This is a guest post from Christopher Pavese, CFA, Chief Investment Officer at Broyhill Asset Management. He and his team have recently been on a research-intensive trip in China, and he has kindly agreed to share what he found. Visit his blog (The View from the Blue Ridge) for more analyses.
The Union of Soviet Socialist Republics (USSR) was a single-party state ruled by the Communist Party. The state was structured under a highly-centralized government and a command economy, meaning both capital and resources could be mobilized quickly and proficiently. However, speed and agility do not guarantee economic efficiency and can often result in a massive misallocation of capital, which ultimately comes at a high price. This is a lesson China has chosen to ignore as signs of capital misallocation are widespread throughout the People’s Republic today.
The Economist Intelligence Unit (EIU) estimates that average living space per head is over 30 square meters in China, extraordinarily high given the country’s current income levels. “Based on international comparisons, a country at China’s level of GDP per head should have 20 square meters of living area, which would mean that China is 53 per cent over-housed,” according to the EIU. Despite China already being the most “over-housed” country in the world, official data show a further three billion square meters of residential property currently under construction, according to The Wall Street Journal.
China’s real estate sector directly accounts for roughly 12 per cent of GDP. To help put this figure in perspective, consider that private real estate investment in the US reached a staggering 6.3 per cent of GDP at the peak of the housing market, in 2005. But China’s astonishing figure also ignores countless related industries driven by the bubble in construction (i.e. steel, cement, etc.) and the illusion of wealth created by a historic credit binge (i.e. appliances, home furnishings, etc.). A more inclusive estimate of Chinese real estate’s impact on GDP could be twice the commonly reported figures. Our friend, Vikram Mansharamani, provided some colour into the excesses in the steel sector in his excellent book, Boombustology:
“When thinking about over investment and the potential for a bust, the steel industry exemplifies overcapacity. Chinese steel production has grown from 23 million tons in 1977 to a run rate of approximately 650 million tons during the first half of 2010. This growth has taken the Chinese steel industry’s share of global steel production from around 3 per cent in 1977 to almost 50 per cent by 2010.
“If we take a moment to break down the sources of demand for Chinese steel, one finds a potentially reflexive relationship with the property market. Anecdotal evidence suggests that up to 20 per cent of Chinese steel production is being used to construct more steel mills!
“Most believe that utilization has been running between 65 per cent and 75 per cent. The WSJ reported in 2009 that there existed 200 million tons of excess capacity, while UBS analysis conducted in early 2010 suggested there was about 175 million tons of excess capacity. To put these numbers in context, 175 million tons of annual steel production is more than the production of South Korea and Japan – combined! Steel does not appear to be an outlier; similar grandiose statistics can be found for the size of the Chinese cement (greater than the rest of the world combined) and aluminium industries.”
With home prices now following transaction activity sharply lower, the biggest risk for the Chinese economy, as well as the rest of the world, is a sharp slowdown in new construction. Granted, official data still paint a more “balanced” picture, consistent with the standard responses we received from various developers throughout the country. When asked about the outlook for real estate prices we were regularly told that, “prices have reached bottom,” or that “prices have stabilised,” but curiously, when asked how much they had fallen, the immediate response was always, “they have not fallen.” Odd. Perhaps the laws of economics work differently in a command economy, but in a market economy prices tend to fall before “reaching bottom.”
While interested parties remain in denial, disagreements between friends are often settled using the following equation: “Figures don’t lie, but liars figure.” Consider that China Vanke, the nation’s top property developer, suffered a 40 per cent drop in January sales. Consider that sales of excavators and bulldozers dropped by 53 per cent and 67 per cent respectively in January, according to China Construction Machinery Business Online. And consider that inventory levels recently reached historic highs at the same time sales activity has dropped off a cliff.
Figures don’t lie and liars figure, but a picture is worth a thousand word. So we’ll summarize how we view the Chinese economy’s attempt at rebalancing away from domestic investment and toward consumption with a few pictures. But first, consider that one of the most insightful nuggets from our visits with various local government officials was the common belief that, “Developing new cities and building new infrastructure will increase consumption.” Judging by the foot traffic shown in this Zhuhai Home Furnishings Mall, you could say that I am slightly suspicious. Please note that this particular savvy shopper is none other than our own, Hunt Broyhill, not a Chinese home owner.
And the striking gentleman at the railing in the photo on the right is none other than Cullen Thompson, CIO of Bienville Capital Management. Also, not a Chinese home owner, although full disclosure, the two women shown on the left picture, may very well be actual Chinese consumers.
We did not have any more success finding foot traffic at The Global Furnishing Design and Exhibition centre in Shanghai, the largest city in the world, and one where you might expect to see more than a few signs of increased consumption.
Not so much.
Victor Shih, author of Factions and Finance in China, estimates that the top one per cent of Chinese households own up to half of the bank deposits in the country. You might have expected to see at least a handful of the 10 million plus people this represents shopping on a weekday afternoon.
More on these bank deposits in our next post . . .