You probably haven’t heard of Yang Huiyan, even though Forbes reckons she’s Asia’s richest woman. The 27-year-old didn’t make her own fortune; she inherited it from her father. That by itself makes her unusual in China, where wealth is still fairly new and the young super-rich build their own businesses.
The other surprising thing is where the money came from. We tend to assume China’s multimillionaires have made their money from manufacturing and exporting. But Yang’s father – like many others – actually cashed in on property, by setting up high-end developer Country Garden Holdings. Like Britain and the US, the Chinese property market has boomed recently, with prices rising by an average of 8.2% in the last few years.
But now – also like Britain and the US – boom is turning to bust. The Hong Kong-listed shares of Yang’s firm are down 75% from their peak last year. Chuanghui, a major chain of estate agents, closed half its 1,800 outlets in January as sales plummeted. Developers are collapsing and buyers are turning away.
However, there’s one big difference between China’s property bust and the one we’re experiencing. The British and American governments practically encouraged an unsustainable bubble to form. The Chinese government have not. Worried about the example of Japan’s giant property boom in the eighties and the long bust that followed, they clamped down on real estate lending much earlier in the cycle.
So while there will be fall-out, it’s highly unlikely to hurt the economy in the same way that it will here. A handful of sectors, such as developers and banks, will be injured. But once the smoke clears, the damage will be limited.
And the investment opportunities will be better than ever…
What’s behind China’s property bust?
China’s property bust comes down to two things. One is the migration of millions of people from country to town. This created huge demand for new housing and encouraged developers to throw up as many blocks as they could. But as usual with property, they threw up too many, letting supply get a bit ahead of demand.
The other was the emergence of property speculation. Mortgages only became widely available in China in the late 1990s, but it only took a few years until a property-flipping culture emerged. Together with an influx of foreign speculators, this drove up prices, especially in hotspot cities such as Beijing, Shanghai, Shenzhen and much of the south.
With the government restricting lending to developers and introducing rules on minimum deposits for buyers, that’s now changed. Prices are still rising overall, but the rate of growth is slowing sharply. Shenzhen is now declining and Guangzhou is flat year-on-year. This probably understates the situation with some types of property, especially the kind the speculators piled into – there are reports of 30%-plus falls on some property in Shenzhen.
But it’s not just a question of prices. Sales have dried up thanks to tighter credit, but also to a “buyers’ strike” mentality. Given the falls in prices we’ve already seen, buyers are quite wisely holding back in the hope that prices will fall further. As a result, sales have slumped 3% year-on-year in the first six months of this year.
This sounds like bad news for the Chinese economy. After all, if we’re so worried about a housing crunch here, shouldn’t the same fears apply there?
China is still in better shape than the West
But the situation is very different. Unlike the UK, personal debt is not a millstone around China’s neck. Here, consumer debt is 102% of GDP. In China, it’s 15%, according to brokerage CLSA. While some people will undoubtedly fall into negative equity, it won’t be the economy-wide problem that we have here.
The Chinese economy is still robust and wage growth still strong. In the West, we became dependent on mortgage equity withdrawal (MEW) and other borrowings to carry on consuming. In China, MEW barely exists. Urban disposable incomes grew at an annual rate of 6.3% in the first half of this year after adjusting for inflation; Western workers can only dream of a pay rise like that. Meanwhile, Chinese households hold far less of their wealth in real estate than we do; cash accounts for around 45% of assets compared with 10% in the US, according to Morgan Stanley.
Finally, on a longer-term view, Chinese property is still in a bull market. It has to be given financial and population shifts. Yes, valuations got ahead of themselves (at least in the eyes of the Chinese government) and a slowdown was highly desirable. But prices are not doomed to stay below this level for a decade or more, unlike in the UK. So even people who see their property falling in value can expect it to be worth more in a few years.
All this means that the impact of the Chinese housing slowdown will be far less marked than in the West. It will probably have some effect on consumer confidence, just as the collapse of the stock market did. But it’s not going to knock the economy for six.
Builders are facing tough times
Still, there will be fallout in some sectors. We’re already seeing it among property developers. Slowing sales, weaker prices and an overhang of unsold properties would be bad enough by themselves, but developers are also experiencing a home-grown version of the credit crunch, thanks to the lending curbs we mentioned above. The real estate entrepreneurs confidence index has plunged to the lowest level in its short history.
Smaller, weaker developers are in severe trouble. One-third of firms have been unable to make payments on land they’ve bought recently, according to the owner of a mid-sized firm speaking recently on Chinese TV. Financial magazine Caijing reports that developers are “desperately searching” for ways to boost capital, including floating on the stock market, issuing bonds, raising new bank loans and – as a last resort – selling projects. And with government controls keeping the first three doors closed for most firms, the last resort is also likely to be the most common resort.
Of course, for anyone with the capital, desperate sellers mean bargains galore. Caijing reports that foreign investors including Morgan Stanley, Blackstone, Capitaland and Singaporean government-controlled GIC Real Estate are among those hunting for deals. Hong Kong property tycoon Vincent Lo has set up an Aim-listed firm, China Central Properties, to snap up distressed assets.
The stronger Chinese developers aren’t being idle either. As long as you have the balance sheet to do it, busts are far better times than booms to buy up your rivals. Hong Kong-based developers, with easier access to credit, could do very well out of this.
This consolidation into larger, stronger firms will be good for the strength of the Chinese property industry. And given the long-term bull market in real estate, investors are likely to do very well from buying into the winners. Going by the negative newsflow, it’s probably still a bit early to be thinking about investing, but we are already looking for stocks that might be attractive in the near future.
Banks have more money – but they also have more problems
While the fallout for the property developers is already clear, another sector could also take a big hit: the banks.
The general view on China’s banks is that they are in much better shape these days. Thanks to the government bailing out three of the big four state banks in 2004 before they floated on the stock market, the level of non-performing loans (NPL) in the system has dropped sharply, as the chart below shows. (Negotiations for a bailout and listing of the fourth, the Agricultural Bank of China, are apparently underway – it had an NPL ratio of almost 25% at the end of 2006).
But if you look at the balance sheets of the six Hong Kong-listed banks, many still have more NPLs than we’d ideally like to see. In particular, for the three banks that got bailed out (Bank of China, China Construction Bank and Industrial and Commercial Bank of China), their allowance for loan losses is still not much more than their level of NPLs. Add to that a high number of special mention loans (loans where there has been at least one payment in the last 90 days) and there’s good reason to be concerned.
The banks point out that their NPL ratios continued falling significantly after their bailout and are still doing so, suggesting they’re becoming much better at managing lending risk. But it’s also important to bear in mind how those NPL ratios were reduced. While the absolute level of bad loans has improved, much of the improvement is actually relative. In other words, they’ve grown their loan books so quickly – thanks in part to strong real estate lending – that the proportion of bad loans has fallen very sharply.
But rapid lending during a boom tends to turn up all sorts of problems when the bust comes. That’s especially true in a country like China, where fraudulent or politically-motivated lending is still common, credit-rating systems for borrowers are still underdeveloped and many banks have only basic systems for monitoring what’s going on across all their branches.
Given that real estate lending is a large chunk of lending and that there are other danger areas in the economy, such as export-focused small business, there’s a solid chance that some banks may have to own up to a growing NPL problem in the next few months. Whether it might be severe enough that they will need to raise capital from shareholders or even seek another government bailout isn’t clear. On balance, it looks unlikely, given that their core capital adequacy ratios are significantly higher than the minimum of 4%. But a rising NPL ratio could easily rattle shareholders in the months ahead.
Of course, this NPL problem is the reason why Chinese banks are such a difficult investment call. Because banks tend to be very big dividend players, getting into a successful one early on is a great way to lock in a huge dividend yield a few years down the line. Consider HSBC – if you invested in it 15 years ago, you’ve not only got a capital gain of over 600%, you’ve got a yield on your initial investment of 40%.
So at some point, it will undoubtedly pay to hold your nose, buy in and try not to worry too much over the years while they sort things out. But given the threat of a spike in NPLs, plus the fact that banks tend to perform poorly in a bear market such as this, now does not look like the best time to buy.
Turning to the markets …
Asian stocks rebounded last week after US GDP growth for the second quarter was revised up to 3.3%. Investors became more optimistic that global growth would hold up and bought back into stocks that get most of their earnings from exports and global trade.
Top performers in Hong Kong included Cosco Pacific, an arm of China’s largest shipping firm, and Foxconn International, one of the world’s largest electronic component manufacturers. However, clothing retailer Esprit was the worst performer in the Hang Seng; despite its Hong Kong listing, the group gets four-fifths of its revenue from Europe and no-one is upbeat on the eurozone economies at the moment.
China was a rare exception to the trend, with the CSI 300 closing down 0.6%. Its weakness in the face of strength elsewhere in the region suggests the Chinese market’s decline is not yet over. China is now the region’s worst performing market over the past year, down 56%
Surprisingly, Thailand closed slightly up on the week, despite worsening political problems. Prime minister Samak Sundaravej is in severe difficulties after the People’s Alliance for Democracy protest group – who would prefer to overturn democracy and replace parliament with appointed lawmakers – occupied his offices and other government buildings and briefly took over a television station. The head of the army has rejected Samak’s calls to intervene and restore order, saying that the prime minister should resign. Inaction by the royalist-supporting army suggests that Samak has no support from head of state King Bhumibol and his governments chances of survival look slim.
Elsewhere, anyone who believes that Asia is immune to the credit crunch should look at the iTraxx Asia indices, which show that credit spreads are ticking up again. Credit spreads measure the difference between the rate at which a normal borrower can borrow and the rate at which a risk-free borrower – usually the US government – can borrow; a higher credit spread means that a borrower must pay a higher interest rate and that lenders are less willing to lend to them.
In Asia, credit spreads for investment grade corporate borrowers are at 163 basis points (bps), from less than 50 last summer. Those for high-yield borrowers (also called “speculative” or “junk”) are at 593 bps from around 230 last summer. Both are down slightly from their peaks of 209 and 688 earlier this year, but credit spreads at these levels remain a severe worry for businesses that need to take on or refinance debt. Higher-risk or already-indebted firms are likely to have to pay a painfully-high interest rate or may even be unable to borrow.