Bodhisattva, I’m Gonna Buy Another House in Town
Last week, while I was presenting at the Black Diamond Conference for investors in Delray Beach, FL, information from my network began arriving about the latest wrinkle in an ongoing saga.
For some time, analysts have been pointing to several unusual elements in the Chinese economy.
Thousands of factories continue to remain open despite parent companies either running at staggering losses or the locations apparently producing nothing at all. The existence of “ghost cities” costing billions but without residents, a cascading housing market hurtling well beyond ability to pay, and a mountain of non-performing debt cast a curious shadow on the Chinese success story often touted.
Such concerns stand in marked contrast to the more highly visible accomplishments. These include the transformation of Shanghai into an impressive financial center, a national high-speed rail network the envy of the world, and the fastest growing airline industry on the face of the earth.
But the underpinning of a remarkable economic advance has come under increasing scrutiny.
For the past decade (at least since central government decisions to stimulate the national economy) Beijing has engineered an internal approach that would seem curious in just about any other system. While most other countries would countenance official involvement in the domestic market to offset problems or set targets, the Chinese public sector drives investment by tying personal financial prospects with an ongoing tsunami of physical expansion.
In China, personal consumption patterns bear little relationship to actual income levels. The average person spends much more than a combination of wages and savings would appear to justify.
Some of this is “off the books” proceeds. The grey market in China provides an additional personal revenue flow for just about everybody. But that is not the primary source. Neither is interest from traditional bank accounts, the levels of which are held low by the government to encourage bank lending to brick and mortar projects.
Results from endemic paper called wealth management products (WMPs), peer-to-peer (P2P) investment services, creative ways of multiplying credit, and other ingredients permeating have combined with a government decision to bail out the stock markets if things get bad have led to a population overextending across economic sectors.
More of the apparent personal wealth in China is found in the control over physical assets not actually employed in any traditional sense. For example, three of my contacts own multiple (and empty) apartments in the sprawling urban expansion underway in most parts of the country.
What makes the spiraling cycle of acquisition at the expense of savings achievable is the government’s acquiescence in consistently releasing greater amounts of currency into the domestic economy.
This has fueled an appreciating value for hard assets that well outstrips either interest received from bank accounts, inflationary pressures on staple market commodities, or the cost of credit. Companies and lower governments are carrying heavy debt burdens because of this.
Production and urban facilities continue to be built not to service genuine need but to absorb increasing levels of debt. The opaque nature of national banking, combined with all levels of public administration finding creative ways to hide liabilities, contribute to this construction urge. That non-performing older debt can be replaced with new lines of credit merely augments the cycle.
The government penchant to inject currency is offset, but only partially, by Beijing continuing to provide artificial support for the value of the yuan in foreign exchange. Upon occasion, that has meant the People’s Bank of China (the country’s central bank) has bought heavily against its own currency. The strategy of significant intervention has been possible because of the positive balance of payments China has in international trade.
Much of the hallowed Chinese miracle is a result of asset book value increasing, thanks to the complex network of overt and subsumed financial machinations. Among other observations, the Chinese way of doing things makes basic figures (like state GDP and company quarterly reports) less reliable as genuine barometers of economic health.
And there are rising indications that the “phantom” nature of development is beginning to have a broader impact. After conversations over the past week, the consensus in my regional network believes the problem is about to hit energy.
Bodhisattva, How’s Your Energy Demand?
In one sense, it already has. Over the past several years, Chinese domestic energy demand has been increasingly connected to two factors. The first is the accelerating acquisitiveness of an expanding middle class. The number of personal vehicles now clogging Beijing, Shanghai, Guangzhou, Nanjing, and other first-tier population centers, combined with an even faster acceleration in car ownership among those living in second and third-tier provincial centers, is one clear signal that the middle class has arrived. Increasing demand for electricity is certainly another
But the second overarching consideration may be more important. Energy demand is fundamental in the ongoing national construction craze. In this category, some of the construction (highways, power plants, transport centers, airports, railway terminals, and the like) directly results from more people in a country of 1.4 billion and counting having the wherewithal to travel and consume.
A greater component, however, is located in the energy demand resulting from the building of entire new cities, whole districts designed to allow existing urban areas to expand, and massive industrial plants that will never reach anywhere close to designed usage.
China leads the world in steel and aluminum production. Yet less of that is genuinely needed. It has the largest forges and most extensive metal working found anywhere. But much of that capacity is effectively mothballed.
The number of new apartment and condo complexes dwarfs anything found elsewhere. However, what had been portrayed as necessary to move rural populations into central locations to serve expanding factory production is now essentially over. The ever-expanding market of new housing is not intended for such internal migrants. Few in that population could afford the rising costs anyway.
The Sparkle in Your Ghost Cities
So long as the value of residential units appreciate, they remain as domestic holders of asset value, and thereby attractive examples of paper wealth for many individual Chinese.
Meanwhile, the weight of empty new cities falls on the books of local governments who then rely on the shadow banking sector to offset the cost of the huge debt incurred in the construction of urban services, facilities, and support in the absence of residents.
Contemporary China has increasingly operated in ways that seem to violate basic economic principles. Its expansion seems less a result of normal market demand and more an essential tool used to soak up excess credit.
As the continuing need for more energy becomes dependent upon this curious physical development, one must ask how long the bubble can last.
To my amazement, the answer being offered by my Chinese colleagues is not what I had expected. While most recognize that the situation appears unsustainable by traditional analysis, they point out what is fundamentally different in this case.
As one put it succinctly during an email exchange: “There are important differences when it comes to China: the extent of the territory; the size of the population; and a central government committed to expansion.”
He then added this later: “Beijing will not allow the assets accumulated by the people to evaporate. The people, in turn, know that.”
I’ll leave with this final observation. Of all the Chinese energy expert contacts with whom I have discussed this issue, most having lived or studied in the West, none believes the rising mainland Chinese energy need will be slowing anytime soon.
Notwithstanding the unusual credit and expenditure environment in which it exists.