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Barron's on China - Falling Star


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The Chinese economy is slowing and is likely to slow a lot more. Get ready for a hard landing.

 

http://online.barrons.com/article/SB50001424053111903857104577467200405790354.html?mod=BOL_twm_fs#articleTabs_article%3D0

 

(A high-speed train in Beijing: a technical marvel, but its fares can't cover its costs.)

 

....Edward Chancellor, a global strategist for the Boston-based GMO, "I can't tell you precisely when the downturn will hit," he says. "No one can. All I know is that China has all the earmarks of a classic mania that will end badly—a compelling growth story that seduces investors into ill-starred speculation, blind faith in the competence of Chinese authorities to manage through any cycle, and over-investment in fixed assets with inadequate returns facilitated by an explosion in credit."....

 

....China faces the prospect of long-term stagnation—a prospect potentially far worse than that of Japan some 20 years ago. ...."The bulk of Chinese high-tech products and indeed exports that come from foreign companies with plants domiciled in China, and they don't have to stay there,"....state- or party-directed human wave attacks work for a time, yielding large increases in output—think of the Soviet Union in the 1950s or Japan in the '50s and '60s. But eventually those economies hit the wall of diminishing returns and never quite caught up to developed economies grounded more in free-market principles and less dominated by selfish special-interest groups....

 

....China face the likelihood of a "quite sharp" slowing in economic output in the next five to 10 years because of an aging population but also perhaps higher crime rates from a growing male population without marriage prospects....

 

....when one tallies up all the liabilities direct and contingent of the Chinese central government, indebtedness of the state-controlled banking system, various government entities like the Ministry of Railroads, state-owned enterprises, local government loan investment vehicles, and considerable cross-holdings of bond debt by SOEs, China's government debt-to-GDP triples to about 150% and is rapidly rising....

 

....Capital flight by corrupt party members and other wealthy Chinese could also shred China's vaunted safety net of $3.2 trillion in foreign-currency reserves. Northwestern's Shih estimates that the top 1% of Chinese households have amassed liquid and real-estate wealth of as much as $5 trillion. The gambling mecca of Macau and leaks in the banking systems afford plenty of ways to get money out of the country....

 

....GDP growth, a task that figures to be far more difficult in the years ahead. Indeed, many say that anything less than 7% could create unrest if the economy fails to produce enough jobs to accommodate the millions of citizens migrating to cities and industrial areas every year....

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For the opposite view, check out the special feature on China in a recent Economist issue.

 

I tend to be more convinced by the Economist's position because they tend to address most - if not all - of the major points in the bear arguments, while most of the bears don't address the Economist's points and obviously aren't digging as deep.

 

The only thing I know is that when everybody becomes bearish on a place, there are bound to be some bargains related to it (I wouldn't buy chinese stocks, but there are indirect ways).

 

But as with all that macro stuff, who the heck really knows what will happen? I'll just keep buying good companies cheaply and hold them for a long time...

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I would not discount Chancellor's points.  He is a learned historian and economist and the Economist has reporters learning economics as they go versus economists/historians commenting on the news.  Below is an interesting perspective of the RE cycle and its application to US and China:

 

https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIA1YdxRKKPedFi61O2OglanIRVoizJpKZd2dGP3C21iwmdNBThDJxxZFF9ysrk8Jg1eLI%2b6M6F%2fBFNwmfMFN9NRiq3W81KPaIUKTo%2b3vT%2bj8A%3d%3d

 

I think those of us in the West have to take everything that comes out of China with a grain of salt because most of the incentives in place to make thing look good and there is no third-party verisifcation of statistics.  As a case in point, look at the all the fraud in the Chinese "reverse merger" firms with the Chinese looking the other way.

 

I agree that the Chinese people have great potential but will the planned goverment and mis-allocation of capital and associated corruption more than offset this potential.  That is the question.

 

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The problem with Chancellor's view on Chinese real estate is that the analysis is based on historical relationships among data coming from predominantly Western experiences.  Whereas the high real estate price in China may very well be a reflection of several unique factors in the current Chinese system that acts together to twist those relationships into something that is entirely unrecognizable from a Westerner's view.  Not saying it's not a bubble, just that this trail of reasoning will not lead to a satisfactory conclusion as to how long the distortion will exist and what the transmission mechanisms are to cause it to collapse. 

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I would not discount Chancellor's points.  He is a learned historian and economist and the Economist has reporters learning economics as they go versus economists/historians commenting on the news. 

 

Have you read the Economist's feature report?

 

I didn't find it convincing because of the authority of those writing it versus the authority of the Barrons piece, but rather because of the arguments themselves.

 

I'm also pretty sure that for special reports they often get contributions from all kinds of experts, including on the ground and in the industry they cover, and not just from their regular journalists.

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It may be true but his observations appeared to hold in Japan and for the SE Asian RE bubble.  The gov't may be able to defer the decline (like the US did with the housing bubble) but the deferral cause problems of its own (increased inflation of a bubble) and a drawn out decline.  A chapter in "The Devil Takes the Hindmost" about the Japanese bubble describes a similar situation with the Japanese and others cliaming the uniqueness of the Japanese system.  In the end it was not so unique.  If the basis of economic growth is the market system bubles and busts are just part of the way the system works.

 

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It seems similar situations has occurred in twain and Hong Kong before but on smaller scale. can someone out there share their experience?

There is probably a RE bubble in Taiwan also. Walking out my apartment, within 10 minute walking distance there are about 4 or 5 selling offices for RE agents.

 

Here in Taiwan, due to the limited supply of land, RE prices has always been high in the Taipei area.  People appear to be willing to spend more money (in terms of so many month's salary) than in US.  But I am not sure whether we have really pushed it too far this time.

 

A small apartment here in Hsinchu costs about US$150-200K.  In Taipei, the price could easily double. To give you an idea about how affordable the prices are. Engineers with MS degrees typically make about US$25K a year. Teachers, considered well paid locally, proabably make about US$20K a year.  Starting salary for college graduates is about US10K a year.

 

Another way to look at it, I was renting an apartment for US$1K per month a couple years ago. The apartment owner wants to sell it for about US$330K. It would seem to me that the price relative to rent is quite high.

 

In Hsinchu, where I live, I was told by several co-workers that there was a mini-bubble in late 1990s, when the science park here was expanding quickly. There was a crash following the burst of 2000 Tech bubble.  It took 6-7 years to recover.  So people do know that it is possible to lose money "for a while" in RE here in Taiwan.

 

One thing may be interesting this time around is that here in Taiwan, one can only get "floating" rate mortgage. I have not been able to find any banks wanting to make loan with a fixed interest rate.  I often wonder why people here are confortable with these large floating rate loan.  I also wonder whether the low monthly payment is pushing the prices too high since the mortgage rate is around 2%.

 

The property tax is less than 0.1%, as far as I know.  Holding costs of a property is quite low here it appears.  So many people seem to be willing to hold on to their properties. 

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Liberty,

 

I have read the Economist report but I think the data it is based upon may be flawed.  There is no third-party verification and no incentive for others to verify the data.  As I recall there was no discussion of this in the Economist report.  Chancellor quotes two examples from the RE sector when the numbers go bad the reporting stopped.  It reminds of the OPEC estimated reserves numbers (which are also self-reported).  You are correct if the assumptions are true but I am skeptical due to the lack of transperancy and incentives for checks and balances.  If there were so many blow-ups of Chinese reverse merger stocks associated with reporting, what makes you think the "official" data does not contain the same flaws?  We will see when the tide goes out, if the Chinese have been skinny dipping.  BTW that is why I stay away from Chinese companies because the success of value investing is based upon having transperent disclosure you can rely on.  If this is not present, the market becomes a casino with investors being the patsies and the insiders being the scalpers. 

 

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It seems similar situations has occurred in twain and Hong Kong before but on smaller scale. can someone out there share their experience?

There is probably a RE bubble in Taiwan also. Walking out my apartment, within 10 minute walking distance there are about 4 or 5 selling offices for RE agents.

 

Here in Taiwan, due to the limited supply of land, RE prices has always been high in the Taipei area.  People appear to be willing to spend more money (in terms of so many month's salary) than in US.  But I am not sure whether we have really pushed it too far this time.

 

A small apartment here in Hsinchu costs about US$150-200K.  In Taipei, the price could easily double. To give you an idea about how affordable the prices are. Engineers with MS degrees typically make about US$25K a year. Teachers, considered well paid locally, proabably make about US$20K a year.  Starting salary for college graduates is about US10K a year.

 

Another way to look at it, I was renting an apartment for US$1K per month a couple years ago. The apartment owner wants to sell it for about US$330K. It would seem to me that the price relative to rent is quite high.

 

In Hsinchu, where I live, I was told by several co-workers that there was a mini-bubble in late 1990s, when the science park here was expanding quickly. There was a crash following the burst of 2000 Tech bubble.  It took 6-7 years to recover.  So people do know that it is possible to lose money "for a while" in RE here in Taiwan.

 

One thing may be interesting this time around is that here in Taiwan, one can only get "floating" rate mortgage. I have not been able to find any banks wanting to make loan with a fixed interest rate.  I often wonder why people here are confortable with these large floating rate loan.  I also wonder whether the low monthly payment is pushing the prices too high since the mortgage rate is around 2%.

 

The property tax is less than 0.1%, as far as I know.  Holding costs of a property is quite low here it appears.  So many people seem to be willing to hold on to their properties.

 

Thank You for your response. It gives great prospective. 

Do you guys have the same debt problem as the US?

Is there a unofficial peg to the USD?

Dose it feel like it was back in the 90s over there ?

Do you think those owners will blow up if interest rate rise by a few hundred bases points ?

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Thank You for your response. It gives great prospective. 

Do you guys have the same debt problem as the US?

Is there a unofficial peg to the USD?

Dose it feel like it was back in the 90s over there ?

Do you think those owners will blow up if interest rate rise by a few hundred bases points ?

 

I am not sure whether there is a debt problem as in US.  I just moved back in 2006 from US so I am not sure about how this one compares against the late 1990s. My guess is that this one is less severe than the one in 1990s.  In 1990s, there was also a stock market bubble at the same time. For the last 5-6 years, though, people in general are quite pessimistic about the Taiwanese economic future.

 

People appear to have enough cash flow based on current interest rate.  However, if interest rate goes up to the 4-5% range from the current 2% range, I am sure plenty of people would be in trouble.

 

The NTdollar exchange rate vs. US dollar appears to fluctuate between 28 and 32.  Right now NT dollar is around 28 and considered on the high side. Most of the businesses would like to have NTD devalued as they are suffering from appreciating NTD. Many Taiwanese companies have cross margin of 3-5% so are worried about any NTD appreciation. 

 

By the way, in here, the "real" RE speculators, are very leveraged. Since land are expensive, new development projects tend to be 13-15 story buildings.  These can take up to 2 years to build. When you buy, you put down 3-5% of the buying price, and over that period of 2 years, you pay maybe another 3-7%.  This essential gives you an "call" option on the apartment.  This "option" is transferable.  There are "RE investors" just flipping apartment units this way.  I didn't know that there are "options" like this before I moved back.

 

At the time of the closing, that is the time you become "the owner", you pay the builder the rest, with loan up to 70%. Most of the speculators will not wait till this stage as amount of leverage will have to be reduced. 

 

Of course, there are also the landlord types, who buy apartments to rent out.  Since Taiwanese interest rate is so low with mortage rate around 2% and one year CD around 0.25%.  A 3-4% gross yield on the property price, appears quite high.  Since the house price quotes are not available daily, people tend to think that prices are stable. If the interest rate goes up to the 4-5% range, "investors" with borrowed money will have cash flow problems, I guess.  "Investors" without borrowing may move their money back to the bank also.

 

Taiwanese Central bank actually has reduced the upper limit on the loan-to-value ratio recently and has issued orders that loan amount per square feet can not exceed certain numbers. It has also summoned heads of various banks for "coffee drinking" (a taiwanese term of moral persuasion) about the real estate loans.  I am not so sure about what Mainland China is doing though.

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Liberty,

 

I have read the Economist report but I think the data it is based upon may be flawed.  There is no third-party verification and no incentive for others to verify the data.  As I recall there was no discussion of this in the Economist report.  Chancellor quotes two examples from the RE sector when the numbers go bad the reporting stopped.  It reminds of the OPEC estimated reserves numbers (which are also self-reported).  You are correct if the assumptions are true but I am skeptical due to the lack of transperancy and incentives for checks and balances.  If there were so many blow-ups of Chinese reverse merger stocks associated with reporting, what makes you think the "official" data does not contain the same flaws?  We will see when the tide goes out, if the Chinese have been skinny dipping.  BTW that is why I stay away from Chinese companies because the success of value investing is based upon having transperent disclosure you can rely on.  If this is not present, the market becomes a casino with investors being the patsies and the insiders being the scalpers. 

 

Packer

 

That's true. As I said, who the hell knows what is really going on? But when reading the economist, I had the impression that they had a pretty good bullshit detector, and what convinced me most are things that aren't so much dependent on official growth numbers but rather on things like total capital investment per capita, increasing internal consumption and the fact that almost all the debt in their system is local and the opposite of hot money that can easily leave (like in the previous asian crisis). Doesn't mean things can't get rough, but they seem to have lots more margin of safety than some think. But we'll see, i have no power to predict the future.

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It's not just a Eastern vs. Western cultural thing, although that's a part of it (buying an apartment in Shanghai is a multi-generational affair).  So those housing value / average income ratio wouldn't settle at the same level as in the West.

 

There's the issue of extreme inequality, the issue of domination over the economy by the State, and that keeping the real estate price high is a way for the State to tax the economy further without calling it so, the issue of lack of investment alternative to preserve any "new found wealth", the issue of "stock" vs. "flow" in Chinese housing (although this last issue is changing every year new housing gets built), the issue of a closed capital account, all of these are a lot more accentuated to the Chinese housing experience compared with those in US, or Japan, Taiwan, and Korea, none of which is specific to only the housing environment in China, but to the Chinese economy in general.  So to call a crash in Chinese housing is really akin to calling a crash in the Chinese economy generally.  But in today's environment, the question is what does it crash against?  the Western banking system?  Afterall, after 20 years of deflation, Japanese housing is still quite untennable for most young people trying to be independent of their parents, and Tokyo remains one of the most expensive cities to live.  How badly has it really crashed?

 

None of this is to say the elevated housing price in China is a sustainable phenomena, just that what causes its downfall is not simply going to be that the price is too high in relation to per capita income by some historical experience in a different market.  In the Chinese context, you kind of need a fundamental reworking of the Chinese economy concurrent with it. 

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Taiwanese real estate prices drive me absolutely crazy. It's all 史八豆 to me. There are loads of empty apartment buildings and real estate agents just like zippy1 says. I remember one day seeing a busy real estate agents office only find out they were only making a commercial ;-)

 

My guess is the central bank would like to raise interest rates but would be afraid of higher NT appreciation.

 

Here is a nice little article (in English) about Taiwan's real estate here: http://www.taipeitimes.com/News/biz/archives/2012/03/30/2003529019

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