The Chinese Conundrum

Bubble Bubble everywhere, Whos the one to Prick

Author:

Mohammad Riazuddin
ZAD Research

Date: 25th, Aug 2015

Foreword
We have all been weary of the expansion of Central Bank balance sheets across the globe leading to
asset price appreciation and immersion of financial system in cheap liquidity. However, the front line
economic numbers seemed to support the monetary policies as growth, no matter how insignificant,
did show up in developed economies, whereas emerging markets continued to soar. We kept on
looking for cracks in developed markets, however the actual bubble was being created in developing
nations. The following chronology might be able to capture what appeared and what actually
happened behind the curtains:-

2001-2007
The Obvious:

Imminent drop in consumption in developing markets was captured and further bloated by weak
monetary policies leading to housing and consumption bubble.
In the Background:
Technology and cheap capital shipped high paying jobs and production to emerging markets. Export
led economic model flourished in Asia. Prime beneficiaries were China, Taiwan, India, Malaysia etc.
Emerging market also benefitted from capital flows emanating from US & Japan hence coining of the
term carry trade (borrowing in countries with low interest rates and investing in high yielding assets
in other countries)

2008-2009
The Obvious:

Financial collapse lead to chocking of western financial system, the epicenter of world economy.
Innovative monetary techniques used to reflate assets and spur demand. Massive doses of liquidity
injected in system to bolster economy
In the Background:

Meanwhile, China decided to restructure its economy to one based on consumption rather than
exports. It gave massive stimulus do domestic economies, lowered interest rates and opened up its
economy further

2009-2014
The Obvious:

The massive liquidity and zero interest rate policy (ZIRP) elevated moods and stock markets coming
to rescue most if not all asset classes. The ones to rejoice most were the bankers followed by junk
raters (private companies, govt. organisations as well as bankrupt countries like Greece)
In the Background:

The liquidity war-chest opened in West and extreme east (Japan) went into hunt for yield beyond
their naturally preferred habitat (in terms of quality as well as region).
An infrastructure and capital asset bubble in East mostly Asia (pre-dominantly China)
Capital Investment as a %age of
GDP increased from 35% of GDP in
year 2000 to 48% in 2014.

%age contribution to GDP, China

50

48
45
40

35
35
30
25
20.7

22.6

20
15

Export

Capital Formation (Hard Investments)

What China meant for worlds

On its way to develop such huge infrastructure, it sucked in massive amount of hard commodities and
soft commodities (leading importer of Oil,iron ore, coal, soyabean, dairy, copper etc.), ones that it
could not produce itself, or erected capacities to support such infrastructure spends.

(Note: China became the largest Oil importer over taking US this May, 2015)
It also lead to economic superfluous in its major suppliers
China Trading Partners

Imports ($ Bn)

% of total imports

Nature

South Korea

190

9.70%

Electronics

Japan

163

8.30%

Electronics & Machines

US

160

8.20%

Electronics & Machines

Germany

105

5.40%

Vehicles

Australia

98

5%

Brazil

52

2.60%

Ores, Coal
Ores, Oil seeds

2015
All the above along with many other global factors culminated into something that we are seeing
today. The obvious and not so obvious scenarios are illustrated below.

1.

Massive over capacity in China and disproportionate consumption Steel

Chinese Capacity - ~1.2 bn tons
Chinese consumption 822 mn tons (50% of world production, followed by EU, US and Japan)
Excess Capacity ~387 mn tons (32%) Combined consumption of US, EU and Japan is 367 mn tons

Cement (2013 data)

World Production 4 bn tons
Chinese production 2480 mn tons (62% of world production) [Largest producer followed by India at 280 mn tons]
China consumed 6.4 bn tons between 2011-2013. US consumed 4.5 bn tons in entire 20th century.

The debt that funded the growth

2.

China survived the 2008 crash because private debt has been constantly close to 100% of GDP. It has however
increased by 80% of GDP in just 6 years and has reached a level where credit driven growth is extremely hard
to pursue further. It is eerily close to the levels seen by US and Japan before their collapse in 1990 and 2008
respectively.

Size and structure of Debt

Debt composition
Not only the size but composition of Chinese debt is also worrisome. Nearly half of Chinese debt is tied to
real estate

Household debt composition

47% of household debt is
mortgage and 58% of their
disposable income. It has
however grew by 21% pa
through 2007-2014

Supernormal growth doesn't mean bubbletill

The above data and figures clearly point out to an over investment in infrastructure and real estate funded by
high level of debt. However, that does not necessarily point out to a bubble, but the following factors do:
a) Massive growth in Gross Floor Area (Absolute and per capita)

Supernormal growth doesn't mean bubbletill

In end 2013, over 64.5 mn homes registered zero electricity consumption implying either they prefer to live with candles
or they are vacant
Wall Street Journal quotes more than 1 in 5 homes are vacant and occupancy rate for sold units published in end 2013 was
22.4% (49 mn).

Even if the urbanisation rate were to increase by 10% (already 54%), it would result in a reduction of mere 2.6% in vacancy
rates. The mortgages tied to such homes totaled $674 bn. In addition to that, it estimated that there were 3.5 mn unsold
units in China.

Supernormal growth doesn't mean bubbletill

To put things in perspective, , average disposable income per capita in China is ~$4500 per annum. Assuming a 50 sqm
room for a couple in Shanghai, price of property would be 33 times an average couples disposable income (assuming one
person works). This implies that it would take over 33 yrs of disposable income to pay down price of a basic property in
Shanghai. However, it is an average. With growing disparity in wealth in China, the Median household income is far lesser.
The following table shows a comparative picture of property affordability in cities across the world. (Click here for map)
City
Hongkong
Beijing
Taipei Taiwan
London
Mumbai
Shanghai
Shenzen
New York
Singapore
Jakarta
Tokyo
Paris
Sydney
Melbourne
Average

Price to Annual
Income Ratio

Gross Rental Yield (City

Center)
45.4
34
30.5
30.5
30.4
26.6
26.3
25
23.8
23.8
23
20.6
12
9.33
25.8

3
2
1
2.5
1.8
2.2
2.1
3
2.7
6.5
2.3
2.2
3.6
4
2.8

Mortgage cost as % of
Income
299
295
188
218
371
231
224
182
147
303
138
137
95
75
207.4

Key characteristics of Chinese Property Market

Many ghost cities, though dubbed as ghost cities were never completed as not enough buyer (resident) interest
developed. Case in point Xinyang, Yujiapu, Erenhot and many more.

Built too early - Migration is best if its voluntary and gradual

Built to encourage land sales - According to the World Bank, Chinas cities must fend for 80 percent of their expenses,
while only receiving 40 percent of the countrys tax revenue. Many municipalities use land sales to make up the difference.
They buy land on the outskirts of cities at the low rural rate; rezone them as urban; then sell it on to developers at the high
urban construction land rate.

The profits are huge. The Ministry of Finance claimed that land sales raised $438bn for Chinas local governments in 2012
alone.
Developers mandated to build early Most of the times the land parcel is far from inhabitation and lacking general
connectivity, social (Schools, universities, hospitals) and hard infrastructure (roads and rails). Then they are forced to build
something on it fast rather than gradually. This is to meet local govt. growth targets
Built (and sold) but no one moves in till they see semblance of civility, and social infrastructure developing
Housing bought with intention of moving deep in future if ever
Lack of economically affordable housing Such houses can be sold for not more than 3-5% over construction costs, but
developers are hardly interested in investing in such projects

Its in best interest of local govts. to slow migration into these newly built cities as once population arrives, social
infrastructure needs to be erected and made functional which costs local govt. Hence every city will need to go through
this ghost town phase

The Bubble Transformation

Export
Bubble

Capacity &
Infra Bubble

Property
Bubble

Stock Market
Bubble

Why was Stock Market Bubble necessary

1. Wealth effect Chinese households hold about 13 trillion yuan ($2.1 trillion) in stocks, according to
estimates by research firm Gavekal, but theyve invested some 149 trillion yuan in urban housing.
As evident from the large unoccupied and
unsold inventory of property, the coming
collapse in prices were endemic. Hence, since
late 2013, Chinese govt. began propagating
stock market as the new avenues of wealth
creation.

Motivation for Stock Market Bubble

2. To rescue debt laden State Owned Enterprises (SOE) SOEs the executive arms of the govt. which are known to be
corrupt, inefficient as well as motivated by politics more than economics were heavily laden with debt (estimate of
D/E ratio of close to 200% in 2013). They were destined to fall, but the biggest Debt-Equity swap happened, with
SOEs raising Equity to pay down debt at higher talked-up valuation supported by accommodative monetary policies

The Stock Market Propaganda

How Chinese govt. talked up the markets: Using state machinery to propagate stock investments
Manipulating financials and growth numbers to create the
eternal growth hallucination
Easing margin lending rules, allowing people to borrow more
to invest
(Aside: More than two thirds of new equity investors exited the
education system by middle school which in China means
around the age of 15)
Allowing (already over valued) property to be furnished as
security for margin trading

The Final Show-down

The teaser..
Relative Price Movement of China destined commodities
120

100

80

56
60

42

40

30

20

Copper

Iron Ore

Steel

Copper, Iron Ore and Steel price in China

fell by 44%,58% and 70% respectively over
the last two years; clear indication of
slowdown as China represents the largest
importer and consumer of the produce.

Chinese real GDP growth (if you really believe the official data) has only been at this level once
in past two decades

The official data are deception at best

The official data are deception at best

The roller coaster

Shanghai Composite Index increased by 152% over a period of 12 months from June 2014 to its peak in June 2015 despite country going
through worst economic growth over past 2 decades. It has however corrected by~43% since then, but it is still 44% higher than last June.

Govt.s rescue, death of Free Markets Nothing covert about it..

In order to support theequity markets, Chinese govt. resorted to most unconventional to almost draconian
measures including : Allowing companies to seize trading in their shares. At one point, more than half the listed shares did not
trade
Disallowing shorts
Allow pension funds to invest 30% of their net assets (equivalent to more than $100 billion) in equities for
the first time.
Prohibition on sale of shares by company employees and shareholders holding more than 5% for 6 months

Banning 28 firms from coming out with IPO in the 2015

Lending $40 bn to state owned banks to support markets

Leading brokerage houses commit $19 bn to invest in blue-chips under govt. duress of course
Finally reducing benchmark lending rate by 25 bps , fifth since Nov 2014, to 4.6% and reducing reserve
requirement for banks by 50 bps to 18%

Collateral Damage
Feeder and neighboring country markets corrected along with China
Major Indices
2m correction %

Australia
7.4

Brazil
17.9

Indonesia
14.1

Malaysia
8.6

S.Korea
11.7

Japan
14.0

Emerging Market Currency Rout

Relative currency performance (against USD)
105.0
100.0

Related currencies
AUD
1yr Dep. In currency % 22.3

95.0

90.0
83.6

85.0

77.7

80.0
75.0

74.9

70.0
65.0

64.4

60.0

AUD

IDR

MYR

Brazillian Real

IDR
16.4

MYR
25.1

Brazillian Real
35.6

To sum it up.
Slower China, Healthier China A hard crash is imminent for China. However, govt. debt is still not very high and
they still have certain ammunition to delay or spread out the pain. Like what they did on Tuesday (reducing lending
and reserve ratio). However there is no escaping from the slowdown. China is most likely to follow, albeit
reluctantly, the path lead by Japan and US in term of massive liquidity injection.
Countries that dependent on Chinese infrastructure boon (Australia, Brazil, Indonesia, Malaysia, South Africa etc.)
will suffer as they had extrapolated the Chinese demand and have invested heavily in capacity building to service
the Chinese demand. At such abhorrent levels of commodity prices, many such investments will go down and have
their respective ripple effect in their respective economies
Competitors China has jumped into the currency war by devaluing its currency by 2% last week and will be
forced to allow its depreciation further. This would further increase competitiveness of Chinese goods.
US Treasury sell-off Since US imports have dwindled China has stopped investing meaningfully in US treasuries.
However, to support it currency it might be forced to reduce it treasury holdings. China has sold of close to $180
bn in US Treasuries over past year.
Losses in China will extend the contagion to other emerging and developed markets which will again lead to delay
in Fed Rate hike. September will become very difficult as markets correct worldwide
Countries that compete with China for capital and have little or no fall out from China will stand to benefit the
most once the de-leverage and recoil completes and dust settles. India would stand as the best contender for
capital.

Thank You