China's Astonishingly Bizarre Land Development Finance System

One thing casual observers of China's real estate markets always try to say is that there is comparatively little leverage in the system, which means that any decline in prices is borne principally by the holders of the property and there are not ripple effects through the rest of the system. This is similar to how declines in stock prices tend to have very little collateral damage since they are very nearly entirely bought without leverage. Sure there is up to 2% of stock bought on margin in periods of excess, but compared to real estate markets, it's modest. That's why the stock market could shed $7 trillion in value during the 2000-2002 bear market and the broader economy felt very few ill effects from it. However, a similar decline in the value of residential real estate nearly destroyed the global financial system.

In China, however, it is simply not true that all real estate transactions are financed with equity. Indeed, a great deal of development is done by local governments, who engage in a program not entirely dissimilar from Tax Incremental Financing (TIF) in this country, where they borrow to develop certain properties and hope that they eventually pay for themselves (that's a very quick and dirty version of it). However, their practices are far sloppier than TIF districts in this country, and that's disheartening since a good number of TIF districts have run into trouble as well. Needless to say, in both cases, if the development stops, these financing deals run into serious serious trouble.

However, unlike TIF, properties are not valued according to fair market value, but in many cases in appears that local governments can just simply say what they're worth and use those amounts as collateral. This would be similar to if a financially troubled TIF district could hire an assessor to say that a $5 million hotel was really worth $57 million and collect the corresponding taxes on it. Fortunately, we have many safeguards in our system of property assessment and property taxation that prevent that from happening, including appeals and state oversight of local governments. China does not have much of a system of property taxation (though that is starting to change), and hence no good comprehensive system of property assessment.

Here are a couple of stories to chew on:

http://www.reuters.com/article/2011/07/14/markets-ratings-china-idUSL3E7IE0F520110714

http://www.bloomberg.com/news/2011-06-27/china-audit-office-warns-of-risk-on-1-7-trillion-of-local-government-debt.html

Does China's First Quarter Trade Deficit Mean Anything?

http://www.marketwatch.com/story/china-hits-first-quarterly-trade-deficit-since-04-2011-04-10

The short answer here is that it is too soon to tell. You'll notice that it was the first trade deficit since 2004, which was when China's trade surpluses really began to take off, reaching stratospheric levels in 2007 and 2008. China's first quarter trade numbers are always a little weird due to the strong seasonal effects of the Chinese New Year, but most of all the problem is likely tied to the deteriorating terms of trade that China faces due to skyrocketing commodity prices while consumer and industrial demand for Chinese products elsewhere in the world isn't growing that fast.

As to whether even a persistent trade deficit would mean anything for China, that's not clear either. Trade deficits can be problematic for countries with fixed currencies, but we are a long way off from a point of a balance of payments crisis in China. As a matter of fact, we are so far off from that that I feel bad for even including those words in the same sentence.

China's more serious problem has to do with its very sick real estate markets that are flooded with too much liquidity, too much supply, and prices that don't reflect reality.

Brazil = China? Well, EWZ = FXI

I was browsing the emerging market ETFs and, before I made an explicit comparison between the iShares Brazil ETF (EWZ) and the iShares China ETF (FXI), I said to myself "That chart looks awfully familiar...".

There is a reason for that:

They trade nearly identically. I remember once preferring Brazil over China, and most of the time that has made sense. Brazil's markets have vastly outperformed China's since 2004. However, it appears that since the huge 2008 correction in all emerging market stocks (and all stocks for that matter) these two markets have been locked in a very tight dance. I know that the Brazilian exports to China are one of the primary drivers of economic growth in Brazil, but you would think that differentials in company performance would produce more variance than this. 

Hong Kong Property Prices

We have previously discussed the property price bubble in mainland China as well as a similar bubble in Australia. Hong Kong, too, not surprisingly has been a center of quite a lot of speculative activity. There's a good post here about it: http://www.favstocks.com/hong-kong-bubble-hong-kong-residential-property-prices-july-2010/2024975/

I read a Bloomberg article today discussing whether or not it will be as bad as 1997. I really rather doubt that because while prices are approaching similar levels, incomes have grown notably in Hong Kong since then. However, there is little doubt that even with that income growth prices have still outstripped people's ability to afford them. This is all despite admirable attempts by the government to stop the bubble from building. 

On a related topic, the mainland Chinese government is rumored to be introducing a property tax in the fall. http://www.bloomberg.com/news/2010-09-21/china-may-unveil-property-tax-in-october-to-reign-home-prices-report-says.html A property tax similar to that in the U.S. does serve as a buffering mechanism to restrain house price bubbles for two reasons. One is that it adds a significant annual carrying cost so that you are dissuaded from sitting on property waiting for the right price. The other is that it cuts down on your expected rate of return and the tax is immediately capitalized into the house price. 

I will point out that states with high property taxes generally were spared from the housing bubble in this country, at least the most direct effects of it anyway. California and its peculiar property tax system actually encourage bubbles because house values are capped for property tax purposes at artificially low rates until they are sold. Depending on the rates China introduces, this will have a major effect on the housing market in China. Those sitting on investment properties that presently have no tenants will find the costs too great and be forced to sell while prices generally will take a hit. I think this is an interesting experiment on China's part to try to rein in a bubble before it reaches unmanageable proportions. However, it may be too late.

What if China's Real Estate Market Does Pop: U.S. Outlook

On the heels of Alex's post on his on-the-street view of the Chinese real estate market, I wanted to provide a good sense of what the actual risks are. As you may have seen earlier, I don't buy into the double-dip recession hypothesis except if there is a large unforeseen shock. Now, as soon as I wrote that, a reader might have gone "AHHHHH!!!! They've said this all before!" Indeed it does sound awfully familiar. Indeed, some friends of mine may know that I thought the 2008 recession, which I admittedly called in 2007, would be shallow and long in the absence of a total freeze in credit markets. In truth, even short of Lehman, it appears that it would have been deep in any case. So, I guess to try to be better prepared it might help to examine what are the potential channels of a relapse.

The first one we might want to examine, because its effects set in the quickest, is on the banking side. I drew up this little table that showed bank risks by country as of Q1 2010. I am quite sure these haven't changed much since then.

In relation to the risks that our banks took in the real estate sector, the risk to China is small potatoes. Even in the event of a total calamity, maybe 30% of that would be written off. Spread among the various banks that lend to China, it's not a particularly big deal. Now, I put in Japan and Korea because it's possible that some of the large financial institutions there have also been providing credit to China. I can't find data on that because: 1. The relevant websites are in their native languages most often and 2. Disclosure in most other countries isn't as good as it is here. It's actually one of the reasons the U.S. has commanded lower risk premiums over the years, recent experiences notwithstanding.

A second channel some might point to is the U.S. Treasury market where China might sell off assets and repatriate money in the event of a major financial crisis. There is actually historical precedence for that where in World War I France and the UK repatriated assets from the U.S. and helped contribute to a rather nasty decline in equity markets here. The fear is that China would cause interest rates to spike prematurely, raising borrowing costs for corporations and governments alike and that the interest rate shock could completely unsettle financial markets. However, this is only really a problem on a short term rather than a long term basis as what can happen is that the Federal Reserve could step in and soak up the sales and slowly work that off over several months in order to keep markets orderly. There is no guarantee that the Fed would do this, but they could do this.

The third major channel is of course through exports. Now, U.S. exports to China are running at about an $80 billion annual rate or so. This is about .7% of GDP. Even a huge hit to these exports of, say, 40%, would not be enough to drive the U.S. into recession, even in our presently weakened state. I have said as much before. However, I did some more thinking on this and of course there are other spill overs. Other trading partners including Brazil and Australia buy decently large amounts of capital equipment including mining machines from the U.S. in order to extract raw materials to sell to China. Add up the $36 billion at an annual rate we sell to Brazil and the $14 billion at an annual rate we sell to Australia along with maybe another $30 billion to other large natural resource extractors and you get, well, around another China's worth of secondary effects. I haven't looked closely enough at the trade data with each of those countries to know how much of what we export is actually economically cyclical, but the odds are that it is quite a bit.

Even with all of this, it would not be a calamity, but it could be enough to grind growth to a complete halt for a time given how modest growth is right now at maybe 2% annualized in the third quarter. Luckily, China seems to be dragging this real estate cycle out long enough that a crisis might not occur until our growth is a little more self-sustaining. As for some other economies, anything Australian-related worries me. They have this potential pitfall as well as their own housing bubble. Brazil would suffer badly if China suddenly stopped importing so much iron ore among other things. The same holds for Peru and Chile and whatever commodity-export countries you might think of.

Now, the Chinese real estate market should give plenty of warning signs before a collapse in both residential and non-residential investment might occur. The first would be stagnation in prices followed by a pullback of some sort. As prices drop, expectations about future returns drop leading to cancellations of building projects and a slow down in new projects. This in turn leads to a drop in the imports of raw materials and machinery. All of that actually takes some time to manifest and you can spot it in advance if you are looking for it.

U.S. Banks' Exposure to Risky Countries

I've heard quite a bit of talk about contagion from some of the more toxic countries in the world and I think it is helpful to actually quantify what we are talking about. I made this table based on data from the Federal Reserve on bank exposure by country:

As you can see, most of the high risk countries do not pose particularly mortal threats to the banking system. This is certainly true when you compare them to the size of the commercial and residential real estate portfolios that they had as of Q1 2008. The spill-over countries are a different story, with the UK being the most problematic if there suddenly was a complete collapse of the European financial system. However, that event looks increasingly unlikely. By the way, I included Australia and China due to their large and out of control real estate bubbles.

As such, I don't fear the risk of a sudden financial shock as much as I do the slow grind of deflation. With 10-year treasuries well below 3.0% now, I think the market is indicating the same.

China Slows and Hong Kong Likes It

This is never a good sign: http://www.marketwatch.com/story/hong-kong-shares-rise-as-china-manufacturing-slows-2010-08-01. The basic logic here is that bad data = lower interest rates = good markets. The reality always and uniformly is bad data = worse earnings = lower markets. I remember markets in the U.S. in 2000 rising on bad data toward the end of the year while awaiting Fed interest rate cuts and falling on signs the economy wasn't slowing. Of course, the recession came, earnings collapsed, and so did stocks. Same thing happened in late 2007 as well, though not as much.

I don't know why this sort of trade keeps getting executed, but oh well.

How Big is the Chinese Property Bubble? Pretty Big

I stumbled across a bunch of charts the other day and this one in particular caught my eye: http://www.businessinsider.com/chinese-land-prices-2010-7#likewise-price-increases-are-killing-income-increases-14 (Credit goes to Jing Wu, Joseph Gyouko and Yongheng Deng at NBER)

What I have said for some time is that despite migration patterns providing a substantial level of support to real estate in China, there is a fundamental problem where price gains have far outstripped income increases. This is also the reason I don't buy the idea that all of these houses are being bought strictly with cash, or at least cash that isn't at some point supported by debt. It just isn't possible.

Just to give you some idea of what a price to income ratio of over 20.0x in Shenzhen means, here in the U.S. California had a price to income ratio of right about 10.0x before prices started plummeting to about half of their all time high. Other markets still had decent sized corrections with price to income ratios of only 4-5x. Generally, much north of 4x is considered to be on the edge of pushing it nationally here while some markets can sustain, over time, more like 5-6x. I've seen some countries that can apparently sustain near 7x, but even for those countries that seems to be the point at which prices stagnate and wait for incomes to catch up.

Returning to China, it is true that there is regional variation, but that has been true in every real estate bubble in history. Here LA, New York, Miami, Las Vegas, Phoenix, Milwaukee, Cleveland, and Detroit all had very different dynamics. In the U.K., London, Liverpool, Manchester, Brighton, and Newcastle had varying degrees of excess. The same applied in Spain in the 2000s and Japan in the 1980s. It's a very non-compelling argument to say the least. What's more is that price to income levels mask another trait of real estate excess which is that those on the bottom end of the income spectrum often get caught up in the frenzy and buy much more house than they can afford in otherwise not particularly overpriced markets such as Atlanta.

It is unclear how much further this has to go, but perhaps Alex can expand with some first hand details on what he saw there.

Are Indian Bank Stocks Good Buys Now?

For years, the Indian bank stock, principally HDFC Bank (HDB) and ICICI Bank (IBN) have traded at earnings multiples that would make even an aggressive growth investor flinch. Back in the heady days of 2006 (at least they were heady days for emerging markets), these banks often traded at 30-40x forward earnings. That compares to the general practice of only paying 15x forward earnings or less for most bank stocks. Part of this discount, regardless of growth rate, comes from the fact that banks can in fact be prone to massive calamities. Of course, we wouldn't know anything about that. Speaking of which, I haven't seen my shares of Wachovia recently. Do you know where they might be? (Disclaimer: I never owned Wachovia)

That being said, after a few years of continued earnings growth and stagnant stock prices, it might pay to see where we are here. IBN, on its surface, seems to be the better buy, trading at around 14x next year's earnings and growing earnings at a torrid pace. HDB trades at over 21x next year's earnings with a very similar growth clip, though the market may be indicating that analyst estimates might be in error. Frustratingly, I must confess I know little of the Indian banking system, being much more familiar with Brazil's among the BRIC countries. What I do know is that the central bank is currently tightening which will probably keep these stocks under pressure for some time to come as their net interest margins come under pressure. I would say then that there is little reason to nibble here for now, but in about six months time it may be fruitful to buy one or both of these banks as long term holdings. The lofty estimates for earnings growth should be obtainable so India is a country with relatively low credit utilization.

Of course, there are those that are skeptical of India's long term prospects. I am not among them and I actually favor the long term prospects of India over those of China for the reason that I believe India to have a more fundamentally sound political system. I am sure there is going to be a great difference of opinion on that point.

On Bad Analysis and the Chinese Real Estate Market

It's amazing how some lines of logic will never die. I saw this article from Bloomberg about the likelihood of a collapse in real estate prices in China. In it was this absolutely awful line of reasoning from Stephen Roach:

"Rogoff’s view clashes with that of Stephen Roach, chairman of Morgan Stanley Asia Ltd., who said last month the property boom isn’t a bubble. While portions of the market such as high- end apartments are overheating, residential demand will remain robust as rural Chinese migrate to cities, he said in a radio interview in Hong Kong with Tom Keene on Bloomberg Surveillance."


Well, this actually sounds familiar. I seem to recall discussions about how the U.S. faced "pockets" of overvalued real estate, though when you added up the pockets they amounted to half the entire real estate market. Also, there were discussions about the growing demographic demand for real estate as well as the fact that inventories were temporarily lean. While not discussed much in this article, the same logic has been used to defend Chinese property prices.


At the end of the day, however, the problem is that average and median sales prices here far outstripped incomes, whatever temporary supply bottlenecks existed to support prices for an instant. In China, many central city areas, from what I have read, are priced at 14x median incomes. California, at the peak, was about 8-10x before declining approximately 40%. It may still decline further. Housing prices must necessarily be a function of incomes in the long run, whatever short term trends may distort them. This is similar to how stock prices must conform to earnings eventually as they are supposed to represent the value of a company. Asset prices cannot remain entirely detached from their underlying determinants for long ("long" meaning more than several years). 


Sometimes, I think analysts forget that asset prices cannot rise independent of their determinants in the long run. This is why they fall victim to bubbles so frequently. This is part of the reason that asset managers do not truly "create" wealth. In the end, it works out to be closer to a wealth transfer. In the case of China, incomes are rising, people are moving toward the cities, and financing has been plentiful. Against the backdrop of squeezed supplies, yes, prices can rise exponentially in the short run. However, the high prices will bring more supply onto the market and they will also sap demand. In time, financing too will ease as overlending will lead to higher default rates. At that juncture, prices will drop to a level more supported by the fundamentals. 


It is odd that a man generally as bearish as Stephen Roach is would fall victim to the sort of arguments that the National Association of Realtors used back in 2005. It could be that he is talking the book of Morgan Stanley in China, but I don't want to make that accusation without evidence. In any case, this bears watching.

A Housing Relapse?

There's a fairly good post over at Calculated Risk about the uptick in inventories shown in recent home sales reports. Additionally, as I have mentioned in the weekly economic updates, the temporary boost that the plethora of government programs has provided to the housing market appears to be giving way with some new price declines possibly setting in.

I would say, as does Bill McBride at Calculated Risk, that a new series of price declines would not be as catastrophic as they were previously. However, they will have a deleterious effect on economic activity and possibly make banks more unwilling to lend. Will it be enough to entirely derail recovery? I don't believe so, but it certainly bears watching.

Further, there is the possibility of synchronized declines with other major markets around the world such as Australia, which appears badly overvalued, and China, as has been previously mentioned. Australia is not a large enough housing market to sink the world, but when the bubble there starts bursting, it will cause some pressure that, if it occurs at the wrong time, could make life difficult.

Anyway, those are just my two-cents.

Will China End the Peg?

We'll see if this latest signal turns out to be anything. There are those that have been buying Chinese ADRs for months and even years on this proposition because as the dollar weakens, Yuan denominated assets rise in value automatically. On a related matter, I hope to write a short piece on exchange rates and their effects on investment decisions tomorrow.

A Nervous Eye Toward the (Far) East

Technically Europe is a closer east than Asia is, but I will conform to the conventional parlance on this one. In any case, while the concerns around Europe are well known, I have been more closely tracking the troubling developments in the property markets in both mainland China as well as Hong Kong, and I don't like what I see. 

From this Bloomberg article on Hong Kong: 
"Home prices have risen 41 percent since the end of 2008, prompting the government to tighten down-payment requirements for luxury homes in October to curtail speculation after record- low interest rates fueled the surge. Financial Secretary John Tsang on May 12 pledged to keep boosting land supply."


Home prices up 41% in 16 months? That's worrisome to say the least. Considering that in the long run home prices are a function of incomes, I find that a little odd. I suspect that there are some at the upper ends of the income strata in Hong Kong that have seen even greater than 41% income growth and that is probably what is propelling prices higher at the margins. However, just as in California five years ago, the super rich are never enough to support a large real estate market (and despite being only one city, Hong Kong is a large market). Eventually, California reached a point where 88% of the population could not afford the median house. Yes, that is just as silly as it sounds. Hong Kong is at a similar juncture right now. Prices will have to correct, the question is when.

Threading Strategies Together

Several different strategies have been discussed here on Finance Monitor along with numerous individual investments and I thought I would provide some context on how to view the discussions in the context of your own investments. The fundamental goal of this post is to weave several different posts on different subjects together. I will try to provide links so that you can quickly look up the prior discussions.

I guess the proper way to start this conversation was with the prior post on risk reduction in portfolio construction. This is one way of looking at your macro strategy, though there are many potential variations on this broader strategy. Within the core portfolio, either use equity index funds or balanced funds and basically just try to keep your overall allocation right, unless you want to be a little more active here. Then, you can engage in what was discussed on the post on dynamic asset allocation.

To do this, use the SPY and TLT ETFs at a basic level. If you have less than $2,000, I strongly encourage you to only re-balance when interest rates suggest you make a large reallocation from stocks to bonds or bonds to stocks. If you re-balance with every twinge, you'll get eaten alive by commissions. For example, let's say the model changes each month and you re-balance with $7 commissions each time (on both purchase and sale) with a $2,000 balance. You will incur $14 a transaction 12 times for a total of $168 in commissions. That would be 8.4% of your portfolio or greater than your average annual gain. With $20,000, it's 0.84%, which is bad, but not ruinous. If you are so fortunate to get up to $100,000, the fees are very low indeed. The ETF fees for TLT and SPY are also very low. In the case of SPY they are 0.09% per year and 0.15% on TLT.

Investing in China: Now, Later, or Never?

I will preface this entire discussion by saying I am not an expert on China. I do not know a word of Mandarin (or Cantonese for that matter), I do not know the names of more than 25 Chinese companies, and I have never been there. I do, however, know a fair amount about Chinese history and Chinese economic development. As there are a few of you that know more about certain aspects of China, I welcome your input.


Of course, when any economy is growing 11% a year, there is a great temptation to want to invest in that country's markets. With China, where the economic prospects seem so favorable, this is particularly true. However, historically the Chinese stock market has proved a treacherous mistress. For most of the ten years leading up to 2006, Chinese stocks, measured by the CSI 300, did not do particularly much of anything even while the economy boomed. Then, between 2006 and early-2008, Chinese stocks increased nearly six fold, one of the most powerful rallies by a major economy's markets in history. Then, over the next ten months, stocks fell 73%, wiping out most of the gains of the past three years. Over the ten months from October 2008 to August 2009, stocks rallied by better than 100%, out-pacing most other markets. 


Since then, however, China has been an unusually poorly performing market, even rivaling some of the troubled European markets. The CSI 300 has fallen from 3,750 in August to 2,762 now, making it one of the few bear markets anywhere in the world. Its best proxy listed here, the iShares FTSE/Xinhua China 25 Fund (FXI), has badly trailed the S&P 500 over 
the past year. Despite all of the talk about China being a better place to invest, the
markets have said otherwise: