China, as we all know, is a booming economy, having experienced GDP growth of above 6% per annum for each of the last 20 years. The conventional wisdom is that this growth has been driven by the low-value manufacturing exports (mainly of consumer goods) that have been sold to the West. However, the data tells a different story. China’s current account balance is shown in the chart below:
This shows that although net exports have grown significantly since 2005, prior to 2005 net exports were a much more modest component of GDP, typically contributing between 0-4% of overall GDP in any one year, and occasionally making a negative contribution. So if the Chinese economy hasn’t been driven by exports, what has been driving it? The answer can be seen in the chart below.
This chart shows how gross fixed capital formation (otherwise known as investments in physical assets), has contributed a high and rising proportion of GDP over the last twenty years. The contribution of net exports to GDP (and GDP growth) therefore looks rather insignificant when compared to the high and growing level of fixed investments. This is interesting because it is very rare that such high levels of fixed investment can be sustained for any length of time. With this in mind, the level of investment as a percentage of GDP in China reminds me of that in Thailand prior to the 1997 Asian financial crisis, which can be seen in the chart below.
Thailand suffered a major collapse in investment as part of the 1997 Asian Financial Crisis. Now, there are some important differences between Thailand and China. Firstly, Thailand relied heavily on foreign capital (often short-term in nature) to finance its investment boom and, secondly, Thailand did not have significant foreign exchange reserves, leaving the exchange rate vulnerable when investors eventually decided to withdraw their capital. The collapse in the Thai fixed investment boom from ~40% of GDP to ~20% of GDP precipitated a major recession, which can be seen in the chart below.
To date, the Chinese investment boom has been financed almost entirely with domestic savings rather than foreign capital, making the Chinese investment boom much more sustainable than other investment booms, such as the one in Thailand, for example. However, simply because local investment is financed by local savings via the local banking system, doesn’t mean that high levels of investment can be maintained indefinitely. Savers require that their capital be returned with interest, so investment projects need to make a satisfactory return in order to maintain the solvency of the banking system. Just ask the Irish.
While I don’t envisage any problems with the supply of additional financing at present, I am quite concerned at the return that developers are achieving on their investment projects, particularly those in the real estate sector. Evidence is coming to light that the Chinese real estate market is becoming increasingly oversupplied. This Bloomberg article quotes one investor who is aware of 55 entirely empty office buildings in Beijing and real estate consultancy CBRE believes the Beijing vacancy rate to be 22%. Some properties are purchased by speculators and left vacant, so confident are certain investors in the probability of further capital appreciation. In 100 Shanghai property development projects, approximately 50% of apartments stand empty. Nationally, there are an estimated 64.5m empty residential apartments in China, enough to house roughly 15% of the population. In addition, there are entire cities that are completely empty – providing an excellent rebuttal of the “build it and they will come” fallacy. Many of the properties built are too expensive for firms to rent or people to buy. Prices have now reached alarming levels, with data from Beijing municipality suggesting that the price:income ratio for apartments in the city has reached 27x and the price:rent ratio 300:1. This video provides some insight into the scale of the problem with empty properties, which although often have government support or funding, are also financed with bank debt:
Yet construction still continues. In any capitalist economy it would have stopped by now, with investors waiting until the vacancy rate fell before committing to new projects. The problem for China is thus: if fixed investment contributes 40% of GDP, and much of that fixed investment isn’t needed, then for GDP to grow, fixed investment in unnecessary properties will need to be even greater next year, and the year thereafter. Therefore, regardless of China’s actual need for properties in the future (and many of them may genuinely be needed in the future), the country now seems to be trapped into a vicious circle of ever more unnecessary property investment. The challenge that I have is that I don’t see any catalyst at present for bringing this situation to a head. As long as it is funded by local savings via the banks, the situation can continue for as long as the Chinese banks can avoid recognising the problems on their balance sheets. Every empty mall, office block and apartment complex represents lost equity for the developer (sometimes the government) and potentially also a bad bank loan, with the recovery rate likely to be quite low. At some point, these failed developments will show up in the banking system as bad loans. However, given the huge latitude that bank executives have to estimate the value of their own loan book, this could take a long time before it becomes apparent to overseas investors. Any thoughts that readers might have about: (a) for how long this situation might continue; or (b) what factors may bring it to an end, would be much appreciated.
The bulls may argue that the situation doesn’t have to come to an end, that China’s economy is going to grow dramatically over the next few decades and that all the empty properties will be taken-up over time due to high levels of rural-urban migration. While this may be correct, a similar statement could have been made about the USA in 1929. An investor may have correctly identified that the US economy would dominate the world in the latter half of the twentieth century, but investing his money in US stocks or real estate in 1929 would have been a major mistake. Does all the empty property signal China is approaching its own 1929 moment? I don’t understand the Chinese economy in a great level of detail, but I do understand enough about economics to know that it is unsustainable for a country to continue building ever greater amounts of property for which there are no requirements. It is akin to paying one company to dig holes in the ground and another company to fill them in. Consequently, I take the view that at some point, most likely within the next decade, and possibly within the next five years, we will see a collapse in the Chinese construction boom.
- Roubini is predicting a hard landing for China’s Economy after 2013 (nextbigfuture.com)
- Chinese Purchases Of U.S. Real Estate Poised To Rise (blogs.forbes.com)
- Roubini On China’s Unsustainable Growth Model — And Why The Rate Hike Looks Desperate (businessinsider.com)
- China Economy: Reality Or Complacency? (businessinsider.com)