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Part XII - The Dominant causes of the Credit Crisis: Cracks in China's Residential Estate Market as it approaches an ocean of icebergs



-- Posted Friday, 24 February 2012 | | Disqus

By David Collett

The widening gap between supply and demand in the residential estate market

The rate of urbanisation versus growth in residential floor space

Overcapacity and wealth concentration

Like the Titanic at the time, China is the biggest in the world in many categories. It’s the biggest exporter, the biggest manufacturer and the biggest property developer in the world. The unwavering belief that China’s real estate market can continue to expand at the current pace without blowing up is probably stronger than the belief in the early twentieth century that the Titanic was unsinkable. But China’s real estate ship has just entered an ocean full of icebergs. Any encounter with these icebergs will probably have the same disastrous consequences as it had for the Titanic. When the crash finally comes, China too may find that it has insufficient lifeboats to engineer a “soft landing”.

The Titanic on its maiden voyage

Part XI of “Dominant Causes of the Credit Crisis” describes the breathtaking speed at which China’s investments in fixed assets are growing. A major part (+-23%) of these investments was channelled into real estate development. The amount allocated to residential real estate is equal to 16% of China’s total investments in fixed assets (TIFA). After investments in real estate grew at a rate of around 25% p.a. from 2003 to 2009, it accelerated in 2010 and 2011 to above 30% p.a. It slowed since October of 2011, reflecting the downturn in the market.

It is difficult to grasp the full extent of floor space created by China’s building programs.  When evidence emerged a few years ago that China has built one or two ghost towns, it was seen as an aberration. Since then more evidence came to the fore to suggest that overbuilding is the norm rather than the exception. Many more ghost towns and suburbs of empty residential units have been detected as time passed. Satellite pictures show new evidence of “forests of skyscrapers”, city buildings and residential units that are not inhabited. From electricity meter readings it is estimated that 64 million housing units in China’s cities are unoccupied (subsequently disputed by Chinese authorities).

There are many opinions as to why China has embarked on such a seemingly excessive building program. One is that the central government is exercising huge pressure on local governments to produce growth at any cost and another is that local governments are motivated by the large income (such as land transfer fees) produced by property and land deals. Others refer to the great urbanisation that is still to come.

Residential estate developers had a great run for at least the last decade but by September of 2011, storm clouds started to gather on the horizon as developers’ sales slumped. They started to give substantial discounts on residential units and lately there are many reports of developers that are experiencing cash flow problems.

Fundamentally, the residential estate market is unsound because China does not have sufficient buyers with the financial wherewithal to buy the housing units that are coming unto the markets. If you classify an urban worker, who earns the average urban wage of +- 40,000 Yuan (US$6250) per annum in 2011, (or estimated average family income of 65,000 Yuan) as part of the so-called rising “middleclass” - the middleclass cannot afford a housing unit in the big cities which are generally priced well in excess of a 650,000 Yuan (US$100,000). Migrant workers are paid about a third of its urban compatriots’ average wage and are therefore even less able to make an impact on the residential market.

The ascent in house prices from 2003 to 2010 is simply astounding giving the fundamentals referred to above. Average house prices tripled between 2003 and 2009 and then went up another 30% in 2010 in some cities. Price to income (in excess of 10:1) and price to rent ratios are all evidence of the unsustainability of the prevailing housing market.

The widening gap between supply and demand in the residential estate market

A relative small group of high income earners bought most of the residential units from plan for investment purposes. From 2001 to 2007, supply and demand moved in tandem. As shown in Chart CA1 below, the residential market hit its first snag in 2008 when the supply/demand gap widened significantly. This gap quickly closed in 2009 as China opened the credit spigots (green line) to stimulate the economy. This credit expansion included a substantial jump in mortgage loans in 2009. But as the pace of investments in residential estate continued to increase from 2010 to 2011, the supply/demand gap began to widen ominously as indicated by the 2nd black arrow on the chart. It came as no surprise when the widening gap started to impact prices and sales volumes from around September of 2011. Prices dropped markedly and sales volumes slumped. It confirmed the reality that not even China is able to defy the gravity of market fundamentals over time.

Not surprisingly, some economists and commentators in the mainstream media are putting a positive slant on the fall of the residential estate markets since September 2011. According to some of them, the recent downturn in the market was orchestrated by the Chinese government by tightening its monetary policies and placing limits on how many houses an individual could buy. All of this was supposedly done to ensure a soft landing for China’s residential estate market. The market’s decline, according to them, is therefore temporary in nature and there is no shortage of confidence that things will return to “normal” once government relaxes the monetary and market restrictions. Government measures may have played a role, but it is by no means the major cause of the deterioration in the residential market.

The above chart suggests that the residential market’s earlier demise (2008/2009) was prevented by the massive injection of credit into the system and that an even bigger injection of credit will be required to revive the markets for maybe another year or two. The acceleration in real estate development (floor space started) from 2010 onwards simply overwhelmed demand. Although investment in the residential market started to slow at the end of 2011 it is unlikely to continue to slow fast enough to allow demand to catch up. As pointed out in Part XI of the “The Dominant causes of the Credit Crisis”, residential estate development is a major component (16%) of China’s investment in fixed assets. Any major slowdown in real estate development will have far-reaching consequences for China’s GDP growth. It will not only impact the capital formation component of GDP but also the government consumption (less transfer fees etc.) and household consumption (fewer wages and other income) side of it.

To make matters worse, the government has embarked on a vast project to build more affordable housing for the lower income earners.  This could only add to the existing oversupply in the housing market. However, it is quite clear that China cannot proceed to develop residential estate at the current rates of expansion. If the current (2010/2011) trends are projected forward to 2020 (chart CA2), the supply/demand gap becomes untenable –suggesting that a market implosion will occur long before 2020.

The first black arrow shows the current gap (2011) between supply and demand and the larger black arrow, the supply/demand gap at the end of 2020. China has only two options – reduce its investment growth from the current 30% to 3.42% (blue dotted line) per annum over the next nine years or increase mortgage credit at a pace well in access of 30% per annum with the hope that it will have the same results as in 2009. To continue as “normal” would be kamikaze economics.

The rate of urbanisation versus growth in residential floor space

One argument that is often raised is that all this space is necessary to provide for future urbanisation. But is this argument really credible? Chart CA3 below, shows that the pace of growth in urbanisation is in decline. For this trend to increase substantially, China will have to increase it’s already sky high fixed investment program by a substantial margin –which is neither feasible nor achievable.  

Looking at the rate of increase in the number of urban workers does not give comfort either. The rate of increase was slightly above 3% until 2007 before it also slowed down.

Chart CA5 below gives some perspective. The growth in residential floor-space in urban areas is clearly moving in the opposite direction of the growth in urban population or the growth in number of urban employees. There is no rational reason why the urbanisation rate will increase to the extent that it will catch up with the current growth in urban residential floor-space.

Overcapacity and wealth concentration

The evidence is overwhelmingly in favour of the argument that China created excess capacity in the residential sector primarily to achieve growth at any price. But as pointed out in previous articles, there is not only overinvestment in the residential sector but overinvestment in manufacturing, infrastructure and other sectors. China has no convincing strategy to bring supply and demand into balance. Although they have a new five year plan to increase consumption, it is not cogent and their track record on this issue rather points to a further widening of the supply/demand gap. They are most likely going to try and kick the can as far down the road as possible. This might be a dangerous ploy as the window of opportunity to close the supply/demand gap is closing fast.

As explained in Part II; III; IV and VIII of the “Dominant Causes of the Credit Crisis”, the world moved into a cycle of increasing income and wealth concentration over the last four decades without showing any signs of reverting back to the more equal distribution levels of the 1960’s. The top 1% has taken an estimated 15% to 20% share of total income (realised and unrealised) from the bottom 99% over the past four decades. As a consequence, demand is growing slower relative to the supply that is generated by increasing investments – which is a direct result of the top 1%’s increased income and savings (See Part IV and XI  in this regard). As relatively higher labour costs and stagnating demand in developed countries blunted margins and investments in productive capacity, many businesses moved their existing facilities and/or any capacity expansions to China and other developing countries. Initially these new investments spurred growth in the developing countries as it pulled millions out of poverty. This also increased world demand to some extent, but as wealth concentration took hold in China and other developing countries; the same process (see Part III and IV) is threatening their economies.

China is one of the last bastions for the unchecked accumulation of fixed asset investment and by implication – the savings of the top income earners. But as increasing overcapacity has now become one of the greatest threats to the world economy, it’s unlikely that it would end well. If China cannot find a way to substantially increase its consumption side of GDP growth within the next few years (if not too late already) the world economy may well tumble into a trade war and/or a deep recession.

© Copyright David Collett 2012.

Whilst every effort was made to ensure the accuracy of this article,  neither this document; nor its author, David Collett; nor any publisher of this article; offer any warranties (whether express, implied or otherwise) as to the reliability, accuracy or completeness of the information appearing in this article. Neither do any of the above parties assume any liability for the consequences of any reliance placed on opinions expressed or any other information contained in the above article, or any omissions from it. Its content is subject to change without notice. Any information offered, is intended to be general in nature and does not represent any investment or business advice of any nature whatsoever. If you choose to rely on such information you do so entirely at your own risk. Neither David Collett nor any third party involved in publishing this article, assume any responsibility or liability for the outcome of such reliance.


-- Posted Friday, 24 February 2012 | Digg This Article | Source: GoldSeek.com

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