be good long-term bets. stimulus has made the financial sector the economy’s Achilles } nergy, precious metals and agricultural commodities E heel and its biggest long-term threat. The country can pave prices should be underpinned by the country’s insatiable over problems this year, but the bills will come due. China will demand, and boost companies in those areas. have to charge borrowers real money and give savers a real } ost Chinese companies are likely to report poor M return to create a healthy financial system in the long run. earnings this year, but valuations look cheap.} he real estate slump is the biggest threat to economic growth T } hina’s demand for basic materials such as cement C and confidence this year. The sector is interwoven with the and steel should peak soon, hitting key suppliers and entire economy and has been a key growth driver. A government- resource currencies in those markets. engineered slowdown has brought down prices to more affordable levels, but also has created ghost cities. Urbanization } hina’s buying of US Treasuries may slow over time, C and growing incomes should balance supply and demand but a fire sale does not look to be in the cards. eventually. The question now is: Can Beijing break a vicious More investment implications on pages 29 to 31. circle of falling prices and sales (when it is ready to do so)?} hina’s economic miracle was built on an undervalued currency, C lots of investment, and subsidized energy and credit forThe opinions expressed are as of April 2012, and may change as subsequent conditions vary.
[ 4 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dChina Inc: Bull, Bear and Bottom Line Factor Bull Case Bear Case A Sickly Financial System It is easy to pave over financial problems in the Banks’ non-performing loans have fallen by 97% short term, Beijing has plenty of firepower for in the past decade, but this masks a poisonous bailouts. Growth in local government debt has reality: Unpaid loans are rolled over. Debts of come to a screeching halt. China has proved state enterprises and, to a lesser extent, of local many times it can fix its banks when needed. The governments appear to be ticking time bombs. same team that engineered a doubling of annual Banks are bleeding deposits and luring customers credit to 14 trillion RMB during the financial crisis with asset-backed securities. (Hmmm, what kind can pull the strings in a different direction. of assets?) Banks are lending to all the wrong people: lumbering state giants and developers. Banks are bad at risk management. A Deflating Urbanization and the desire for upgrades provide Local governments, banks and companies all bet Real Estate Bubble steady demand. Affordability is improving due to prices would keep rising and are overexposed. falling prices and rapid real wage growth. Buyers Real estate has been the driver of economic pay a majority of the purchase in cash, so price growth. Homes are too expensive for average declines will not hurt the financial system. Savers earners. Overbuilding has resulted in ghost have few other places to park their cash. A cities and a huge inventory of unsold properties. push on low-end “social” housing will keep Beijing may not be able to arrest a vicious the construction industry busy. cycle of lower prices and lower sales. Too Much Investment and Is there such a thing as too much investment? Investment is a case of diminishing returns: It Too Little Consumption Capital stock is not yet excessive by international takes $5 to generate $1 of GDP growth. The model standards, and China needs investments in is based on an undervalued currency, low real infrastructure and automation to keep up wage growth and financial repression—factors productivity growth. Consumption is rising that policymakers are loath or unable to change. rapidly, and half of households will soon classify China’s command economy appears ill-equipped as “middle income.” Rural wages are growing faster to stimulate consumption. Much industry would than urban ones, making for more balanced collapse without below-cost energy and interest development. Building out a social safety net rates. “Vested interests” will work hard to torpedo would unleash a pile of precautionary savings a shift to a consumption model. Commodities for illness and old age. demand is at risk. Watch out, Australia. Political Risk The Communist Party arguably is built for stability: All politics are local. It is an uphill battle to It knows internal strife can result in Cultural effectively steer the country toward a new course. Revolution-type horrors. Regimes historically China has not done enough to improve the have faced popular revolts only when incomes environment, curb corruption, address the widening reach the world’s median: China has a long way inequality gap and stimulate consumption. to go there. Beijing has kept a tight lid on internal The leadership often is paralyzed because it is dissent and has not had a major overseas pulled in too many directions. China’s military confrontation in the last 30 years. build-up could set up the world for a major confrontation down the road. Competitiveness China’s value-added exports are increasing and Heavy subsidies have thwarted competitiveness industries are investing in automation to stay and innovation. Violations of intellectual property competitive and improve quality. China is filing rights still occur. The easy productivity gains more patents and is now dominating industries have been harvested, and wage growth is a of the future such as solar power. The country problem. China has yet to develop real brands. has a first-class infrastructure. The migration of labor-intensive industries to Vietnam, Cambodia and elsewhere is a good thing.
Blackrock investment institute Bottom Line Signposts (What to Look for)We expect a soft landing in 2012. Longer term, } Reserve ratio changesthe financial system represents the biggest risk } Deposit outflows and sales of wealth management productsto the economy, we believe. The sheer magnitude } Bank cash flows and operating cash levelsand pace of credit growth does not pass our } Credit growth and non-performing loan trendssmell test. } Corporate bond issuance and trading } Gradual moves toward market-driven deposit and lending rates } Demand for gold and other “hard” assetsBull BearReal estate is the No. 1 threat to China’s growth } Inventories, sales volumes and price trendsthis year because the sector is so interwoven with } Ratio of new construction vs. sold floor spacethe rest of the economy. Supply and demand } Debt and stock prices of major developers and consolidation in the sectorshould balance out in the long run. The lack of } olicy actions such as property taxes or, conversely, more curbs Pleverage is a big positive. } Sales of construction machinery and durable household goods } Sales and volumes in secondary and tertiary cities } Granting migrant workers urban residency permits so they can own homesBull BearA pullback in consumption in the wake of falling } Monthly retail, auto and luxury salesreal estate prices and slowing export growth is } Consumption share of GDP and GDP growth, and real wage growtha major risk this year. Longer term, a big worry } Raw materials imports, energy subsidies and commodities pricesis that a rush to rebalance could lead to an } Import/export trends (beyond one-month aberrations such as this February)economic implosion. } Loosening the currency peg and opening capital markets } Privatizing state enterprises and liberalizing interest rates } New sources of local government financing } Macau gambling revenues and capital flowsBull BearA one-party system is geared to retain its } Political unrest beyond local flare-upshegemony and ensure stability. The upcoming } Food price inflation, unemployment and rising inequalityonce-a-decade leadership change is hairy. Bo } Efforts to curb corruption, protect the environment and ensure food safetyXilai’s downfall is the tip of the iceberg, and one } High-profile casualties of the upcoming leadership change such as Bo Xilaithat is freezing policy for now. } Restrictions on social networks such as Weibo } Confrontations in the East China Sea with other Asian countries or the US } Increased secessionist and religious militancyBull BearLoss of competitiveness is the lowest risk to the } Productivity and real wage growtheconomy this year and beyond. China already is } High-end machinery ordersmoving up the value chain. } RD spending and patent applications } Trends in returns of Chinese who have studied abroad } Emergence of domestic and global Chinese brands } Protectionist actions by China’s trade partnersBull Bear
[ 6 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dIntroduction: Why China MattersChina matters—a lot. The country has rapidly become the second- The big questions are how the current government will navigatelargest economy in the world. It will likely contribute two-fifths the domestic real estate slump and the global economic slowdown,to global growth this year, twice as much as the United States. and whether the future leaders will be able to solve a tickingSee the chart below. Resource-hungry China has an outsized bad debt time bomb and deliver on promises to rebalance theinfluence on most commodities markets, and is the largest economy toward consumption and sustainable growth.foreign holder of US Treasuries. Add in challenges of maintaining a “harmonious society” in aGDP per capita jumped more than 20-fold to $4,400 in the 30-year place with rapidly growing expectations, corruption, a long historyperiod ended 2010. Ports, bridges, airports, expressways and of regionalism and world-beating income inequality, and you haveentire cities have been built in record time. China is now the largest a troublesome brew. This is before you even consider artificialmarket in the world for cars, computers, mobile phones—the pricing of money and a financial system that subsidizes borrowerslist is endless. Wine sales have more than tripled in just five years. at the expense of lenders. Or ponder environmental despoilment, deteriorating demographics, water shortages and a growing addiction to imported energy. It is a wonder the place works A Heavy Burden so well—or at all. There is enough fodder for a fierce debate China’s Share of Expected 2012 Global Economic Growth between panda haters and panda huggers. Now read on… China 40% Rest of Asia 24% A Matter of Timing Other Emerging Markets 17% Real reforms to rebalance China’s economy are on hold this US 17% Other Developed Markets 2% year because of the once-a-decade leadership change. An imminent collapse is unlikely, we think. The current leadership will not go out with a bang, but certainly does not want a train wreck during the final stages of stewardship. Business cycles exist in China as elsewhere —but we expect aSource: Deutsche Bank (January 2012).Note: Assumes global economic growth of 3.2% in 2012. soft landing in 2012. Flattening Out Sales of Heavy Machinery and Autos 100 250% 2,000 150% 200 120 80 UNITS (THOUSANDS) UNITS (THOUSANDS) 1,500 Y-O-Y GROWTH (%) Y-O-Y GROWTH (%) 150 90 60 100 60 1,000 40 50 30 0 500 0 20 -50 -30 0 -100 0 -60 2008 2009 2010 2011 2012 2002 2004 2006 2008 2010 2012 Monthly Machinery Sales YoY % Monthly Auto Sales YoY %Sources: Bank of America Merrill Lynch, China Construction Machinery Institute and China Association of Automobile Manufacturers.Notes: Machinery sales data through January 2012. Auto sales data through February 2012.
Blackrock investment institute In this interim period, it is important to read the economic tea Like some corporate chieftains, China likes to manageleaves. Real estate prices, sales and construction are important expectations by under-promising and over-delivering.ones. Politically sensitive food inflation is another one, as aremanufacturing gauges such as the various purchasing manager Premier Wen Jiabao set a 7.5% annual growth target for 2012indexes (PMIs). in March—the lowest rate in almost a decade. Most China watchers, however, believe the country will want to achieve atAt the start of 2012, the data were both conflicting and skewed least 8.5% a year. Official targets exist to be beaten. Like someby the effects of the early lunar New Year holiday. Real estate and corporate chieftains, China likes to manage expectations bykey consumption indicators pointed down, while other gauges under-promising and over-delivering.pointed up. It is realistic to expect China to move toward economic growthFor example, sales of heavy machinery used in construction, of 6%-7% a year this decade versus the 10%-plus clip in the oldsuch as excavators, crashed. Auto sales flattened, pointing to days, we believe. Five reasons:a general slowing in the wider economy. See the charts on the } he political leadership appears to understand the Tprevious page. drawbacks of too much credit.By contrast, transport volumes are strong. And a gauge of small } low growth in the debt-ridden developed world likely means Sbusiness activity has been ticking up. See the chart below. This slack demand for exports.is important because small businesses employ 60% of China’sworkers and make up 90% of companies. } he real estate boom has ended because tightening T measures have taken hold.The rebound could indicate the government’s easing policy } nfrastructure spending is slowing as policy shifts from Ion liquidity has started to work. Bank credit enabled large favoring bridges for the masses to pills for the people.companies to pay their supplier bills. Secondly, it could meanthe bottom has not fallen out of exports because many small } avings rates—the fuel of deposit and loan growth—are Scompanies are exporters. likely to remain flat or drop from mind-blowingly high levels. Beijing is expected to arrest this year’s slowdown in growth A Ray of Light with all sorts of administrative and fiscal measures, while at the China’s Small Business PMI, 2011-2012 same time trying to keep a lid on inflation and prevent more bad debts that eventually could overwhelm the banking system. 60 58 Most people, perhaps too many, believe Beijing will walk this 56 tightrope. At US investor gatherings in late February, one Wall SMALL BUSINESS PMI 54 Street firm’s China strategist polled the audiences and found 52 just one bear among roughly 1,000 people. This lonely creature 50 contrasted with a host of cubs the previous year. 48 46 Beyond 2012, the picture becomes very different. It is now clear 44 China’s 2009 stimulus was too much, in too short a time. Beijing 42 overestimated the US recession’s fallout. The result is a pile of 40 debt—which looks ready to fall over in the next few years (or Jan ’11 Mar ’11 May ’11 Jul ’11 Sep ’11 Nov ’11 Feb’ 12 stay shaky forever).Source: China Federation of Logistics and Procurement.Note: Data through February 2012. Most people, perhaps too many, believe Beijing will walk this tightrope.
[ 8 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dCredit: Too Much, Too QuicklyFor a poster child of “financial repression,” pick any of China’s What changed in 2004? China had started to rack up huge accountone-billion-plus consumers. They have been bankrolling the surpluses because of bumper exports and an underappreciatedcountry’s infrastructure boom and manufacturing machine— RMB currency. The surplus hit an unprecedented 10% of GDP atand have lost money in real terms in the process. (A cynic would its peak in 2007. The central bank started to offset, or sterilize,say the West now is importing this made-in-China concept.) the flood of foreign currency by selling bills at very low rates.Consumers who park their savings at banks have received For bankers, these were “bills you can’t refuse.”negative returns after factoring in inflation, an average loss To keep the banks profitable, authorities set deposit rates low.of 0.54% a year since 2004. See the chart below. Low deposit rates and high reserve ratios also would put a brake on inflows of “hot money” speculating on appreciation of the Don’t Take It to the Bank! RMB. The result: an effective tax on consumers who kept their Real Return on Household One-Year Deposits, 1997-2011 savings at banks. 8% Financial repression worked well because consumption took 7 a back seat in China’s investment-driven master plan. More on 6 China’s hard-pressed consumer and unprecedented investment REAL INTEREST RATE (%) 5 Average Interest 4 Rate = 3.04% boom later. In this chapter, we review the credit boom these 3 2 savings helped create. 1 0 -1 The Great Credit Leap Forward -2 Average Interest Rate = -0.54% Armed with a reliable supply of cheap deposits, banks went on -3 -4 a lending binge. The biggest beneficiaries were state-owned -5 enterprises (SOEs) and local governments. ’97 ’99 ’01 ’03 ’05 ’07 ’09 ’11 The first group revved up exports and capital expenditures evenSource: Peterson Institute for International Economics. more, supported by cheap credit and subsidized energy costs.Note: Data through December 2011. It was a lifeline to many enterprises that had no business staying in business. Debts Have a Way of Piling Up—Even in China Credit Growth in Billions of RMB and as a Percentage of GDP, 1993-2011 15,000 50% CREDIT GROWTH (RMB BILLIONS) CREDIT GROWTH TO GDP (%) 12,000 40 9,000 30 6,000 20 % GDP 3,000 10 0 0 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 New RMB Loans New Foreign Currency Loans New Entrusted Loans New Trust Loans New Bank Acceptances Corporate Bonds New Stock Issued by Non-Financial Enterprises Insurance Claims Paid Insurance Company Real Estate OtherSources: Carl Walter, Su Ning, China Bank Statistics and People’s Bank of China.
Blackrock investment institute The second group financed infrastructure works, office towers, It is unlikely China will let the market collapse.conference centers and an array of faux landmarks, from Nobody wants to see a local government defaultChengdu’s Dorchester-inspired British town to Venetian canals or a big state firm go belly up.and a replica of St Mark’s bell tower at the New South China Mall in A bank CEO in a coastal city may say his operation is lending 100%Dongguan. This helped inflate an emerging real estate bubble. of deposits, no problem. He gets away with it because his bankCredit grew and grew ... until a great leap forward in 2009. Worried is part of a national network that (still) has enough deposits in thethe world financial crisis and subsequent US recession would interior to make up for shortfalls on the coast. The governmenthit China hard, Beijing engineered a huge monetary stimulus. may abolish this cap because it has many other ways to controlCredit doubled to a clip of at least 14 trillion RMB a year. See loan growth, notably its stranglehold on interbank market.the chart on previous page. Everything appears just hunky-dory for China’s banks: Non-Credit grew at an compounded annual growth rate of 36% in the performing loans (NPLs) fell by 97% over the past decade andperiod 2004 to 2010. As a result, the total value of bank loans now average just 1% of the loan book. See the chart below.and bonds quickly exceeded GDP. See the chart below. A Likely Sad Ending Too Good to Be True Outstanding Loans and Bonds, 1996-2010 Non-Performing Loan Ratios of Major Banks, 1998-2011 60,000 140% 35% LOANS AND BONDS (RMB BILLIONS) LOANS AND BONDS TO GDP (%) 50,000 120 30 NON-PERFORMING LOANS (%) 100 40,000 25 80 30,000 20 60 20,000 15 40 10,000 20 10 0 0 5 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 0 Bank Loans Bonds ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 Loans/GDP Loans and Bonds/GDP Sources: UBS, People’s Bank of China, China Banking Regulatory Commission and CEIC.Sources: Carl Walter, People’s Bank of China and Wind Information. Note: Data before 2002 only cover the Big-4 state-owned banks.This is where the problem lies: Take a machine that runs along This is dangerous, especially because both local authoritiesat a steady pace, suddenly inject adrenaline and order: “Go and SOEs are already deep in debt. It is unlikely China will let thelend.” The sheer magnitude and pace of this unbridled credit market collapse, though: Nobody wants to see a local governmentgrowth does not pass our smell test. It suggests to experienced default or a big state firm go belly up. There is nothing subtleinvestors there has to be trouble somewhere, sometime. about the government guarantees of these entities.Bad Debt? Just Roll It Over High-profile bankruptcies just do not fit into China Inc.’s masterChina has plenty of rules to keep credit growth in check. But plan of economic growth and employment. And banks are very muchthey are loosely enforced. For example, Chinese banks are part of the plan. Banks are, after all, an extension of the fiscalsupposed to lend up to 75% of deposits. But banks need to show policy. This is also the reason they trade at such low valuations.a 75% loan-to-deposit ratio only at the month’s end—givingthem about 30 days each month when they can lend more. Take a machine that runs along at a steady pace, suddenly inject adrenaline and order: “Go lend.”
[ 10 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dNo Banker Will Come Clean This Year have deteriorated across the industry in the past three years, with many second-tier banks already facing shortfalls, accordingThe practice of rolling over loans works—as long as banks have to ratings agency Fitch Ratings.enough deposits to play with. It is like a bath filling up fasterthan it empties out. Do not expect any banks to come clean this year. Bank chieftains angling for government positions in the leadership change willBut companies and consumers—faced with cash flow needs want their records to remain squeaky clean.and fed up with negative real returns—are starting to vote withtheir feet and are pulling deposits. Banks, especially in coastal Put yourself in the position of a bank CEO. You have been presidingareas, are trying to fight these outflows by offering asset-backed over five years—20 quarters—of profit increases. Now you aresecurities that carry higher interest rates. About 10% of deposits gunning for that position in the State Council. Are you going tohas flowed into these “wealth management” products. See the bring down your profits this year by increasing provisions? Justchart below. to be prudent? Chances are you will not. You leave it for the next guy to deal with. Looks Familiar? To be sure, there are plenty of deposits. They are just not for Investment in Asset-Backed Securities Quadrupled, 2007-2011 lending. One example: To recycle the inflows of foreign exchange and prevent the RMB from appreciating, the central bank obliges 8,000 ASSET-BACKED SECURITIES (RMB MILLIONS) banks to hold vast quantities of reserve bonds yielding only 1.5%. 7,000 This deflates the money multiplier and kicks sand into the engine 6,000 of a credit-led economy. 5,000 Bank chieftains angling for government positions 4,000 in the leadership change will want their records to remain squeaky clean. 3,000 2,000 In all, the Triple R (Required Reserve Ratio) and other measures 1,000 tie up some 10 trillion RMB of deposits. This has given the central bank the means to provide stimulus when the economy needs 0 it. Every cut in the Triple R pumps some 380 billion RMB into the 2007 2008 2009 2010 2011 system (provided the cuts are not offset by capital outflows). Index-Linked Asset-Backed Other Asset-Backed Bills Asset-Backed Loans This doesn’t mean SOEs and other politically connected players have a tough time getting credit. Not at all. They are issuing bondsSources: Carl Walter, Wind Information and Fitch Ratings. like there is no tomorrow—forced down banks’ throats at slightlyNote: Data through June 30, 2011. higher rates than one-year deposit rates. The result is a huge debt capital market where very few trades take place. Why? If a bankDeposits from corporations under cash flow pressure (and with the sells these bonds, it is almost guaranteed to take a loss becauseability to export capital by padding overseas invoices) dwindled to nobody wants them at the price the bank paid for them. Bottomnear zero in the first nine months of 2011, compared with growth of line: The corporate bond market is bank lending in disguise.3.7 trillion RMB in 2010. In the third quarter alone, corporatedeposits of an estimated 1 trillion RMB vanished into thin air. The bulls believe China has proved again and again it can fixCombined with the strangle of rising reserve ratios, growth in these problems. The basic argument goes like this: Chinese banksthe M1 money supply has dwindled to a clip of 3%-4%. go bust every decade, but the country has just found a much better way to deal with it than the West. Conclusion: AnyMoreover, deposit outflows have triggered a slow-motion cash weakness in the financial system will be dealt with quietly.crunch. Smaller banks in particular are vulnerable, partly becausetheir loans are coming due earlier. Operating cash reserves Deposit outflows have triggered a slow-motion cash crunch.
Blackrock investment institute [ 11 ] Acronym to Watch: LGFV Structure and Mechanics of Local Government Financing Vehicles (LGFVs) How LGFVs Come To Be Typical LGFV Structure Central Government Local Government Equity/Loan Ownership of Local Enterprises, 23 Provinces Injection Land and Tax Subsidies 5 Autonomous Regions 4 Municipalities (Beijing, Shanghai, Chongqing, Tianjin) Repayment 2 Special LGFV Bank Administrative Regions Cash Loan Incorporated 6,500-8,200 LGFVs Profit Cash Investments 333 Prefectures 2,858 Counties Activities (Infrastructure, Utilities, Transportation, Land Development) 40,858 TownshipsSources: Deutsche Bank and China Statistical Yearbook 2010.A Less Offensive Four-Letter Word time bomb, especially at a time a main source of local government revenues—land sales—has dried up amidLocal governments cannot borrow unless they have specific falling real estate prices.approval from the State Council, the country’s highest executiveadministrative body chaired by the premier. This doesn’t happen Where there is a will, there is a way—especiallyvery often. It is not meant to happen often. Think of it as a in China.company requiring CEO sign-off for all travel and entertainment.TE costs will go down very quickly. Others are optimistic. LGFV net debt barely increased in 2011 because regulators discouraged banks from making new loans,Where there is a will, there is a way, though—especially in according to research firm CLSA. This compared with a 19% riseChina. Local authorities have set up special entities to pay for in LGFV net debt in 2010 and a 62% stimulus-fueled jump in 2009.infrastructure and other projects. This is perfectly legal. The CLSA says. Local governments can pocket an increasingly smallerchart above shows the mechanics of these so-called local share of land sales because of higher spending on compensationgovernment financing vehicles (LGFVs). and relocation. As a result, local revenues from land fees The bulls believe China has proved again and again equaled just 9% of total national spending on infrastructure it can fix these problems. in 2011, CLSA notes. In any case, all local debt is an explicit liability of the centralLGFVs have taken out trillions of RMB in loans backed by land government—which saw a 30% jump in tax revenues in 2011.sales. China bears have long argued this represents a ticking Beijing can pay a lot of bills.
[ 12 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d Get Out of Debt Tomorrow Over the Refinancing Hump A Possible Solution for Bad LGFV Debts Maturities of Local Government Debt 3,000 3,500 35% 30.2% 2,550 600 2,500 3,000 30 600 24.5% RMB BILLIONS 2,000 TOTAL DEBT (RMB BILLIONS) 2,500 25 600 1,500 PERCENT DUE (%) 2,000 17.2% 20 260 1,000 120 245 1,500 15 125 0 11.4% 9.3% Local Govt. Revenues Asset Sales Recoveries on Projects Potential NPLs Local Govt. Bond Central Govt. Support Over-Provision for NPLs Write-Offs 1,000 7.5% 10 500 5 0 0 2011 2012 2013 2014 2015 2016 and BeyondSource: Deutsche Bank estimates.Notes: Assumes 30% of LGFV loans default. Assumes local governments sell 10% of assets Sources: Deutsche Bank and National Audit Office.and divert 2% of revenue. Note: Data as of year-end 2010.Even if 30% of all LGFV loans default, the problem is manageable, In addition, most LGFV debt is spread out after scaling a renewalaccording to Deutsche Bank. Local government bond issues, hump last year, with almost a third due only after 2016. Seeasset sales and diverting 2% of government revenues would the chart above.solve most of the problem in its view. See the chart above.
Blackrock investment institute [ 13 ]Real Estate: Can a Bubble Be Deflated? The City Beckons Urbanization and Migration 22 Cities 5 Million = 180 Million 71 Cities 2-5 Million = 216 Million 552 962 1,307 1,427 121 Cities 1-2 Million = 175 Million mln mln mln mln 100% 214 Cities = 571 Million Harbin 467 Shenyang 80 mln Beijing 745 SHARE OF POPULATION (%) mln Tianjian 60 790 490 mln Xi’an mln Nanjing 40 Shanghai 960 mln Chengdu Wuhan Hangzhou 562 20 mln Chongqing 172 62 mln Guangzhou 0 mln 1950 1978 2005 2025 Rural UrbanSources: ISI Group, CEIC and National Bureau of Statistics.Note: Numbers in millions of people.Rapid urbanization drove China’s housing boom for much of the Something’s Got to Give2000s—and is likely to do so in the future. China is expected to Some 40%-45% of all residential properties sold in early 2009have almost one billion urbanites by 2025. It already has 214 were for investment purposes, according to think tank Petersonmetropolitan areas with more than one million people, four Institute. Other speculative bubbles built in jade, art and goldtimes as many as the United States. See the chart above. prices, but there was nothing like real estate. Beijing inadvertentlyMany Chinese already owned their homes, but often these were made it the preferred asset class, egged on by powerfulshacks or rural dwellings. There was definitely a need to upgrade, interests that cashed in on this state-sponsored freebie.and many households did just that. Other speculative bubbles built in jade, art and goldThen savers desperate for yield and “hard assets” started to prices, but there was nothing like real estate.snap up apartments. Where else could they go? Banks offerednegative real interest rates. The stock market was perceived asa big high-roller table at best. And offshore markets were—andare—pretty much shut.
[ 14 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dLocal governments did their part to support the boom by providing The risk to housing in China is not so much itsinfrastructure and sponsoring grandiose projects. They bought imminent collapse, but how ubiquitous otherfarmland at artificially low prices and sold it for a profit to segments of the economy are exposed to it.developers. Over time, local governments became addicted to Sales volumes and prices fell after government measures tothese land sales as a source of revenues. And the practice to dampen speculation and prevent prices from spiraling beyondappropriate land became the root cause of periodic local the reach of the emerging middle class. There are some tentativeoutbreaks of social unrest. signs of bottoming (see the charts below), especially in second-Real estate has been a great wealth creator, for companies, local and third-tier cities where people buying homes for themselvesgovernments and individuals alike. The top source of wealth are a more important source of demand than investors.among China’s richest 1,000 people is real estate, according to thelatest ranking by Hurun Report Magazine (which was appropriately A Men’s Shirtmaker Diversifiessponsored by the Hainan Clearwater Bay luxury development). The real estate market is the biggest risk to China’s economicNo wonder those feasting want the banquet to continue. growth this year. The tipping point will likely come in the second quarter, when downside risks to the entire economy will start to Sales volumes and prices fell after government measures to dampen speculation and prevent outweigh inflation and affordability considerations. Or will they? prices from spiraling upward. Our assumption is Beijing wants to take real estate prices down 25%-30% from their highs. With a 10% fall already, there is a painfulBubbles involving real estate are quite common. This seemed to additional 15%-20% to go. This is dangerous. The biggest riskhave all the signs, including the endemic involvement of local is stagflation—when activity drops off a cliff while prices stay high.governments and the corporate sector. It is clear the boom In that case, the government may stick to its tightening policy.cannot last. (Nor does Beijing want it to last.) Consider:} hina’s residential housing construction equaled almost 10% C How big is the real estate sector? It makes up 20% of fixed of GDP in 2011, compared with 6% for the US economy during investments, translating into a 10% share of GDP. But the sector the height of the boom in 2005. looms much larger in reality. We suspect land is collateral for more than half of loans. Real estate is interwoven with the} eal estate accounted for 40% of urban household wealth R entire economy. In other words: The risk to housing in China is in 2010, double the proportion in 1997, according to Peterson not so much its imminent collapse, but how ubiquitous other Institute. It is hard to imagine it doubling again in the next decade. segments of the economy are exposed to it. That Sinking Feeling Real Estate Prices and Sales Volumes in Major Cities 12,000 150% 120 Y-O-Y SALES VOLUME GROWTH (%) 10,000 RMB PER SQUARE METER 90 8,000 60 6,000 30 0 4,000 -30 2,000 -60 0 -90 2007 2008 2009 2010 2011 2012 2010 2011 2012 Weekly Sales Prices Volume GrowthSources: Deutsche Bank and Soufun.Notes: Price and sales volume trends in 39 major cities. Volumes represent year-over-year growth in four-week periods. Data through March 2012.
Blackrock investment institute [ 15 ] Clearing Out Inventory Can We Finally Afford It? Months to Clear Real Estate Inventory at Current Sales Rates Housing Prices as a Factor of Annual Household Incomes 40 12 35 11 FACTOR OF HOUSEHOLD INCOME 30 MONTHS TO CLEAR INVENTORY 10 25 20 9 15 8 10 7 5 6 0 2007 2008 2009 2010 2011 2012 2008 2009 2010 2011 2012 Housing Affordability Inventory +1 Standard Deviation -1 Standard DeviationSource: Deutsche Bank. Source: Deutsche Bank.Note: Weekly data through March 18, 2012. Note: Estimated data through end 2012.One example: The CEO of a men’s shirtmaker says he expects Anecdotal evidence abounds: Coffers with cash in Macau and100 billion RMB in revenue in three years, with the core shirt Hong Kong. Record real estate prices in Vancouver. Australianbusiness making up just 1%. It is tough to make money in the mines and vineyards snapped up by Chinese buyers.apparel business, so the CEO is building a 400-meter office Once people start believing prices will keep falling, they stoptower—the highest in his city—and outlet malls. buying. Just 19% of people expected housing prices would goThis particular CEO is not alone. He illustrates how real estate up in the first half of 2012, down from around 45% in 2009,runs through the entire economy. It is not about a few developers according to a December People’s Bank of China quarterlygoing bust. It is about local governments. It is about the entire survey. The same survey showed 21% expected prices tocorporate sector. It is hard to see a happy ending here. We fall and 46% anticipated a flat market.struggle to find a precedent in history where the bursting Things looked pretty grim in the first quarter. For example, notof a property bubble did not lead to financial distress. one transaction closed in Beijing, a city of 20 million, during the entire Chinese Year of the Dragon celebrations, accordingA Quiet New Year for Realtors to JPMorgan. Overall, transactions have plummeted andA slowdown or, worse, a crash in the real estate market inventory has risen to 15 months worth of sales. See thealso would hurt consumer spending. If the US experience chart above on the left.is any guidance, ever-increasing real estate prices can driveconsumption. Take them away, and consumption plummets. The inventory may be understated as the gap between floor space under construction and the amount sold is huge: 1.9 billion vs.Some money is already fleeing the country. China had capital 1.1 billion square meters in 2011. The gap is slowly closing, butoutflows in the fourth quarter of 2011—the first time since the there is a big overhang. And new construction usually lags sixAsia crisis in the late 1990s. Speculative inflows betting on an months behind trends in real estate sales.RMB revaluation dried up as it became clear China’s economywas slowing. This put the spotlight on the wealthy taking money Once people start believing prices will keep falling,abroad. they stop buying.
[ 16 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dCommercial real estate is hit hardest, especially in second-tier The question we ask ourselves is: Suppose thecities. Chongqing, for example, will have nearly 800,000 square government took its foot off the brake; could itmeters of new commercial space in 2012, whereas the annual reignite demand in housing?take-up has been just 150,000 square meters. population, or 200 million people, live in cities but do notThe government has started to offer incentives for first-time have a proper registration.home buyers, including lower mortgage rates combined with Another avenue is the push toward low-end “social housing.” This“guidance” to banks to lend to this group. It could ax deed taxes will not do much for prices of high-end private homes, but it doesand even cut mortgage down payments—although it would not serve the dual purpose of creating affordable housing for theresort to the latter measure lightly. masses and keeping the construction industry going. Expect social housing construction to almost double to more than sevenBreaking a Vicious Circle million units this year, according to Bank of America Merrill Lynch.Some fear it is already too late to re-engineer a real estateturnaround—even in a command economy such as China’s. The market is starting to believe the magic of policy. Bonds andThese bears predict a vicious circle of lower real estate prices shares of Hong Kong-listed developers rose sharply at the startand lower activity. of the year. One company even raised new equity. The triumph of hope over experience? Only time will tell.On the positive side, China has had much shorter real estatecycles than the West. Policy measures reversed a downturn It is clear the government is not ready yet to reverse its housingat the end of 2008 in six months, for example. In the current policy. Premier Wen Jiabao in early March emphasized houseclimate, affordability is improving fast. If prices were to fall 20% prices were still too high and that relaxing existing curbs couldfrom their peak and real wages were to grow 13%, affordability cause “chaos.” This dampened investor hopes for a policy reversalwould improve by one third in one year. In the US market, this and caused stocks to post their biggest daily loss in months.would take about a decade. See the chart on the previous page. The questions we ask ourselves are: Suppose the governmentOne way to boost the housing market—and consumption—is took its foot off the brake; could it reignite demand in housing?reforming or doing away with the hukou system that bars migrant And suppose the paralysis in policymaking lasts long enoughworkers without proper urban registration from essential services to destroy confidence in real estate as an inflation hedge?such as schooling and healthcare. As much as 15% of the