China Property: It Is All About Local Govt Funding

PVCconsumptionChinaJune2014

By John Richardson

THE more that things change in China’s property markets the more they stay the same, according to Deutsche Bank and Standard & Poor’s Ratings Service.

First of all, here are the Deutsche Bank arguments why all remains well  in the sector, courtesy of this FT Alphaville blog post:

  • The current decline in property prices marks the third cyclical downturn in about six years. The past two cycles resolved themselves after prices fell 20%. If this happens again, affordability will greatly improve as the rise in average disposable incomes has been 12% over these last six years.
  • Even after 15 years of rapid growth in residential investment, about half the urban population still lives in pre-reform housing.
  • And so upgrading or replacement demand, which is linked with the migration of a further 150 million people to China’s biggest cities, could support urban residential construction at about last year’s level for many more years.
  • Around this positive structural view there will inevitably be cyclical rises and declines as developers and the government occasionally build houses in the wrong place, but when prices once again fall by 20%, all of this pent-up demand in China’s biggest cities (called Tier 1 cities) will return.
  • This is likely to happen later this year, meaning a boost to all the chemicals and polymers that go into property. The above chart illustrates the rapid growth in PVC consumption on the back of China’s construction boom.

Standard & Poor’s, in a 9 June Webinar, “China Property Watch: Will The Market Deteriorate Or Rebound”, took a similarly positive view.

Sales would pick up later this year on a much more modest decline in prices, which it said would average 5% across the country.

The problem was the red hot market in 2013 and so a price correction was inevitable, leading to buyers waiting for prices to bottom out, it argued.

And despite developers of achieving 27% of their total 2014 sales-growth target in January-April, the ratings agency stressed that there was no need to the panic button as H1 is traditionally slow period.

The bigger developers were still sitting on huge cash piles and had no problem in accessing money either from the banks or the bond markets, it added.

The fundamentals of the market remain strong because, of again, lots of unfilled demand for housing. And so S&P thinks that the downturn will last only about another six months.

We disagree and here is why:

  • Only 5% of housing construction is in China’s  Tier  cities, such as Shanghai and Beijing,  according to Nomura. This explains the significant oversupply, which we have detailed before, in  China’s  smaller cities (plus there is the longer-term demographic argument about a weaker real-estate sector, which we discuss in the post to which we have just given you a link).
  • Anne Stevenson-Yang of J Capital Research, in same FT Alphaville blog post that we linked to above, says that China’s lower-tier cities have been at the back of the queue for central government revenue since 1994 changes to how China’s regions are funded.
  • While national and provincial governments make money from toll-roads and hospitals, smaller local governments, which run Tier 3-5 cities, have had to provide roads, gas hook-ups and other infrastructure at their own cost. And to make balancing their books even harder, price controls have prevented them charging customers fair market prices for roads, gas connections etc.
  • The solution? Build housing lots of housing and hope that land values would continue to appreciate – hence, ghost cities such as Ordos.

“China had nothing like a property market, but policy shifts conspired to make it feasible for China to harvest a massive property dividend: The 1998 housing privatisation created a market, and the land-auction system implemented in 2000-02 constricted the land supply, squeezing up land values,” writes FT Alphaville.

“The invention of the ‘local government financing vehicle’ in the late 1990s created a handy method for loading up with debt, while the bank bailout that lasted from 1998 to 2006 vastly expanded the money supply.

“All the elements were present to support a national construction project that makes the Great Wall look like Lego.”

The way that local governments fund themselves, especially the ones that run China’s smaller cities, is being taken apart and completely re-assembled, we argued last November.

No longer are local authorities being allowed to get land on the cheap and build ever-more condos and factories into already oversupplied real estate and industrial sectors.

The construction, sale and outfitting of apartments accounted for 23% of China’s gross domestic product in 2013, according to Moody’s Analytics.

That was up from 10% in 2006 and is higher than American housing’s share of GDP reached during the height of the US housing boom in 2006, Moody’s added.

So less new construction means lower overall GDP growth – and lower growth in demand for all the chemicals and polymers that go into the construction sector.

And because of the oversupply in China’s smaller cities we think there is a significant chance of prices falling more than the 20% forecast by Deutsche Bank.

Beijing might not mind this at all because even though average incomes have risen by 12% over the last six years, low-income earners are struggling to afford property.

The problem is sorting the winners from the losers as this restructuring takes place.  Watch this space for our thoughts on this.

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