Author : John E. Charalambakis
Date : August 9, 2010
In our June newsletter, we announced that in a few months we will publish our research on what we believe to be a Chinese bubble. In that issue we showed how the Chinese coincidental and leading indicators point to a slowdown in China. Since then, the numbers have come to vindicate our claim. We will be publishing our Chinese findings in our September newsletter. One of our main points is that China looks like a big slush fund, where state operations are sustaining a bubble on several fronts i.e. not just in real estate.
August Memory I: Last Friday August 6, I took my family to Pearl Harbor. Visiting the USS Arizona and the memorials there on the 65th anniversary of the Hiroshima atomic bombing was a sobering experience. The Japanese attack was the beginning of a new era in world history and in global financial balances. Japan attacked because of its imperial ambitions. It was defeated because of US military superiority and because it was running out of industrial assets used in the buildup of its imperial machine. In addition, the US for several months prior to the infamous December 7, 1941 attack had frozen Japanese assets, and thus the Japanese could no longer buy the petroleum they needed.
August Memory II: It was August 1969, when Dr. Daniel Ellsberg decided that the Pentagon papers could no longer stay secret and the truth should come out about slush funds used without Congressional approval for US covert involvement in Southeast Asia over the course of 20+ years.
August Memory III: On August 15, 1971, President Nixon decided that the US could no longer honor the dollar convertibility into gold, and thus the era that started at the end of World War II was ending, bringing with it frequent financial crises, over-extension of credit, and collateralization of paper assets.
August Memory IV: On the 29th anniversary of the Nagasaki atomic bombing that is on August 9, 1974 (like today), President Nixon resigned over what was discovered to be additional slush funds that were used for covert operations.
It seems that slush funds have a common destiny. Sooner or later they are discovered, especially if they are used for covert operations. Our case regarding China as a big slash fund, is based on three facts, namely: real estate problems; banking problems via special purpose vehicles and off-balance sheet financing; and credit extension without a middle class that can sustain that credit creation.
August Reflections on Chinese Real Estate: In China while the real estate sector has been used extensively for growth and the employment of unskilled labor, it lacks the sophistication of a developed market. That has led to a commercial sector where many buildings are vacant. The vacancy rates fluctuate between 25-45% in major cities. The projects were financed through state-owned banks that had established special purpose vehicles (SPVs) to own those projects. The lack of market sophistication did not allow proper due diligence (of course someone could say the same for the “sophisticated” US market) on collateral and on the business propositions. A good part of those loans will turn out to be non-performing loans and the banks will suffer losses. It seems to us, that the commercial real estate sector was used as a slush fund to cover up for growth.
The residential real estate sector is another story. Those Chinese who have savings, do not have many productive investment options to place their cash. Thus, they bid up house prices and buy homes – in the beginning at least with minimal leverage, something that changed in the last 5 years – as a place to stash their savings. For them, homes are equivalent to cash. The problem is that as we now well know – and here is the lack of sophistication – real estate cannot be as liquid as other asset classes. Even worse, when it is in a bubble phase and investors are looking for an exit, prices could collapse. Thus China is facing an irrational situation – which on its surface looks credible due to the high growth rates – where apartment complexes are vacant (remember they buy those apartments not to live in but as a way of savings and investments) while people cannot afford housing, since the prices have skyrocketed. The lack of a functional middle class that can sustain the new asset classes may turn out to be the boomerang that will haunt Chinese growth.
In conclusion, we would state that the clearing price for Chinese real estate is much lower than what is demanded these days, and if that is the case, then the bubble will burst.
August Reflections on Chinese Banks: In our newsletter next month, we will discuss the banking sector problems in detail. At this stage, we shall concentrate on three things: First, the real estate bubble was built upon leverage, especially in the commercial sector. Chinese banks do not loan based on credit scores or incomes. They loan based on collateral. An over-valued piece of real estate leads to over-extension of credit. When the postman comes, you better be ready for a write-off. A few months ago, the Chinese banking authorities asked the banks to perform stress tests assuming a 30% real estate price drop. Last week it was revealed that the new benchmark is a 60% write-off. Could the Chinese banks afford even a 40% write off?
Second, last year the markets celebrated a story that pretty much told the masses that it was the Chinese growth that propped up the global economy. The truth of the matter is that the Chinese banks became conduits of the Chinese stimulus. The latter was roughly 20% of Chinese GDP. Can you imagine the White House proposing a stimulus of 20% of US GDP? (That would be about 2.8 trillion dollars). The banks became a slush fund to prop up the economy, via infrastructure spending that cannot generate enough income to pay off the loans that SPVs took out.
Third, the tragedy is that last month the markets celebrated also the biggest IPO in the history of global capital markets (Agricultural Bank of China that raised more than $22 billion, a bit less than the originally planned amount of $25 billion). It was part of the efforts to recapitalize the balance sheets of Chinese banks. This recapitalization is a prelude to the dilution of shareholders equity who will not be bailed out when the postman rings the bell the second time.
Between November 2008 and December 2009, Chinese lending increased by almost 33%. If that is not over-extension of credit, then I really do not know what qualifies as over-extension of credit. By no measure did their GDP grow by 33%. The banks lent without any discretion. They were just executing orders; placing those loans into SPVs to finance infrastructure projects whose net present value was negative (I would say nothing about their internal rates of return!)
Now, the situation resembles my August 15, 1971 reflection above. The Chinese central government has started revoking the guarantees it made to the local governments that set up the SPVs and borrowed the money. Those guarantees represent approximately 40% of the loans made. The slush funds revealed in the Pentagon papers were nothing but the prelude to the global financial crisis that followed the delinking of the dollar from the gold. Let’s us just remember that the dollar-gold revocation brought oil prices from a low of $3/barrel to $40/barrel within 8 years. The delinking preceded geopolitical events that changed the Middle East and the geopolitical as well as geoeconomic environment for generations to come. The Chinese slush funds and the restless credit expansion seem to be the prelude to the revoking of the loan guarantees offered. Investors are lured into China by the IPOs and the recently announced currency flexibility. When the postman rings the bell, investors will be looking for the exits.
I am afraid that a stampede will take place, because not enough exits have been built, which brings us to the concluding point.
August Reflections on the Middle Class: Ten days ago the Financial Times (FT) published an excellent report on the status of the US middle class. A couple of years ago along with two colleagues we started developing a model – using the support vector machine algorithm – demonstrating the significance of the middle class. In a nutshell, a shrinking middle class jeopardizes the whole structure of a functioning developed economy. The FT report showed that the middle class in the US is shrinking rapidly. Let us not forget that a country cannot call itself developed unless it has a middle class. It was the development of the middle class – via wealth and asset creation – in the US that advanced us to the place of claiming the international reserve status. Value creation – where industrial and financial capital move together – becomes the value proposition that develops and sustains a middle class, which in turn sustains growth. Unfortunately, a divergence between industrial and financial capital has taken place, where the latter prevailed without any respect to the underlying collateral base. The lack of a middle class in China may turn out to be its Achilles heel when the postman rings the bell and the real estate sector starts declining. In turn, while Chinese banks may very well start suffering huge losses due to non-performing loans. The US cannot play the role of consumer of last resort – as it used to – since not only its middle class is in a deleveraging mode, but also the banks’ balance sheets are still full of paper assets whose value is unknown.
China has tremendous potential. However, in order to explore it, it needs to shake up its policies of capital allocation and direct them towards value and wealth creation via the development of a middle class. Unless that happens, we will be stuck by our August memories where slush funds lead to the revoking of promises made, which in turn could throw the whole world into a financial turmoil.
The USS Arizona now is a memorial to an infamous attack of an imperial nation that was looking to expand its power through its occupation of China, and which also thought that it could contain the rising US power.
In less than half of a nautical mile from the USS Arizona, the USS Missouri is docked. On its decks the Japanese surrendered, after the August 6 and August 9 atomic bombs. Their imperial dreams were crashed. The USS Missouri reminds us that promises kept advance nations to greatness, while promises revoked are just Nixonian nightmares of resignation and disgrace.
Ode to the coming ride of hard assets revaluation!