The Strange World of Chinese Real Estate Liquidity

We are frequently so entranced with the meteoric price increases of Chinese real estate that seem to dwarf anything we’ve seen before that we frequently lose sight of details that really matter.  These details beyond price headlines really matter because many of these are the market dynamics that impact future changes.

One recently caught my eye and I will be honest in saying that I’m still trying to process the impact of what this data means.  The Chinese real estate market has extremely low levels of relative liquidity.

What I mean by that is that relative to the number of housing units in specific metro areas, there are actually a relatively small number of housing transactions.  Many times transactions will be reported for major metro areas in China, but there is frequently little context given that obscures the relative measure of liquidity.

To give you, some idea of what I mean the average home in the United States is sold roughly every 20 years.  This excludes housing units that are apartments, but gives us some idea.  Furthermore, this number does not fluctuate as much as you might think except in extreme periods like during and after the 2008 subprime crisis.

However, in China these numbers are astoundingly different.  As an example, in 2015 Shenzhen housing transactions relative to the number of housing units was under 1.9%. If each unit could only be sold once before being sold again, it would take Shenzhen 54 years before being resold.  What is amazing is that projected 2016 housing transactions in Shenzhen have gone down from 2015.  If current rates hold, unit turnover will fall to about 1.2% or approximately an 86 year turnover cycle.

In other cities, we see similar levels of low relatively real estate market liquidity.  2016 projections, estimate Shanghai unit turnover at under 2.7%, Tianjin at 3.4%, and Xiamen at 2%.  This would equal cyclical turn over rates of 37.6, 29.6, and 50.3 years.  To put these numbers in perspective, China only opened in 1979 so according to these numbers, each unit has yet to even sell a second time with many years to run.

Other cities show similarly low levels of relative unit turnover.  I’ll be honest in saying that giving some the peculiarities of the Chinese real estate market, I’m still trying to think through all the potential implications.  I have a couple of theories.

First, it is quite likely that Chinese real estate hit a tipping point a few years ago where real estate had been transferred on a preferential basis to existing urban residents under various schemes, the large majority of savings had been consumed to purchase housing units, and the only driver of the Chinese real estate market became channeled credit via state owned banks.  As I noted in a previous post, 2015 was the first year where the marginal new housing unit would have equaled a mortgage of greater than 50% LTV.  2016 is likely to be a significant increase from 2015 implying that the real estate driver has changed from a couple of years ago.  It is not longer unit transfer and savings consumption and credit growth of households.

Second, this seems to place a lot of pressure on Beijing to keep real estate prices elevated.  Many in China view this as a form of savings given the lack of other options and household income levels that are both under pressure and slower growing than real estate prices.  While households are little invested in the stock market, they are heavily invested in real estate implying much higher wealth dependence effect on real estate.

Third, it seems to imply much greater fragility in supporting the real estate market than is generally assumed.  Typically when prices go up, we see rapid growth in turnover volume but not only have we not seen this, in some cases we have see a decline in turnover.  The only apparent support of the real estate market is higher credit growth which means to support this, PBOC will need to pump even higher levels of credit to support price increases or stability.  This implies a lot more fragility in the real estate market given the relative lack of volume.

I think there are other implications but I’m still thinking through many of these implications.  However, I think it is pretty clear, there is a lot more going on here that requires thinking about the market microstructure of what is driving these dynamics.

Follow Up to Bloomberg Views on Real Estate Asset Price Targeting

I want to write a little follow up to my piece in Bloomberg Views about real estate prices in China.  As usual start there and come here for the follow up and explanation.

It is not just the value of real estate prices that I think is concerning but the framework for what is driving the increase in prices and the theory behind it.  Before I focus on the Chinese situation, let me back up to before the 2008 global financial crisis and what economists were arguing about before the collapse in US housing prices.

Prior to the collapse in real estate asset prices in the United States in 2008 that precipitated the global financial crisis a key, albeit somewhat wonky debate, was whether monetary policy should worry about asset price inflation or just aggregate price inflation. Then Governor Fredric Mishkin argued in a May 2008 speech that “monetary policy should not respond to asset prices per se, but rather changes in the outlook for inflation…impl(ying) that actions, such as attempting to ‘price’ an asset price bubble, should be avoided.” It is questionable in light of the 2008 financial crisis, whether this argument would hold sway today.

On a brief side note, I would love to see a vigorous debate on this topic but there has been little debate on this topic.  I think it is generally accepted that loosened monetary conditions have helped push up asset prices in developed markets, but I have not seen much debate about whether monetary policy should be used to try and restrain asset prices or even drive them down.  Alan Greenspan actually argued before 2008 that monetary policy was better placed to help stimulate after a bubble has popped rather than trying to determine the correct level of asset prices.

Chinese authorities, more for political reasons that from an adherence to economic modelling, have implicitly targeted what they believe to be an acceptable growth rate in real estate prices.  Using a combination of monetary stimulus and regulatory measures, Chinese officials implicitly target real estate asset price growth that they believe represents an acceptable rate of price growth.

This has resulted in a couple of conclusions or outcomes. First, Beijing appears to have an implicit real estate asset price target.  I say implicit because they have not announced a specific price target as part of the monetary policy framework, but it is clearly near the top of the list of prices they watch and there is a clear monetary and broader regulatory real estate asset price target. They do not want prices sinking nor do they want prices rising too rapidly.  Given what we know about how Beijing manages the prices of all other prices and asset prices, I don’t think it is a stretch at all to believe or watch how they behave and see an implicit asset price growth target framework at play here.  Second, Beijing does not appear that good at price targeting.  Just like the Fed, BOJ, or ECB with their broader inflation targets, the PBOC does not seem that good at asset price targeting though they continually miss on the high side rather than the low side.  Third, there is a clear behavioral response to the implicit real estate asset price target.  There is a reason about 70% of Chinese household wealth is in housing and people buy second and third apartments. There is an expectation that the real estate price target framework of Beijing will be carried out resulting in safe appreciation.

I have become incredibly skeptical of the implicit asset price targeting because you see how clearly investors behave in response to the unofficial asset price growth target.  Asset price growth targeting by central banks inevitably leads to gaming of the system by investors.  Though it may be difficult for investors to profit from generalized 2% price increase, it is much simpler when the government is targeting price increases in such a fundamental asset as housing in China.

I also wonder if there is a difference between asset price targets and specifically about the amount of leverage attached to the asset purchase or amount of wealth it represents as a portion of the national portfolio.  Given the 70% portfolio slice of household wealth, should we differentiate between that major portion and the portfolio holding that represents say 10%.  I would think based just on the wealth effect, there is good reason to treat real estate differently than other assets.  This would seem to imply targeting a lower real estate asset price growth target.

It may also be necessary to think about asset prices differently based upon the debt tied to them.  Use a simple example, you can buy a stock with a 10% return or you can use that same money to buy a house that you also take mortgage to buy that will grow in value 10%.  Now Chinese households are not as leveraged as US households, but I have heard way too many stories of how Chinese skirt the financial system rules to believe it isn’t a lot more widespread than people believe, but given the leverage attached to mortgages, there is higher risk.  Assets attached to rising leverage ratios, as is the case with China, might signal the need for a lower asset price target if one at all.

Finally, it should not be overlooked at housing prices started rising so dramatically as real economic output was really slowing so dramatically.  Previously when real estate prices were rising so dramatically, it was argued it was not a bubble but tied to expectations about future economic growth.  However, with economic growth slowing, and household incomes slowing even more, what is the fundamental rationale now for home price increases?  The real estate asset price target is clearly out of sync with the broader economic reality.

I return to two simple questions: how appropriate is an asset price growth target for China, what are the risks they are running, and how good are they at producing desired results? I would say: not very, high, and not very good.

The Enormity of the Fire Breathing Debt Dragon

There is some skepticism of just how large the approaching debt crisis is by China-Dragons.  The argument goes that just as China did a little over 10 years ago, Beijing will simply create a bad loan  management firm to take those assets of the banks balance sheets.  The simple problem is this: the sheer size of the financial stress dwarves what even the Beijing puppet master can muster.

The South China Morning Post who has probably the best China coverage in the world puts the sheer size of the debt dragon into perspective and the role Beijing played in creating it:

“While many small and medium-sized enterprises, hobbled by a slump in exports, cried foul at missing out on their share of stimulus cash, steel traders were among the biggest beneficiaries of the state-backed loans.  In 2009, Shao and other steel traders were approached by banks which were actively seeking to extend loans to the private entrepreneurs. “They simplified loan approval procedures, gave us discounts to interest rates and encouraged us to take advantage of regulatory loopholes to borrow the money,” Shao said. “We are strong believers in the saying that cash is the king; therefore, we were more than happy to take the money.”

In other words, the banks were chasing down favored industries and companies pleading with them to take more loans at discounted rates.  But wait, it gets better:

“Shao says loan assessment officers told him he could move the same batch of steel products he had already borrowed against to a different warehouse, and use it as collateral against another loan. “Steel products worth several million yuan could be collateralised several times to obtain credit that amounted to scores of millions,” said Shao. “Nobody cared about our repayment capabilities at that time.” Some of the money went back into the steel trading business, with newly bought products being used as collateral to secure yet more easy credit. A steel trader with a personal net worth of 100 million yuan could eventually have about 10 billion yuan of cash on hand via the aggressive borrowing, people with knowledge of the situation said.”

Read that again in case you missed it: by using the same product as collateral to obtain many different loans, you could turn 100 million into 10 billion!  Needless to say the cash from this borrowing orgy was not exactly well used:

“And the abundant cash, combined with the credit lockdown many SMEs were suffering, presented yet another opportunity for steel traders.  Billions of yuan flew into the underground banking system in Zhejiang province, heartland of the shadow banking industry, to chase the high interest returns offered by illegal lenders. “I didn’t even bother to ask them how they would use the money,” Shao said of people he lent cash to. “The borrowers promised to pay higher interest than the banks’ lending rates and I just agreed on the spur of the moment. Now I don’t even know where some of the cash has gone.”

Nor was this baiju fueled lending binge limited to steel traders.  The credit crisis is spreading to smaller cities throughout China with the predictable consequences of collapsing sales, bankruptcies, and falling real estate prices. According to this New York Times article of one mid-size Chinese town, apartment prices rose from $20,000 to $330,000 in a city where the average per capita GDP was $4,000.  That translates to a home price to income ratio of 80.  Considering the United States peaked in San Francisco around 11, this would imply one of the biggest housing price corrections in the history of mankind.

It should come as no surprise that steel traders cash and real estate prices went hand in hand.  Between the incentives to turn out low price steel for large apartment blocks and lending to fuel their purchase, this completes two sides of the same coin.

Think I’m exaggerating the magnitude of this and the coming correction of asset prices?  Watch this 60 Minutes piece touring cities built for hundreds of thousands where no one lives.

The coming correction to asset prices will be one of the largest and most painful we have ever seen.

The Ongoing Data Discrepancy in Chinese Inflation and GDP

A question I have answered frequently in recent history is why I decided to write my working paper How Badly Flawed is Chinese Economic Data? and the answer is simple.  I was astounded that smart people would so readily believe the economic propaganda being announced by Beijing.  Apparently, other people have been just as skeptical and and heartfelt thank you to CNBC for broadcasting this:

Now whether you agree with everything that I have said, how I calculated it, or the final conclusions I reached let me give you some new information.  According to new official data (as I stress about Chinese data: do not actually believe it) in 70 major cities the price of new homes rose 7.5%.  Nor was this increase limited to new homes as existing home prices jumped also.  According to Bloomberg: “Existing home prices rose 15 percent in Beijing last month from a year earlier and increased 11 percent in Shanghai and Guangzhou each, according to the data”

Now to put these numbers in perspective you must bear in mind that according to the same people that released these statistics, from 2000-2011 urban areas saw housing price inflation of 8% total.  It must be emphasized that the real estate asset price and the consumer price change are two very different things but they are also very related.  The real estate component of CPI is not going to increase in perfect correlation with the change in real estate prices, especially when there is a bubble.  However, nor are the housing CPI and real estate asset price independent and unrelated.  To think that real estate asset prices go up by 7.5% annually but the housing CPI goes up by only 8% in 12 years in ludicrous.

The reason this matters is that banks are enormously stressed and continuing to lend to developers to buy land, consumers to buy apartments, and related industries to stay in business.  Think the banks aren’t stressed?  Chinese interbank rates are already spiking in anticipation of the end of the month capital adequacy ratio tests and the market is pushing for additional PBOC liquidity.

There are a couple of problems here.  First, it should serve as a warning sign that every time there is a capital adequacy test, Chinese banks go into panic mode.  That is not a good sign.  Second, banks should not be this dependent on on the central for bank for ongoing liquidity.  This smacks of an ongoing quiet bailout.  In normal times, banks should be able to lend to each other with minimal central bank intervention to ensure smooth financial market operation.

Given the line of rights issues that have already started are continuing by banks, this sounds a lot like a government engineered bailout except under quasi-Communist Authoritarianism, you get try to dupe the private investors into putting up the capital.  (Am I the only one that finds it odd that the quasi-capitalist US does a public bailout while the quasi-Communists conduct a private bailout?).  Point being, the PBOC and string of new rights issues are telling you just how stressed Chinese banks are.

You definitely can’t believe the macroeconomic data any more than you can believe a set of public Chinese books.

My New Working Paper on Bogus Chinese Economic Data

So after getting a bunch of questions about a blog post I did about bogus Chinese economic data, some challenging what I wrote and some just wanting to know more, I decided to give it a bit more formal treatment.  I put together a working paper entitled How Badly Flawed is Chinese Economic Data? The Opening Bid is $1 Trillion available here.

I plan on covering some of the major findings periodically over the next couple of weeks but Chinese is so fraudulently manipulated as to be Alice in Wonderland absurd.  Let me give you one simple example below in this table.

According to the official National Bureau of Statistics China (NBSC), the price of private housing in urban areas between 2000 and 2011 rose by a grand total of 6% with rural area prices grew slightly faster registering a 20% increase.  It needs to be emphasized that these are not annual numbers but rather the total increase in China in 12 years.  To anyone who is alive and has heard of China, these numbers are not simply questionable but downright comical and fraudulent.

It is also worth noting that according to the NBSC, approximately 70% of Chinese households are considered “private housing” occupants.  This means that the NBSC is saying about 70% of Chinese households have faced housing price inflation of between 6-20%.  More about this break down in a future post which is very interesting in itself.

The primary point of the paper is not simply to reveal more discrepancies in the Chinese economic data, which it does, but also to measure the impact of these fraudulent statistics on real economic activity.

If you don’t want to read the paper or hit the highlights, don’t worry I will be posting the greatest hits here over the next couple of weeks.

Enjoy and cross your fingers.