China Syndrome?

Posted by jeff

Mon Jun 7th, 2010 02:21 PM

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Since March 2010, Mr. Bernstein has served as Senior Vice President, Research, for AH Lisanti Capital Growth, LLC, a registered investment adviser. This commentary solely represents Mr. Bernstein’s views and opinions as of June 7th, 2010, does not constitute investment advice and does not depict the views of AH Lisanti Capital Growth, LLC.

If you read the newspaper or surf the web, you know that several well known market pundits and professional investors including Marc Faber, James Chanos, and Harvard's Kenneth Rogoff have been calling for a Chinese economic crash driven by a breakneck pace of growth, easy money and a real estate bubble. Owners of commodities, materials and energy stocks have shown obvious concerns about the recent tightening of monetary policy by the Chinese authorities, as well as direct regulatory efforts to rein in real estate speculation. The chart of Dr. Copper(View image), "the metal with an economics degree," clearly highlights the concerns that began in January about slowing Chinese growth. So the question becomes, is there really a Chinese housing bubble? and is it starting to pop right here right now?

I was fortunate enough to attend a teleconference last week hosted by JP Morgan with the head of Chinese real estate research at Jones Lang Lasalle in Beijing, Michael Klibaner. Klibaner explained some of the misconceptions about the Chinese residential real estate market. While the Chinese real estate market was operated with a fair amount of leverage on the part of developers in the past, a real estate downturn in 2007 cleansed this imbalance and developers are being forced by banks to maintain much higher liquidity levels. The typical construction loan is underwritten today at a reasonable 50% loan to value ratio. Recall that there was not a huge amount of spec building going on for most of the U.S. housing bubble, however. It was the buyers who were specs. The same issue is the one being nipped in the bud today in China. New regulations are limiting buyers of real estate to the purchase of two second homes and in some cases are only allowing current residents of a city to buy a second home.

Perhaps most interesting were the comments on why the Chinese real estate market is not considered to be a gambling arena so much as a primary savings vehicle. Due to the fast pace of economic growth and loose money policies being utilized to sustain it, China has a negative real interest rate, that is, the interest rate less the inflation rate. This means that if you put money in the bank you are guaranteed to lose money on an inflation adjusted basis. For this reason middle class and wealthy Chinese, who are benefitting mightily from the fast pace of economic growth in the terms of cash flow generated from their businesses, are challenged to find a place to invest their savings. The Chinese are prolific savers in part due to the country's lack of healthcare and other social safety nets. Furthermore, the populace has been turned off to equities due to the illiquidity and volatility of the Shanghai bourse. As a result, the Chinese have gravitated to real estate as their primary saving vehicle.....chilling you say?

Perhaps the most fascinating aspect of the discussion regarded the leverage trends in Chinese residential real estate. In part due to a desire to salt away as much cash as possible in real estate, Chinese buyers' taste for leverage is low, the volatility of prices and their generally string upward bias could be another factor. To wit, the average loan for the purchase of a home in China takes place at an LTV of.....drum roll.....55% and fully 25% of residential real estate purchases are made in cash. As a result of the general appreciation trend in real estate values in China, the average LTV of loans on the books of Chinese banks today is......45%, yes ladies and gentlemen 45%.

Bubble in prices or no, it takes three factors to make an unstoppable crash: elevated prices, excess supply and leverage. I would argue that the current U.S. commercial real estate bear market demonstrates that leverage is by far the most important factor. In China elevated prices are the only factor that seem likely to be in place. I would note that according to a recent U.K. Telegraph article, "Although China's property market is volatile, and will remain so, it's worth noting that even today's prices aren't out of alignment with the expansion of the economy. An index calculated by Commerzbank which divides Chinese property prices by nominal GDP has fallen more than 40pc since 1997. That suggests, over the long-term at least, current prices are sustainable."

Relieved? don't be too sanguine. According to Klibaner, the measures taken by the government have already caused building to slow markedly in several major cities and this is part of government's strategy to reduce economic growth from the double digit area to 8% exiting the year. This is already weighing on steel prices and other building-related commodities in the construction supply chain. So on the whole I don't believe we are seeing the beginning of a Chinese nuclear meltdown, those commodity ETFs and materials stocks could still have some downside.