It has been quite some time since I have written anything on China, so I think it is a good time to revisit China. I don’t need to tell you what is going on with the economy there, as I’m sure you have been following the developments in China. It is all over the news, and it is difficult not to take notice.
I am not arguing that all the positive factors — growth, urbanization, formation of middle class, wealth formation — are not continuing. My point is that no modern economy, free-market or guided by governments (think Japan and Singapore for example), goes straight up without a major shakeout. Now, we can argue that a mild shakeout in China’s real estate markets has been taking place for some time, with sales volumes and prices going down for a number of months in China. But a bubble did not burst, along the lines of the U.S. or European experience.
What is important is that the market conditions for developers have been deteriorating; land prices are going higher, credit is becoming tighter and buyers’ sentiment is turning negative. Increasing costs and deteriorating market sentiment are not a good combination. But developers keep on borrowing at higher rates that are compressing their profit margins, and they keep on building. In addition to that, borrowing from China’s shadow banking sector, which was already a mismatch between borrowing terms and project cycles, is becoming more difficult.
Thus, to make ends meet, Chinese developers, especially smaller ones, have to rely on increasing property prices to meet profit targets that are becoming more and more doubtful under the current conditions. According to a survey by Duke University and CFO magazine, 90 percent of CFOs at U.S. firms active in China believe there is a bubble in China’s real estate markets and that this bubble is going to burst in 2014. While I would not bet my life savings on this, it is clear that the situation is difficult and some degree of caution is clearly warranted.
However, when I talk to asset managers active in China, most of them, while admitting difficulties, consider the current situation a buying opportunity. According to a report from CBRE: “The current situation presents a window of opportunity for investors to negotiate lower prices and yield-enhancing investment terms on projects in upper-tier cities where the demand-supply situation is more balanced.”
It could be a buying opportunity, but it could be a trap. Lower prices can keep on going lower, as we have seen in the U.S. and Europe. Only time will tell.
But what really bothers me is how much faith analysts, observers and asset managers are placing on the Chinese government’s ability to control the markets through “Price Reduction Restrictions” and loosening of “Home Purchase Restrictions” that were originally put in place to curb speculative buying and to control the bubble.
Douglas Elliott, a fellow with the Brookings Institution, recently noted: “The reason I am not pessimistic overall is because the Chinese central government has the financial capability and administrative skills to deal with the problems as they arise.”
How can one “restrict reduction of prices” when the buyers lose faith in the markets? How can a government official stop prices from declining when the buyers panic and withdraw from the market? The statistics may show that genuine demand exists and people are still moving from villages to cities. But it is also a known fact that most of the buying in first-tier and perhaps second-tier cities has been speculative, with wealthy families buying multiple properties. Will they continue buying when the prices continue going down? And what happens when they stop buying?
Even Byron Wien, a renowned Blackstone analyst, wrote in his recent market commentary, discussing the views of the ‘Smartest Man in Europe’: “I don’t expect a hard landing, however, because they have enough control over the economy to avoid that.” But, he continues, “Still, I presently have no investments there.”
The Chinese central government is just a group of people, and people make mistakes. Just think back to 2008 and how many mistakes our government officials, guided and supported by our experienced and knowledgeable industry leaders, made. One day, Chinese government officials will make a mistake, and because so much hope is based on their infallibility, the repercussions could be bigger than those we saw in 2008.
To demonstrate that I am not Chicken Little, here is what Zhou Xiaochuan, governor of China’s Central Bank, said in a recent interview: “We are not very experienced in dealing with the property market — we haven’t experienced too much cyclical volatility. So I think we should be more cautious in making judgment on the situation. For example, the judgment on whether supply has significantly exceeded demand. We should be prudent and need some time to watch.”
If the governor of the Central Bank of China calls for caution, should not investors heed that call?
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Alex Eidlin is managing director – Asia Pacific with Institutional Real Estate, Inc.
