Chinese real estate is in the headlines again

The LA Times came out Saturday with a widely-noticed article on Beijing real estate, which features my friend Jack Rodman.  Jack, who runs a firm called Global Distressed Solutions, is a bad-loan and distressed real-estate expert who has spent the last several years in China, and somehow has the energy to poke around among all the spectacular buildings in Beijing and other cities, worm his way in, and see if behind the beautiful façades there is actually some semblance of economic viability.

Apparently not.  According to the article:

By Rodman’s calculations, 500 million square feet of commercial real estate has been developed in Beijing since 2006, more than all the office space in Manhattan. And that doesn’t include huge projects developed by the government. He says 100 million square feet of office space is vacant — a 14-year supply if it filled up at the same rate as in the best years, 2004 through ’06, when about 7 million square feet a year was leased.

…To its credit, the government recognized in 2007 that the real estate market was headed toward a bubble, economists say. In an attempt to make real estate more affordable, restrictions were introduced on ownership of second homes and on foreign home buyers. But the measures came too late, accelerating the crash of an already weakening market.

The Beijing Municipal Bureau of Statistics reported this month that housing sales in the city dropped 40% last year. Chinese economists have predicted that housing prices will drop 15% to 20% in Beijing this year. Shanghai has experienced a similar decline.

Any conversation about Chinese real estate with Jack is likely to be depressing because his terrible stories aren’t much relieved by vagueness.  Unfortunately he probably knows as much about the real estate market as anyone, and his conversation tends to be pretty specific and avoid the kinds of generalizations that we often make here, given the difficulty of getting hard data about some of the problems.  When Jack talks about empty buildings he gives actual addresses.

And it’s not just foreign newspapers that are warning about real estate trouble.  China’s leading independent business weekly, Caijing, also has an article this week that discusses the real estate mess:

Battered by global financial turmoil, foreign investors are moving quickly to liquidate stakes in Chinese property developers. The market is sinking, and investors are eager for a way out.  Real estate developers, including some of the nation’s largest, are fighting to stay afloat. And so far, none have declared bankruptcy.

But key developers who snapped up land and, sometimes in a desperate scurry for cash, signed deals with equity funds and investment banks during China’s property market boom are now slipping toward loan defaults and failure.

Worries about the real estate sector are nothing new, of course.  The important issue, for me, is the impact of problems in the real estate sector on the banking system.  The LA Times article goes on to explain why:

The situation could get worse. Most of the real estate has been financed by Chinese banks, which have avoided writing down the loans. Eventually, they will be forced to, and that probably will have a ripple effect throughout the economy. 

The problem is actually a little messier than that.  There have been rumors for over a year that with the forced credit contraction of last year a lot of the riskier real estate developers had to turn to the informal banking sector for loans, and it is not at all clear to me how these get resolved in case of payment difficulties.  I am assuming – like, I think, most others – that the government will want to avoid a rapid liquidation of bad loans by the banks.  They will not want banks to seize collateral and sell it off for fear that this would cause the market to collapse and would result in the kind of debilitating debt deflation that Irving Fischer described in the 1930s, in which assets are liquidated to meet loan payments, causing asset prices to fall, which puts additional downward pressure on loans, and so on in a self-reinforcing cycle.

Now it is not clear to me that this kind of liquidation is always harmful.  A strong argument can be made, and has often been made, that the liquidation process makes a crisis feel worse in the short term, but results in a much faster recovery because at some point very low prices create economic value to businesses of owning the assets, and their use of these assets can fuel a rapid recovery.

The classic case is the massive railroad building program in the US in the 1860s and early 1870s, which left the railroad owners saddled with expensive assets which required passenger and cargo rates that were too high to be useful to most potential passengers.  Many of the railroads were never able to stop losing money.  When these railroads went bankrupt after the 1873 collapse, and were subsequently liquidated, new owners were able to buy them for pennies on the dollar, and so were able to make them profitable while charging much, much lower freight and passenger rates.  These lower rates sparked an economic boom by sharply reducing transportation costs, and the final value to the economy was much greater than the initial losses on the railroad assets.

The worst case, by this thinking, is if assets that are not viable at current prices are effectively taken off the market because the owners are not forced to liquidate, in which case they become a pure deadweight for the economy.  The counterargument, of course, is the Fischer argument – that forced liquidation is inherently less stable because it causes a self-reinforcing cycle of price collapses.

I am not able to say which argument is correct, and anyway this sounds as much like a political argument as an economic one, but it is worth considering what might happen in China.  The consensus, and I agree with it, is that the government is far more concerned about avoiding short term instability than about promoting long term viability, and so will make every effort to force banks to stretch out the restructuring process, avoid panic liquidations, and take assets off the market.

This policy can work with the formal commercial banks, but what is less clear to me is how the liquidation process will work in the informal banking sector.  I am not sure whether pressure can be placed on the informal banks to prevent liquidation without seriously interfering with a wide range of market and governance mechanisms.  Certainly rumors about some of the fairly brutal collection mechanisms in parts of the informal banking sector suggest that creditors might not be too eager to confront lenders.  Unfortunately I do not have much of a sense of whether this process is already taking place.  If any of my China-based readers knows more about this, I would really appreciate some help.

For those who find this topic of great interest, there was a fascinating article in Friday’s South China Morning Post.

With the mainland economy tanking to its slowest growth rate in seven years and banks wary of lending as defaults rise, small business operators are hocking belongings and company assets for loans from pawnshops.  “Banks are reluctant to lend,” says Huang Jing, deputy business manager at Shanghai Oriental, the city’s second-biggest pawnshop. “But we have a lower threshold and can provide loans much more quickly and with shorter terms.”

Banned at the start of the Cultural Revolution, pawnshops were considered a form of capitalist exploitation that preyed on poor and desperate people. They were outlawed for two decades, until 1987, but now they do a brisk trade.  From gold bullion to houses and factory equipment, customers offer a variety of assets to get loans from pawnbrokers.

Quoting Wang Fuming, chairman of a pawnshop with about $1 billion in loans, two-thirds of which are to small and medium businesses (Chinese pawnshops are huge compared to their Western counterparts and can include hundreds of branches and are actually, funnily enough, among the most efficient parts of the country’s banking system), the article goes on to say:

“About 90 per cent of small businesses in Shanghai fail to get bank loans,” Wang says. “The problem is more severe with a weak economy.”  The central government has eased its monetary policy and urged banks to lend, with January lending showing a record rate of growth. Yet most new loans are directed at the country’s 4 trillion yuan economic stimulus plan and state-owned companies.

This quote about the difficulty of small businesses in Shanghai to get loans reminds me of the point, very forcefully made, by MIT’s Yasheng Huang in his excellent new book, Capitalism with Chinese Characteristics, about the difficulty small entrepreneurs have had after the reforms in the 1980s.  For Huang Shanghai is Exhibit A in his claim that there has been a reversal away from a market economy to a state-led economy in the past fifteen years.  He especially mentions that as the commercial banks turned mainly to funding SOEs, it was the informal banking sector that took on the bulk of the financing for SMEs.

Meanwhile, speaking of funding SOEs, there is a lot of talk in the markets about second big stimulus package aimed at delivering more consumer spending (“A second big stimulus package?” some unkind folk may wonder, “Did I miss the first?”).  The front page of today’s People’s Daily has an article with the large headline “Communist Party leadership warns of ‘austere’ year for China.”  It goes on to say:

The ruling Communist Party of China (CPC) said Monday the country will launch a comprehensive economic package to tackle an “austere and complicated” year ahead.

“We will increase large-scale government investment, implement and readjust a plan to revive industries, make great efforts to boost innovations, and greatly enhance the level of social security,” said a press release issued after a meeting of the Political Bureau of the CPC Central Committee.  The meeting was presided over Hu Jintao, general secretary of the CPC Central Committee.

Meanwhile Xinhua yesterday reported PBoC concerns about deflation:

China’s central bank on Monday warned of deflation in the near term caused by continuing downward pressure on prices.  Commodities prices were low and weak external demand could exacerbate domestic over-capacity, the People’s Bank of China (PBOC) said in an assessment of fourth-quarter monetary policy.  “Against the backdrop of shrinking general demand, the power to push up prices is weak and that to drive down prices is strong,” the PBOC said. “There exists a big risk of deflation.”

While assuring us that it would ensure ample liquidity in the banking system and promote the reasonable and stable growth of credit, the PBoC, along with the CBRC, also stated three days ago that it was planning to investigate the lending spike.  According to an article in the current Caijing:

A dramatic increase in bank lending in January has attracted attention from investigators with China’s central bank and regulatory agencies, Caijing has learned.

The China Banking Regulatory Commission plans to investigate the huge cash flow after banks issued 1.62 trillion yuan in loans during the month. Notes trading represented 38 percent of the total credit.  Some analysts have claimed companies may be using government-encouraged bank loans to invest in the Chinese stock market, which has rallied since the start of the year.

Until today the stock market had continued its upward surge – although the SSE Composite suffered a dizzying 7.5% drop last Tuesday and Wednesday on concerns that the PBoC investigation, if it determines that a primary cause of the recent market surge was bank lending to stock speculators, may pull the rug out from under the market.  The overall surge, largely on speculation about which sectors are going to receive bailout packages from the government, has made China the top performer among global stock markets this year, with the SSE Composite rising about 20% year to date.

A lot of my Chinese financial market friends are very worried that small investors are rushing in too quickly and are likely eventually to get hurt, since what is driving the markets – as always – is not changes in fundamentals but rather rumors of government intervention.  The game seems to be to guess which sector will receive the next set of rumors about government bailouts and to buy accordingly.

Even if the rumors are true, I think the market is ignoring how difficult it will be for profitability to revive and how even more difficult it will be for asset prices to stabilize.  Even real estate companies have seen stock prices benefit from rumors, although the sector is in serious trouble and it is only because they are in such trouble that the government would consider supporting them.  Still, this is always how the stock markets work here – it ain’t about fundamentals, its all about government rumors.

At any rate today, the market may have suddenly refocused on how bad the news outside is, falling straight down after its opening, led by commodity producers and insurance companies, with the SSE Composite losing 4.6% to close at 2200.1.  If the next couple of days the market remains bad, the government will almost certainly make supportive noises, so I don’t know if this drop is a temporary fall before prices move up again, or if it is the beginning of a longer decline, but either way I think the market rebound has far exceeded any real basis for optimism.  It will be much lower in a few weeks or months.

9 Responses to "Chinese real estate is in the headlines again"

  1. Victor   February 24, 2009 at 10:50 pm

    Hey Michael, great post. However, there is a lot of money sitting on the side waiting for good opportunities, especially in the major cities of BJ and SH. The distressed asset guys I know are somewhat frustrated because there is clearly a bubble, but yet there is still willing money out there, so the discount has been mild in the major markets. I am not sure what the situation is in inland provincial cities, but I will find out in March.

  2. Jack Rodman   February 25, 2009 at 12:08 am

    Michael, sometimes the newspapers don’t get all their statistics correct. I told the LA Times that from 2006-2009 that all construction activities in Beijing would total about 1 billion sq. ft. equal to 3 times the commercial property market in Manhattan (from an article in Bloomberg Markets March 2006).From 2007-2009 I indicated that 100 million sq. ft. of commercial office would be completed comprised of 60 million Class A office and 40 million Class B and so-called ‘strata-title’ or condominiumized buildings like the SOHO projects.Not all of this space is vacant but there are sure alot of empty buildings everywhere you go from the CBD to Finance Street.The 65 listed property developers are hemmoraging cash and aGoldman Sachs research report (09/09/08) shows these developers raising capital from two sources: “self-raised but not equity” totalling rmb 478 billion and “other” rmb 724 billion.I have thought this is the “hot money” that you’ve often written about and of course it is now flowing “out and not in” for the reasons you’ve cited. If so the impact on developers must be devastating. One of the biggest problems is all the PE firms, hedge funds and opportunistic investors who threw money into real estate companies (and other businesses) to capture a pre-IPO stake only to find themselves without an ‘exit strategy’ when the IPO market collapsed in early 2008. To make matters worse these investmentswere structured for speed and tax efficiency and leave the investors with ‘hollowed’ out offshore structures with share pledges, collateral agreements, guarantees and “no IPO put-options” that the developers cannot honor. To add insult to injury the creditors ability to secure their assets or preserve their investments onshore is”problematic” and the focus of my current business endeavorsin China.Your railroad analogy of repricing and remarketing the assets to stimulate the economy is exactly what happened to all those office buildings in Phoenix, Texas and Colorado during the Savings and Loan crisis. It worked in Japan post Bubble and helped alot in Korea. However I agree with you the thought of doing this in China would be anethema to the government as it would allow the foreigners to make money on distressed assets.Plus it would crystalize the value of the bad loans on bank books.In summary, I don’t think we’ve seen the last of the China real estate stories.

    • CCT   February 25, 2009 at 12:26 pm

      Jack,I posted a comment originally on Michael Pettis’ blog. I thought I would repeat myself here, and get your input.The numbers you give here on commercial real estate coming only differ dramatically from figures provided by other industry analysts. Colliers, for example, publishes a detailed quarterly summary of all office (and retail) space coming online in Beijing. Digging through the numbers ranging from 2006 to 2Q2008… your numbers are off from theirs by an order of magnitude.You state here 60 million sq ft of class A office space came online from 2007-2009. Colliers comes up with a total of only 2 million square feet (at least running through mid-2008). Colliers lists specific properties and their vacancy numbers. In fact, for class A office in Beijing, they show vacancy rates of approximately 15%-16%… a number which is matched by numerous other cities world-wide, and hardly suggestive of impending disaster.Can you explain the discrepancy? It would help, for example, if you could let us know the specific names/addresses of specific properties you’re looking at that Colliers skipped in their otherwise comprehensive survey.

  3. Jack   February 25, 2009 at 7:24 pm

    Most of the commercial brokerage firms are exclusive leasing agents for many of the empty or near empty buildings and they only include in their supply figures buildings that have a certificate of occupancy and are currently in the market for leasing. Also the commercial brokers represent international tenants and they exclude from supply what they consider Class B buildings or strata-title buildings. My estimate includes all the buildings that are ‘topped-out’, most have the exterior curtain walls in place and could potentially be complete and open for leasing within 2009. For example China World Phase 3would be in my figures. Also many completed projects such as Central Point on 2nd E Ring Road and the PICC Tower at Yintai,Glory Center, Office Park in the CBD are virtually complete but for various reasons notcurrently being marketed. I include these in the supply side.Its in the best interest of the brokerage community to paint a rosy picture to the building owners they represent. I also agreethat not all the 100 million sq. ft. is suitable to international tenants, but regardless, the buildings exist whether they were functionally obsolete when they were built or not. I suggest any skeptics merely drive around the CBD and Finance Street and draw their own conclusions.

  4. bcg_81   February 26, 2009 at 7:33 am

    Jack, how representative is the situation you’re describing in Beijing of the broader real estate market in China? Some argue that while the market for higher-end commercial space in Tier 1 cities is clearly bad, it is the worst, and supply-demand is favorable enough in other markets (e.g., affordable residential housing across a broader range of smaller cities) that we should expect that plus increasing affordability, easier credit and government stimulus to make a significant contribtion to growth this and next year. What do you think?Many thanks for your contribution.

  5. Anonymous   February 26, 2009 at 7:53 am

    please update the real estate situation in Indian metros

  6. Long time 'China Watcher NOT based in China Guest   February 26, 2009 at 9:17 pm

    YOU SAID:”I am not sure whether pressure can be placed on the informal banks to prevent liquidation without seriously interfering with a wide range of market and governance mechanisms. Certainly rumors about some of the fairly brutal collection mechanisms in parts of the informal banking sector suggest that creditors might not be too eager to confront lenders. Unfortunately I do not have much of a sense of whether this process is already taking place. If any of my China-based readers knows more about this, I would really appreciate some help.”These ‘mechanisms’ likely are Triad (tongs) whose methods of collection can be equated to the Mafia, only worse. Even emperors trembled before the Triads. ‘It is obvious that the heavens have been disturbed and there is conflict.’

  7. Guest   February 28, 2009 at 5:01 am

    The strong saving base of general public who have no thorough knowledge of the economy outside China is a major supportive force for the property market. One imprtant practice among Chinese is that the current income earning generation would like to take care their decendants’ future accomodation by taking the current price advantage. Meanwhile, don’t forget one thing China is still on plus side for its economic growth. The government will try to assure the growth rate this at 8% level by all means.

  8. Amy Sommers   March 2, 2009 at 7:51 pm

    Excellent post on the threads and linkages tying together a complex situation.Re the point about difficulties small businesses/entrepeneurs encounter in obtaining financing: a factor contributing to this difficulty is that much commercial lending conducted by PRC banks is real-estate based (i.e., even if the loan facility will be used for non-real estate purposes, the bank’s willingness to make the loan arises from the borrower’s use of real property as collateral). So far as I am aware, Chinese banks do not have an SBA-type of facility available, so small business owners who don’t have real property assets they can mortgage for working capital must turn to savings and personal networks to raise it. The informal finance system is a major factor in PRC economic activity and as one commentator remarks, lends itself to triad participation. With incentives aligned to make corporate financing easier if one has real estate assets, coupled with the rapid rise in prices seen in a variety of asset classes in the past 5 years, it is perhaps not surprising that Chinese (and later foreign) investors saw real estate as a source of recurring wealth. Addressing availability of small business funding is something that would benefit China’s economic development in the longer-term.