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China: Economic Catastrophe Unfolding

China: Economic Catastrophe Unfolding

china real estateBy Terence Doherty, guest author

Here’s some recent news about the real estate markets in China. I think it is fascinating watching how these things unfold. This proves once again that the lesson of history is that we don’t learn the lessons of history.

I predicted over 2 years ago that the Chinese stock markets would implode dramatically, much to everybody’s disbelief and skepticism. It began a few months sooner than I thought, but, that is exactly what has happened. Now for the last year or so, I have predicted that things will get VERY bad in the Chinese real estate markets over the next several years. Again, most people I have talked to about this (especially Chinese) have almost universally dismissed this notion as absurd.

But this is not just a guess.  When you read these articles, you will see just some of the evidence that leads me to this conclusion. There are a lot of data on this, and most of it comes from statistics issued by various Chinese government agencies. But it is not advertised by the mainland press or TV.   So, many Chinese are not at all aware, and think that everything will soon be wonderful, because that is pretty much what they constantly hear from the official media.

That is one thing I noticed immediately about China: there is a constant barrage everywhere you turn—-TV, advertisements, magazines, newspapers, billboards, etc.—-that essentially suggests that everything is wonderful and getting more wonderful all the time, and everybody is just happy, happy, happy, and China is getting better and better and stronger and stronger.  I was really struck by this. It was like living in a never-ending infomercial. Maybe some go to China and are not very aware of this, but to me it was like a constant din.

Actually, at least some of this data is readily available on the mainland. But it requires digging.  The official news agencies like Xinhua and the People’s Daily just keep repeating the same mindless mantra in endlessly varying ways every day: “Everything is good, there are only a few small little problems, but the Motherland is unstoppable and will just get mightier and mightier.” If the Falun Gong would just chant that mantra, they would get to keep their organs and they would have no more problems in China. 



The news here is actually worse than I realized. One very alarming thing is that the Chinese banks have avoided writing down bad debt. I should have assumed this would happen, since it is hard to see how it could be avoided, given the nature of the Chinese culture. This is NOT a good idea. It is like pretending that defaults and bad debt simply don’t exist, and this is very bad for the financial sector in the long run. 

This is exactly what the Japanese banks have done, and it is partly because of this that their stock markets have imploded over the last 20 years, and their economy has been stagnant for many years—-the Nikkei collapsed in late 1989 after peaking at about 39,000. Now, a full 20 years later, it is only trading at around 8800, and would have to rise another 450% just to equal the old highs, and that would not even consider the effects of the reduced buying power of the yen today vs. 1989. When you take that and inflation into consideration, the Nikkei would probably have to rise more like 700% or 800% or more from current levels to equal the equivalent of 1989 values. This is actually not very atypical for an imploded bubble. And that is exactly what the Shanghai and Shenzhen markets are looking at, since you have the exact same lethal combination in 1989 Japan as you do now in China: dual bubbles in real estate and stocks (one has imploded), and a decided reluctance to face facts and write down bad debt and defaults. In contrast, in the US in March 2000, we had a bubble in the stock market but not the real estate sector. And even though 7 trillion dollars in stock equity disappeared after March 2000, there was an increase in value of the real estate markets of 8 trillion dollars that more than offset those losses. That is a major factor that allowed the economy to expand in subsequent years, but that is not possible in China, just as it was not possible in 1989 Japan.

This is a singularly ominous combination that makes China’s economic future outlook over the next 25 years very grim. And that, in turn, will lead to acceleration of civil unrest. In fact, that has already happened: incidents of violent civil unrest have accelerated markedly all across China over the past year or two. But I think this could well get far more noticeable and disruptive. Some economists have said that in order to avoid disruptive amounts of civil unrest (as opposed to the more manageable baseline levels of unrest that are a constant), China’s economy must grow by 8.5% per year or more, just to keep enough people quiet. I suspect that is probably more or less approximately true in principle, although I don’t know where they came up with that number. But regardless of what that magic number might be, when that economy gets really bad—--watch out. That’s the seeds of civil war, if you ask me. If you have a very large group of desperate people coupled with an extreme polarization of wealth, you have a classic “haves” vs. “have  nots” Marxian confrontation that is the underpinning of most if not all major revolutions. Then, the only missing ingredient is a charismatic leader (like Mao, for example…..).

Eventually, debt must be written down, otherwise confidence in the banking sector will be insufficient to promote liquidity, and if you cannot promote liquidity and credit markets, you can not stimulate economic recovery. And that is the story of Japan over the last 20 years. That is what has been happening here in the US over the last year or two, but this is getting better here because banks and other financial institutions have been booking their losses (mostly because the government forced them to do this when they gave them the stimulus money). So why do banks resist writing down bad debt? Because in the short term, it makes them look like failures, and people in positions of power are afraid they will lose their jobs. So, to keep their jobs and to “save face,” (NEVER underestimate the critical importance of “face” in Asian cultures!), they just keep pretending everything is wonderful. The problem is they keep their jobs and look like they are very clever, but that just makes things worse and worse, and eventually causes the economy to just stagnate and go nowhere. Just ask the Japanese…….

Anyway,….. no matter what people may tell you, this is the worst possible time to buy real estate in China in particular, or to invest in China in general. Read these and you will see why.
Look at this one –, dated January 9, 2008…..

They talk about a book that was “just published” by some hedge fund whiz by the name of Rogers who lives in China now. The book is about as bullish as you can get on China. He says that “even if China’s stock market were to plummet, that country’s economy would remain healthy, and would continue to advance unchecked.” He calls China “the world’s greatest market.” 
I don’t know if this is a pump-and-dump scheme, but it sure sounds like one to me. Somebody ought to inform Mr. Rogers that even as his book was being published, the Shanghai and Shenzhen bubbles had already burst, had plummeted 15% in a few months, and were destined to drop far more over the remainder of 2008. And despite the fact that these bubbles lost over 70% in a year, they have NOT seen the bottom yet. And, they won’t see those lofty 6000+ levels again in real dollar (or real RMB) terms for another 30 years at least. 
If you ask me, there’s no better short in the world than China. The problem is that the vehicles for shorting anything in China are very limited and not ideal. Well-heeled investors in China can short those markets, but this is a relatively recent development (maybe 2 years ago they changed the regulations). The average retail investor in China still can not short anything in those markets, because there are very stiff capital maintenance requirements with brokers there. And, the average retail investor elsewhere has only a couple of choices.  

So how to make money in China?

I think you could make a lot of money in China in two rather obvious ways:

Short-sell the Shanghai and Shenzhen stock indexes (there are ways to do that here in the US, albeit not ideal ways)
Short-sell the Chinese real estate market (not sure how you can do that).
Here’s a very recent piece on a report just released by Albert Edwards and Societe Generale. Edwards correctly called the 1997 bubble in Asia. They are now predicting new lows will be reached in Asian markets in the second half of 2009. He is dead on with this quote:  “The continued enthusiasm for all things China reminds me so much of the way investeors were almost totally blind to the fact the US growth miracle was build on sand. China could be the biggest disappointment yet.”  
[See:   Soc Gen: "Expect New Equity Lows In H2", China Is The Global Achilles Heel, Zero Hedge].

I would only add that, in my view, there is no doubt: China will be the biggest disappointment yet. That economy will display in historically unprecedented graphic detail exactly how much devastation bubbles can cause, ESPECIALLY simultaneous bubbles. China reminds me of a place near where I live called “The Wedge.” It is a famous place for body surfing and belly-boarding, and just as famous (or infamous) for the steady toll of injuries and deaths the place produces. The waves come from the northwest, bounce off the jetty, then head back into the path of incoming waves. Two waves meet and potentiate one another, and rise to peak in a “wedge” shape that often has unbelievably ferocious power. And, because these waves break very close to shore in shallow water, there have been quite a lot of people who went “over the top” and were jackhammered into the sand and rendered paraplegic or quadriplegic there, or killed outright. You’d never believe the ferocity of this place unless you have been there and seen it with your own eyes and ears (it is LOUD). Crowds gather on the sand on big days just to gaze in awe (and watch the inevitable carnage). People don’t simply get “rag-dolled” here when they don’t make the wave, they can get flat pulverized into the sand.

The WEDGE – Huge Surf / April 11, 2007 

Well, I think you’ve got the equivalent in China, because both real estate and equity markets have formed frightening bubbles. And, just to add to things, an increasing proportion of both commercial and residential real estate lies vacant, building continues nonetheless, the banking sector’s fortunes are strongly tied to the construction and real estate markets, there is virtually no secondary market for real estate to speak of, and Chinese banks are notoriously reluctant to write down bad debt. Sounds to me a lot like Japan in the late 80s—only worse. The Nikkei even today is trading about 75% below where it was trading at the peak in late 1989. And that doesn’t even consider the change in buying power of the yen over that time. This is a devastating loss that takes at least a full generation to repair.

I think China will recapitulate what happened in Japan, and for all the same reasons. You’ve got precisely the same prerequisites for disaster in China, so why would it be any different this time? Plus, there are some additional reasons why things will be particularly bad there over then next 25 or 30 years. One thing we have learned about bubbles—-once they are fully formed, there is no way to tame them, just like a fully-formed wave at the Wedge when it’s really firing. They just have to expend their explosive energy, and anybody with the common sense God gave gravel will just get out of the way. There is no way to suppress or regulate these things once they begin to gather momentum. No government or regulatory body has ever succeeded in doing so, to the best of my knowledge, and few if any have any motivation to even try. Why would anybody mess with a cash cow that is driving an economy at breakneck speed, after all?

We have not seen the full force of the implosion yet. That is still probably months away. In the meantime, the bull trap sucker’s rally that the Chinese stock market have been in for several months now rather predictably out-suckers even the US sucker’s rally. The Shanghai market is up almost 70% from the lows in November. That one has gone about as far as it can go, and is gonna crash and burn soon.

Here’s a very interesting story published a few weeks ago in the Far Eastern Economic Review on the real estate markets in China.  You will see that the gist of this is that a huge proportion of real estate bought in China lies empty. The reasons are not completely understood, but it is not simply a matter of a huge supply/demand imbalance (although that is certainly the case). Beyond that, there are more ominous undertones with potential repercussions that are very bad.
It seems that many Chinese buy real estate because they view it as a “can’t lose” investment (sound familiar?). They don’t often rent out the space. It is not as easy to rent residential space in China, because anybody who can would rather buy a new house, partly because of the prestige value, but also partly because they believe that real estate is a “can’t lose” investment. Evidently they have the belief that at some point in the future, they could always sell the property, since it is still technically “new.” Remember, there is at best only a very small secondary market in real estate in China. Nobody in China goes shopping for a “used” home, they always look for a home in brand new developments. These are typically high rise apartment buildings that are really not very attractive at all by our standards (with some exceptions in parts of Beijing and some of the other largest cities). They often look more like tenement slums, particularly after they age a few years, because nobody does much painting or landscaping in Chinese residential areas. I have never seen housing tracts like the ones that are so common in the US, and I suppose they exist somewhere to a very limited extent, but I never even saw any single-family free-standing homes. It’s all high rise condo/apartment buildings. I realize this is kind of paradoxical…..that Chinese would believe they can always make money selling a home second-hand despite the fact that the secondary market is small or even nonexistent in places. But, that’s China. I think they are less concerned with actually realizing a gain, than in maintaining a paper gain. Again, a not insignificant factor here is the prestige value.
Anyhow, obviously this attitude among Chinese has only made things worse, because it has kept a doomed real estate market hovering and even pushing higher artificially. The demand for living space has not kept this market up, just the demand for real estate as a place to park cash. But builders don’t care, they just keep building anyway. Now, this will lead to disaster, partly for the same reason that disaster struck the stock markets there: investors who were once convinced that the Chinese stock market was a get-rich-quick machine lost confidence as they lost money, and that started the implosion in that market. Now, a large percent of residential real estate in the big cities at least is unoccupied. What might happen to that real estate when the value of new residential real estate begins to plummet? What would YOU do if you owned a residence in Beijing, and suddenly discovered that brand new housing of comparable size/location could be bought for much less than what you paid for yours? How long would you hold on to it? How long would you continue to pay the mortgage?
I think you’ll see people walking away from mortgages, just like you do everywhere else, except the scale will be massively increased because much of the property is unoccupied, and cannot be sold very easily, except perhaps at a deep discount. And, as properties pile up on bank asset sheets, what will they do with them in a country that doesn’t have much of a secondary market and has far worse unemployment than we do? They can’t even sell them at fire-sale prices to any significant degree. 
Chinese banks have a problem that might be just as bad: a ton of housing that will end up on their books, and no way to get rid of most of it. That could lead to eventually booking nearly total losses, which virtually never occurs in the US.  And, just as occurred in Japan, they will pretend as long as they can that these losses don’t exist, but it is only a question of time until they are forced to face facts. Knowing a thing or two about China and Chinese, I bet Chinese banks will label the real estate that ends up on their books as “assets” and will value them at full value, as if the mortgage were still being paid and would eventually be paid in full. They would probably want to just downgrade the stated interest rate on the mortgage to zero, but the problem there is that with mortgages in China, there are big down payments (typically at least 25%), and the terms of the mortgages are usually rather short (typically 10 years). So, most mortgages require paying more on the principal from the beginning. That makes it much harder for a bank to pretend that no loss has occurred. They’ll figure out some way to rig the books. Chinese expertise at lying with numbers is well-established and among the best (or worst, depending on whether you value the truth or not). In fact, it is long-established unwritten government policy to produce absurdly optimistic statistics. But the end result will only be postponed somewhat. And people will remain fooled longer than they otherwise would have.
Anyhow, I think this is all pretty much inevitable. Chinese will predictably lose confidence in real estate as a “cash-equivalent” commodity or hedge against inflation. They will look to park their assets in whatever other safe havens they think there are, such as gold, US treasuries, etc. They certainly won’t pour money into the stock markets. They will walk away from mortgages en masse, and scramble to try to sell real estate holdings at a loss, probably with very limited luck. There won’t be a lot of buyers lining up to buy discounted residences in a deteriorating real estate market, with unemployment rising and corporate profits sinking and business going under and exports dropping (all of this has been steadily developing or is well underway).
This might seem rather gloomy, but I really can’t see much of anything optimistic in China’s future over the next several decades. Quite the opposite, you have been hard-pressed to have scripted a better economic doomsday scenario if you tried. 


Besides the fact that corporate profits in China are down 30% this year, there is another series of widely underappreciated statistics: trade.

China’s economy is heavily dependent on exports of cheap goods. For one thing, this approach is unsustainable and does not of itself lead to economic strength. That’s why many cheap labor countries that similarly produce a lot of cheap, low-tech items do not thrive (e.g., Thailand, Honduras, Vietnam, etc.). In fact, they merely wallow in poverty that they can’t seem to get out of. Don’t forget, despite a wealthy class in the big cities in China, there is really no middle class, and the average wage in the countryside is often less than $100 per year. Even in the cities, the equivalent of the working class there typically makes around 1000 to 2000 RMB per month (roughly $145 to $290 US per month). But the vast majority of Chinese live in the countryside, which is another world compared to Shanghai, Guangzhou, and Beijing, which house just a small fraction of China’s population. Imagining that these cities typify China is like standing on the Strip in Las Vegas and imagining that this is just a typical road in a a typical American town. So, China is classified as an emerging/developing economy by the World Bank.

We know one thing about recessions and depressions: economies that depend the most on exports are the ones that suffer the most. And without question, of all the major exporting countries in the world, China’s economy is the most heavily dependent on exports, mostly consisting of cheap goods.

So what has happened to China’s exports?

Well—notwithstanding a never-ending stream of perennially wrong predictions for over 6 months that things are turning around and recovery is imminent—there’s no good news no matter where you look. The rosiest statistics involve those denominated in dollars, but that markedly underestimates the real RMB-linked economic impact. But what do these statistics show?

In November, exports dropped in China for the first time in 7 years. In December, the drop was even steeper, and exports have dropped every single month thereafter. In May, exports dropped over 26% compared to the same month last year, which was the greatest drop that economy has ever experienced. Worse, exports to the European Union (China’s biggest foreign market) plunged 41.3% in May.

Inexplicably however, many analysts (especially in China, unsurprisingly) insist the worst of the slump is over, despite little or no tangible evidence to support that conclusion. But this has been a constant theme since November: every month, government (and other) spokesmen in China assert that things would quickly improve. For example, after exports fell 22.6% in April (which was a record, until the following month), Commerce Ministry spokesman Yao Jian said that China was confident exports would imporve “on the basis of the gradual recovery seen in the first quarter.” Gradual recovery? You call plunging exports, with each month exceeding the previous month, “gradual recovery?” 

Even the Wall Street Journal got suckered into this lunacy. After exports dropped 17.1% in March and then 22.6% in April (both figures exceeded estimates, by the way), the WSJ cited increasing investment statistics, and said “The investment data reflect how Beijing’s stimulus program, which is focused on public infrastructure investments backed by a flood of bank credit, has helped stabilize the economy.” 

I am not sure what “flood of bank credit” they are referring to. Actually, cheap credit by Chinese banks is drying up rapidly, which is not the least surprising, given the economic reality. In fact, in April, lending by Chinese banks dropped two-thirds compared to March.

One of the reasons the government is putting the brakes on lending is because there is widespread suspicion that as much as one-third of the new loans during the first quarter were going into the stock market, not fixed investments. Could that be why the Shanghai market is up 54% so far this year, despite nothing but economic news moving from bad to really bad, and corporate profits down 30%?

The upshot is that while inflation has plagued China for years, now they have a new and far more ominous economic foe: DEFLATION. Not many seem to have noticed, but as of May, the Chinese economy had experienced FOUR straight months of deflation.

What was the response? Here’s an example, which is pretty much the same sort of tone we have seen all along in response to increasingly bad economic conditions in China:

"’Although the indices continued to see negative growth in April, deflationary concerns appear to be subsiding as the economy shows signs of recovery,’ said Jing Ulrich, chairman of China equities at JPMorgan.” China Economic Net

WHAT signs of recovery, other the continuous drone of optimistic pronouncements from analysts and government officials?

A month later, when “signs of recovery” once again failed to materialize, but instead were replaced with another month of plunging exports and deflation, Forbes gave this laughable pronouncement:

“China’s consumer prices continued to fall as expected in May, but analysts expect a price rebound by the end of this year. Meanwhile, the deflation could be a boon for consumers as China weathers a slowdown of wage growth.”

Well, I suppose wage growth is only a concern for that rapidly shrinking proportion of Chinese who actually have jobs. You think unemployment is bad here, well we are living the high life compared to China.

In Beijing, they threw out most of the peasants who migrated to the cities looking for work and ended up building the Olympic facilities. Now, the huge numbers of Chinese peasants that flocked to the cities (which was, by the way, the largest migration of human beings in the history of the world) have gone back to their farms, but they are mostly not needed there, either. 23 million migrant workers can’t find a job in the cities, and they can’t find work back home.  University graduates spend years looking for work, and often end up selling clothes or working in one of the omnipresent KFCs. China’s answer?  Well, according to the China Post, they want to train people to be housekeepers! Right. THAT oughta turn China into an economic powerhouse!

For some reason, everybody seems intent on putting lipstick on this pig and calling it a Playboy bunny.

See also: 

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  1. allan

     I’ll tell you another thing about China, they don’t make Chinese food the way they used to.  I’ve lived on both coasts, the north and the south and I still can’t find a decent egg roll.  As for MSG, don’t get me started.

  2. ilene

    I’ve lived on both coasts, the north and the south and I still can’t find a decent egg roll.

    Allan, maybe you should sprinkle some msg on them?

  3. Terence.Doherty

    I don’t think you could even find an eggroll in China. I have never seen one there. The food in China is very very different from what Americans call "Chinese food." Many Americans would probably consider it disgusting. Most of it is loaded with fat, or oil of some kind. But they DO have a zillion KFCs, although most of the KFC food is different than what you would find here. Not sure if they use MSG or not in China, but they sure use a lot of oil.  And in some parts, a LOT of extremely hot spices.

  4. Terence.Doherty

    By the way, there are some interesting and informative comments on this piece in the discussion on Zero Hedge.


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