Braking china

Braking China …
Without Breaking
the World

BlackRock Investment Institute
April 2012

[ 2 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d

What Is Inside Joel Kim
Head of BlackRock Asia-Pacific
First Words and Summary 3 Fixed Income
China Inc: Bull, Bear and Bottom Line 4
Introduction: Why China Matters 6
– A Matter of Timing
Credit: Too Much, Too Quickly 8 Mark McCombe
– The Great Credit Leap Forward Chairman, BlackRock Asia-Pacific
– Bad Debt? Just Roll It Over
– No Banker Will Come Clean This Year
– A Less Offensive Four-Letter Word
Neeraj Seth
Real Estate: Can a Bubble Be Deflated? 13 Head of Asian Credit, BlackRock
– Something’s Got to Give Fundamental Fixed Income Group
– A Men’s Shirtmaker Diversifies
– A Quiet New Year for Realtors
– Breaking a Vicious Circle Jeff Shen, PhD
Head of Asia-Pacific and Emerging
Investment and Consumption: Market Equity, BlackRock Scientific
Looking for Balance 17 Active Equity Group
– A Case of Diminishing Returns
– Go Buy a Refrigerator!
– A Blueprint for Rebalancing Success
Ewen Cameron Watt
– Bankers Are Shooting Fish in a Barrel
Chief Investment Strategist,
– Wanted: Carefree Spenders
BlackRock Investment Institute
– In Search of Luxury Goods
Politics: Change Is Hard 23 BlackRock’s China Forum
– The Emperor Is Far Away About 50 leading BlackRock portfolio managers and external
– Vested Interests and Paralysis experts from around the globe recently exchanged views on China’s
– 300 Million Publishers economic trajectory at the BlackRock Investment Institute’s
China Forum. Many went in bullish and came out still bullish—
– From Small Piles of Rocks to Oil Shock
but with much less complacency and certainty. This publication
– Tit for Tat in Trade Wars
summarizes their ideas.
Competiveness: Beyond Cheap Labor 27
The BlackRock Investment Institute leverages the firm’s
– Of Robots and Old People expertise across asset classes, client groups and regions.
Markets: Counting on China 29 The Institute’s goal is to produce information that makes
– Equities and Corporate Bonds: BlackRock’s portfolio managers better investors and helps
A Growing Addiction deliver positive investment results for clients.

– Commodities: An Outsized Influence Lee Kempler Executive Director
– overnment Bonds: A Big Overhang
G Ewen Cameron Watt Chief Investment Strategist
Jack Reerink Executive Editor

The opinions expressed are as of April 2012, and may change as subsequent conditions vary.

Blackrock investment institute [3]

First Words and Summary
China is at a crossroads. Investment-driven growth has spun manufacturers. Domestic savers financed China Inc.’s master
an economic success story without equal since the country plan by accepting savings rates below inflation, wage increases
opened for business in 1978. This has come at a cost: Unbridled that lagged economic growth and a minimal social safety net.
credit growth, overbuilding, environmental damage and a widening This is changing, but powerful interests are stacked against
divide between the haves and have-nots. a true shift to a consumption economy: exporters, state
enterprises and local governments.
It has become clear China’s old playbook of “invest and grow” no
longer works so well. But a shift to a consumption-driven society } hina’s new leadership could take the tough measures needed to
C
is tough for a command economy and wrought with pitfalls. The engineer a shift—liberalizing interest rates, opening capital
country’s upcoming once-a-decade leadership change brings markets, market pricing of resources, and building out social
both opportunity and uncertainty. The downfall of “princeling” services. But Beijing is not almighty; local governments tend
Bo Xilai, the former charis-matic leader of Chongqing, shows to go their own way and a desire for consensus has often resulted
tumult below the surface. This changing of the guard will in political paralysis. Risks of a popular revolt or foreign conflicts
reverberate well beyond its own population, as China has are low as the one-party state has kept a tight lid on dissent
become the globe’s growth engine. and is focused on fulfilling its domestic social contract.

We are optimistic on China’s economic trajectory in the short term. } eal wage growth, rising materials costs and environmental
R

A nagging worry: Markets already factor in a “soft landing” this restrictions are changing the workshop of the world—for the

year, leaving potential downside risk. The leaders walk a tightrope, better. Some labor-intensive industries are moving elsewhere

and have lowered the official growth target to 7.5% for 2012. We and automation is increasing. There is room for more productivity

are concerned about China’s ability to keep up its economic march growth even as the easy gains have been harvested. Protection

in the long run. Challenges are big and solutions are not easy. of intellectual property is still weak and global brands have
yet to emerge, but we believe chances are China will remain
This publication discusses key factors driving China’s economy competitive and confound the doomsayers.
this year and beyond, signposts for change and implications for
investors. Examining the financial system, the deflating real
estate bubble, the tricky shift to a consumption economy, So What Do I Do With My Money?TM
politics and competitiveness, our main findings are: } lobal consumer companies and high-end machinery
G
} n explosion in credit growth resulting from Beijing’s 2009
A
makers are likely to be good long-term bets.
stimulus has made the financial sector the economy’s Achilles } nergy, precious metals and agricultural commodities
E
heel and its biggest long-term threat. The country can pave prices should be underpinned by the country’s insatiable
over problems this year, but the bills will come due. China will demand, and boost companies in those areas.
have to charge borrowers real money and give savers a real
} ost Chinese companies are likely to report poor
M
return to create a healthy financial system in the long run.
earnings this year, but valuations look cheap.
} he real estate slump is the biggest threat to economic growth
T
} hina’s demand for basic materials such as cement
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and confidence this year. The sector is interwoven with the
and steel should peak soon, hitting key suppliers and
entire economy and has been a key growth driver. A government-
resource currencies in those markets.
engineered slowdown has brought down prices to more
affordable levels, but also has created ghost cities. Urbanization } hina’s buying of US Treasuries may slow over time,
C

and growing incomes should balance supply and demand but a fire sale does not look to be in the cards.

eventually. The question now is: Can Beijing break a vicious More investment implications on pages 29 to 31.
circle of falling prices and sales (when it is ready to do so)?

} hina’s economic miracle was built on an undervalued currency,
C
lots of investment, and subsidized energy and credit for

The opinions expressed are as of April 2012, and may change as subsequent conditions vary.


China Inc: Bull, Bear and Bottom Line
Factor Bull Case Bear Case
A Sickly Financial System It is easy to pave over financial problems in the Banks’ non-performing loans have fallen by 97%
short term, Beijing has plenty of firepower for in the past decade, but this masks a poisonous
bailouts. Growth in local government debt has reality: Unpaid loans are rolled over. Debts of
come to a screeching halt. China has proved state enterprises and, to a lesser extent, of local
many times it can fix its banks when needed. The governments appear to be ticking time bombs.
same team that engineered a doubling of annual Banks are bleeding deposits and luring customers
credit to 14 trillion RMB during the financial crisis with asset-backed securities. (Hmmm, what kind
can pull the strings in a different direction. of assets?) Banks are lending to all the wrong
people: lumbering state giants and developers.
Banks are bad at risk management.

A Deflating Urbanization and the desire for upgrades provide Local governments, banks and companies all bet
Real Estate Bubble steady demand. Affordability is improving due to prices would keep rising and are overexposed.
falling prices and rapid real wage growth. Buyers Real estate has been the driver of economic
pay a majority of the purchase in cash, so price growth. Homes are too expensive for average
declines will not hurt the financial system. Savers earners. Overbuilding has resulted in ghost
have few other places to park their cash. A cities and a huge inventory of unsold properties.
push on low-end “social” housing will keep Beijing may not be able to arrest a vicious
the construction industry busy. cycle of lower prices and lower sales.

Too Much Investment and Is there such a thing as too much investment? Investment is a case of diminishing returns: It
Too Little Consumption Capital stock is not yet excessive by international takes $5 to generate $1 of GDP growth. The model
standards, and China needs investments in is based on an undervalued currency, low real
infrastructure and automation to keep up wage growth and financial repression—factors
productivity growth. Consumption is rising that policymakers are loath or unable to change.
rapidly, and half of households will soon classify China’s command economy appears ill-equipped
as “middle income.” Rural wages are growing faster to stimulate consumption. Much industry would
than urban ones, making for more balanced collapse without below-cost energy and interest
development. Building out a social safety net rates. “Vested interests” will work hard to torpedo
would unleash a pile of precautionary savings a shift to a consumption model. Commodities
for illness and old age. demand is at risk. Watch out, Australia.

Political Risk The Communist Party arguably is built for stability: All politics are local. It is an uphill battle to
It knows internal strife can result in Cultural effectively steer the country toward a new course.
Revolution-type horrors. Regimes historically China has not done enough to improve the
have faced popular revolts only when incomes environment, curb corruption, address the widening
reach the world’s median: China has a long way inequality gap and stimulate consumption.
to go there. Beijing has kept a tight lid on internal The leadership often is paralyzed because it is
dissent and has not had a major overseas pulled in too many directions. China’s military
confrontation in the last 30 years. build-up could set up the world for a major
confrontation down the road.

Competitiveness China’s value-added exports are increasing and Heavy subsidies have thwarted competitiveness
industries are investing in automation to stay and innovation. Violations of intellectual property
competitive and improve quality. China is filing rights still occur. The easy productivity gains
more patents and is now dominating industries have been harvested, and wage growth is a
of the future such as solar power. The country problem. China has yet to develop real brands.
has a first-class infrastructure. The migration of
labor-intensive industries to Vietnam, Cambodia
and elsewhere is a good thing.


Bottom Line Signposts (What to Look for)
We expect a soft landing in 2012. Longer term, } Reserve ratio changes
the financial system represents the biggest risk } Deposit outflows and sales of wealth management products
to the economy, we believe. The sheer magnitude } Bank cash flows and operating cash levels
and pace of credit growth does not pass our
} Credit growth and non-performing loan trends
smell test.
} Corporate bond issuance and trading
} Gradual moves toward market-driven deposit and lending rates
} Demand for gold and other “hard” assets

Bull Bear

Real estate is the No. 1 threat to China’s growth } Inventories, sales volumes and price trends
this year because the sector is so interwoven with } Ratio of new construction vs. sold floor space
the rest of the economy. Supply and demand } Debt and stock prices of major developers and consolidation in the sector
should balance out in the long run. The lack of
} olicy actions such as property taxes or, conversely, more curbs
P
leverage is a big positive.
} Sales of construction machinery and durable household goods
} Sales and volumes in secondary and tertiary cities
} Granting migrant workers urban residency permits so they can own homes

Bull Bear

A pullback in consumption in the wake of falling } Monthly retail, auto and luxury sales
real estate prices and slowing export growth is } Consumption share of GDP and GDP growth, and real wage growth
a major risk this year. Longer term, a big worry } Raw materials imports, energy subsidies and commodities prices
is that a rush to rebalance could lead to an
} Import/export trends (beyond one-month aberrations such as this February)
economic implosion.
} Loosening the currency peg and opening capital markets
} Privatizing state enterprises and liberalizing interest rates
} New sources of local government financing
} Macau gambling revenues and capital flows

Bull Bear

A one-party system is geared to retain its } Political unrest beyond local flare-ups
hegemony and ensure stability. The upcoming } Food price inflation, unemployment and rising inequality
once-a-decade leadership change is hairy. Bo } Efforts to curb corruption, protect the environment and ensure food safety
Xilai’s downfall is the tip of the iceberg, and one
} High-profile casualties of the upcoming leadership change such as Bo Xilai
that is freezing policy for now.
} Restrictions on social networks such as Weibo
} Confrontations in the East China Sea with other Asian countries or the US
} Increased secessionist and religious militancy

Bull Bear

Loss of competitiveness is the lowest risk to the } Productivity and real wage growth
economy this year and beyond. China already is } High-end machinery orders
moving up the value chain. } RD spending and patent applications
} Trends in returns of Chinese who have studied abroad
} Emergence of domestic and global Chinese brands
} Protectionist actions by China’s trade partners

Bull Bear


Introduction: Why China Matters
China matters—a lot. The country has rapidly become the second- The big questions are how the current government will navigate
largest economy in the world. It will likely contribute two-fifths the domestic real estate slump and the global economic slowdown,
to global growth this year, twice as much as the United States. and whether the future leaders will be able to solve a ticking
See the chart below. Resource-hungry China has an outsized bad debt time bomb and deliver on promises to rebalance the
influence on most commodities markets, and is the largest economy toward consumption and sustainable growth.
foreign holder of US Treasuries.
Add in challenges of maintaining a “harmonious society” in a
GDP per capita jumped more than 20-fold to $4,400 in the 30-year place with rapidly growing expectations, corruption, a long history
period ended 2010. Ports, bridges, airports, expressways and of regionalism and world-beating income inequality, and you have
entire cities have been built in record time. China is now the largest a troublesome brew. This is before you even consider artificial
market in the world for cars, computers, mobile phones—the pricing of money and a financial system that subsidizes borrowers
list is endless. Wine sales have more than tripled in just five years. at the expense of lenders. Or ponder environmental despoilment,
deteriorating demographics, water shortages and a growing
addiction to imported energy. It is a wonder the place works
A Heavy Burden
so well—or at all. There is enough fodder for a fierce debate
China’s Share of Expected 2012 Global Economic Growth
between panda haters and panda huggers. Now read on…
China 40%
Rest of Asia 24% A Matter of Timing
Other Emerging Markets 17%
Real reforms to rebalance China’s economy are on hold this
US 17%
Other Developed Markets 2%
year because of the once-a-decade leadership change. An
imminent collapse is unlikely, we think. The current leadership
will not go out with a bang, but certainly does not want a train
wreck during the final stages of stewardship.
Business cycles exist in China as elsewhere —but we expect a
Source: Deutsche Bank (January 2012).
Note: Assumes global economic growth of 3.2% in 2012. soft landing in 2012.

Flattening Out
Sales of Heavy Machinery and Autos

100 250% 2,000 150%
200 120
80
UNITS (THOUSANDS)

UNITS (THOUSANDS)

1,500
Y-O-Y GROWTH (%)

Y-O-Y GROWTH (%)

150 90
60 100 60
1,000
40 50 30
0 500 0
20
-50 -30
0 -100 0 -60
2008 2009 2010 2011 2012 2002 2004 2006 2008 2010 2012
Monthly Machinery Sales YoY % Monthly Auto Sales YoY %

Sources: Bank of America Merrill Lynch, China Construction Machinery Institute and China Association of Automobile Manufacturers.
Notes: Machinery sales data through January 2012. Auto sales data through February 2012.


In this interim period, it is important to read the economic tea Like some corporate chieftains, China likes to manage
leaves. Real estate prices, sales and construction are important expectations by under-promising and over-delivering.
ones. Politically sensitive food inflation is another one, as are
manufacturing gauges such as the various purchasing manager Premier Wen Jiabao set a 7.5% annual growth target for 2012

indexes (PMIs). in March—the lowest rate in almost a decade. Most China
watchers, however, believe the country will want to achieve at
At the start of 2012, the data were both conflicting and skewed least 8.5% a year. Official targets exist to be beaten. Like some
by the effects of the early lunar New Year holiday. Real estate and corporate chieftains, China likes to manage expectations by
key consumption indicators pointed down, while other gauges under-promising and over-delivering.
pointed up.
It is realistic to expect China to move toward economic growth
For example, sales of heavy machinery used in construction, of 6%-7% a year this decade versus the 10%-plus clip in the old
such as excavators, crashed. Auto sales flattened, pointing to days, we believe. Five reasons:
a general slowing in the wider economy. See the charts on the
} he political leadership appears to understand the
T
previous page.
drawbacks of too much credit.
By contrast, transport volumes are strong. And a gauge of small
} low growth in the debt-ridden developed world likely means
S
business activity has been ticking up. See the chart below. This
slack demand for exports.
is important because small businesses employ 60% of China’s
workers and make up 90% of companies. } he real estate boom has ended because tightening
T
measures have taken hold.
The rebound could indicate the government’s easing policy
} nfrastructure spending is slowing as policy shifts from
I
on liquidity has started to work. Bank credit enabled large
favoring bridges for the masses to pills for the people.
companies to pay their supplier bills. Secondly, it could mean
the bottom has not fallen out of exports because many small } avings rates—the fuel of deposit and loan growth—are
S
companies are exporters. likely to remain flat or drop from mind-blowingly high levels.

Beijing is expected to arrest this year’s slowdown in growth
A Ray of Light with all sorts of administrative and fiscal measures, while at the
China’s Small Business PMI, 2011-2012 same time trying to keep a lid on inflation and prevent more bad
debts that eventually could overwhelm the banking system.
60
58 Most people, perhaps too many, believe Beijing will walk this
56 tightrope. At US investor gatherings in late February, one Wall
SMALL BUSINESS PMI

54 Street firm’s China strategist polled the audiences and found
52 just one bear among roughly 1,000 people. This lonely creature
50
contrasted with a host of cubs the previous year.
48
46 Beyond 2012, the picture becomes very different. It is now clear
44 China’s 2009 stimulus was too much, in too short a time. Beijing
42 overestimated the US recession’s fallout. The result is a pile of
40 debt—which looks ready to fall over in the next few years (or
Jan ’11 Mar ’11 May ’11 Jul ’11 Sep ’11 Nov ’11 Feb’ 12 stay shaky forever).

Source: China Federation of Logistics and Procurement.
Note: Data through February 2012.
Most people, perhaps too many, believe Beijing will
walk this tightrope.


Credit: Too Much, Too Quickly
For a poster child of “financial repression,” pick any of China’s What changed in 2004? China had started to rack up huge account
one-billion-plus consumers. They have been bankrolling the surpluses because of bumper exports and an underappreciated
country’s infrastructure boom and manufacturing machine— RMB currency. The surplus hit an unprecedented 10% of GDP at
and have lost money in real terms in the process. (A cynic would its peak in 2007. The central bank started to offset, or sterilize,
say the West now is importing this made-in-China concept.) the flood of foreign currency by selling bills at very low rates.
Consumers who park their savings at banks have received For bankers, these were “bills you can’t refuse.”
negative returns after factoring in inflation, an average loss
To keep the banks profitable, authorities set deposit rates low.
of 0.54% a year since 2004. See the chart below.
Low deposit rates and high reserve ratios also would put a brake
on inflows of “hot money” speculating on appreciation of the
Don’t Take It to the Bank! RMB. The result: an effective tax on consumers who kept their
Real Return on Household One-Year Deposits, 1997-2011 savings at banks.

8% Financial repression worked well because consumption took
7
a back seat in China’s investment-driven master plan. More on
6
China’s hard-pressed consumer and unprecedented investment
REAL INTEREST RATE (%)

5 Average Interest
4 Rate = 3.04%
boom later. In this chapter, we review the credit boom these
3
2 savings helped create.
1
0
-1
The Great Credit Leap Forward
-2 Average Interest
Rate = -0.54% Armed with a reliable supply of cheap deposits, banks went on
-3
-4 a lending binge. The biggest beneficiaries were state-owned
-5 enterprises (SOEs) and local governments.
’97 ’99 ’01 ’03 ’05 ’07 ’09 ’11
The first group revved up exports and capital expenditures even
Source: Peterson Institute for International Economics. more, supported by cheap credit and subsidized energy costs.
Note: Data through December 2011. It was a lifeline to many enterprises that had no business
staying in business.

Debts Have a Way of Piling Up—Even in China
Credit Growth in Billions of RMB and as a Percentage of GDP, 1993-2011

15,000 50%
CREDIT GROWTH (RMB BILLIONS)

CREDIT GROWTH TO GDP (%)

12,000 40

9,000 30

6,000 20
% GDP
3,000 10

0 0
’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11
New RMB Loans New Foreign Currency Loans New Entrusted Loans New Trust Loans New Bank Acceptances
Corporate Bonds New Stock Issued by Non-Financial Enterprises Insurance Claims Paid Insurance Company Real Estate Other

Sources: Carl Walter, Su Ning, China Bank Statistics and People’s Bank of China.


The second group financed infrastructure works, office towers, It is unlikely China will let the market collapse.
conference centers and an array of faux landmarks, from Nobody wants to see a local government default
Chengdu’s Dorchester-inspired British town to Venetian canals or a big state firm go belly up.
and a replica of St Mark’s bell tower at the New South China Mall in
A bank CEO in a coastal city may say his operation is lending 100%
Dongguan. This helped inflate an emerging real estate bubble.
of deposits, no problem. He gets away with it because his bank
Credit grew and grew ... until a great leap forward in 2009. Worried is part of a national network that (still) has enough deposits in the
the world financial crisis and subsequent US recession would interior to make up for shortfalls on the coast. The government
hit China hard, Beijing engineered a huge monetary stimulus. may abolish this cap because it has many other ways to control
Credit doubled to a clip of at least 14 trillion RMB a year. See loan growth, notably its stranglehold on interbank market.
the chart on previous page.
Everything appears just hunky-dory for China’s banks: Non-
Credit grew at an compounded annual growth rate of 36% in the performing loans (NPLs) fell by 97% over the past decade and
period 2004 to 2010. As a result, the total value of bank loans now average just 1% of the loan book. See the chart below.
and bonds quickly exceeded GDP. See the chart below.

A Likely Sad Ending Too Good to Be True
Outstanding Loans and Bonds, 1996-2010 Non-Performing Loan Ratios of Major Banks, 1998-2011

60,000 140% 35%
LOANS AND BONDS (RMB BILLIONS)

LOANS AND BONDS TO GDP (%)

50,000 120 30
NON-PERFORMING LOANS (%)

100
40,000 25
80
30,000 20
60
20,000 15
40
10,000 20 10

0 0 5
’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10
0
Bank Loans Bonds
’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11
Loans/GDP Loans and Bonds/GDP
Sources: UBS, People’s Bank of China, China Banking Regulatory Commission and CEIC.
Sources: Carl Walter, People’s Bank of China and Wind Information. Note: Data before 2002 only cover the Big-4 state-owned banks.

This is where the problem lies: Take a machine that runs along
This is dangerous, especially because both local authorities
at a steady pace, suddenly inject adrenaline and order: “Go
and SOEs are already deep in debt. It is unlikely China will let the
lend.” The sheer magnitude and pace of this unbridled credit
market collapse, though: Nobody wants to see a local government
growth does not pass our smell test. It suggests to experienced
default or a big state firm go belly up. There is nothing subtle
investors there has to be trouble somewhere, sometime.
about the government guarantees of these entities.

Bad Debt? Just Roll It Over High-profile bankruptcies just do not fit into China Inc.’s master
China has plenty of rules to keep credit growth in check. But plan of economic growth and employment. And banks are very much
they are loosely enforced. For example, Chinese banks are part of the plan. Banks are, after all, an extension of the fiscal
supposed to lend up to 75% of deposits. But banks need to show policy. This is also the reason they trade at such low valuations.
a 75% loan-to-deposit ratio only at the month’s end—giving
them about 30 days each month when they can lend more.
Take a machine that runs along at a steady pace,
suddenly inject adrenaline and order: “Go lend.”


No Banker Will Come Clean This Year have deteriorated across the industry in the past three years,
with many second-tier banks already facing shortfalls, according
The practice of rolling over loans works—as long as banks have
to ratings agency Fitch Ratings.
enough deposits to play with. It is like a bath filling up faster
than it empties out. Do not expect any banks to come clean this year. Bank chieftains
angling for government positions in the leadership change will
But companies and consumers—faced with cash flow needs
want their records to remain squeaky clean.
and fed up with negative real returns—are starting to vote with
their feet and are pulling deposits. Banks, especially in coastal Put yourself in the position of a bank CEO. You have been presiding
areas, are trying to fight these outflows by offering asset-backed over five years—20 quarters—of profit increases. Now you are
securities that carry higher interest rates. About 10% of deposits gunning for that position in the State Council. Are you going to
has flowed into these “wealth management” products. See the bring down your profits this year by increasing provisions? Just
chart below. to be prudent? Chances are you will not. You leave it for the next
guy to deal with.

Looks Familiar? To be sure, there are plenty of deposits. They are just not for
Investment in Asset-Backed Securities Quadrupled, 2007-2011 lending. One example: To recycle the inflows of foreign exchange
and prevent the RMB from appreciating, the central bank obliges
8,000
ASSET-BACKED SECURITIES (RMB MILLIONS)

banks to hold vast quantities of reserve bonds yielding only 1.5%.
7,000 This deflates the money multiplier and kicks sand into the engine
6,000 of a credit-led economy.

5,000
Bank chieftains angling for government positions
4,000 in the leadership change will want their records to
remain squeaky clean.
3,000

2,000 In all, the Triple R (Required Reserve Ratio) and other measures
1,000 tie up some 10 trillion RMB of deposits. This has given the central
bank the means to provide stimulus when the economy needs
0
it. Every cut in the Triple R pumps some 380 billion RMB into the
2007 2008 2009 2010 2011
system (provided the cuts are not offset by capital outflows).
Index-Linked Asset-Backed Other
Asset-Backed Bills Asset-Backed Loans This doesn’t mean SOEs and other politically connected players
have a tough time getting credit. Not at all. They are issuing bonds
Sources: Carl Walter, Wind Information and Fitch Ratings. like there is no tomorrow—forced down banks’ throats at slightly
Note: Data through June 30, 2011.
higher rates than one-year deposit rates. The result is a huge debt
capital market where very few trades take place. Why? If a bank
Deposits from corporations under cash flow pressure (and with the sells these bonds, it is almost guaranteed to take a loss because
ability to export capital by padding overseas invoices) dwindled to nobody wants them at the price the bank paid for them. Bottom
near zero in the first nine months of 2011, compared with growth of line: The corporate bond market is bank lending in disguise.
3.7 trillion RMB in 2010. In the third quarter alone, corporate
deposits of an estimated 1 trillion RMB vanished into thin air. The bulls believe China has proved again and again it can fix

Combined with the strangle of rising reserve ratios, growth in these problems. The basic argument goes like this: Chinese banks

the M1 money supply has dwindled to a clip of 3%-4%. go bust every decade, but the country has just found a much
better way to deal with it than the West. Conclusion: Any
Moreover, deposit outflows have triggered a slow-motion cash weakness in the financial system will be dealt with quietly.
crunch. Smaller banks in particular are vulnerable, partly because
their loans are coming due earlier. Operating cash reserves Deposit outflows have triggered a slow-motion
cash crunch.

Blackrock investment institute [ 11 ]

Acronym to Watch: LGFV
Structure and Mechanics of Local Government Financing Vehicles (LGFVs)

How LGFVs Come To Be Typical LGFV Structure

Central Government Local Government

Equity/Loan Ownership of Local Enterprises,
23 Provinces Injection Land and Tax Subsidies
5 Autonomous Regions
4 Municipalities
(Beijing, Shanghai,
Chongqing, Tianjin) Repayment
2 Special LGFV Bank
Administrative Regions Cash Loan
Incorporated
6,500-8,200 LGFVs

Profit Cash Investments

333 Prefectures

2,858 Counties Activities
(Infrastructure, Utilities,
Transportation, Land
Development)
40,858 Townships

Sources: Deutsche Bank and China Statistical Yearbook 2010.

A Less Offensive Four-Letter Word time bomb, especially at a time a main source of local
government revenues—land sales—has dried up amid
Local governments cannot borrow unless they have specific
falling real estate prices.
approval from the State Council, the country’s highest executive
administrative body chaired by the premier. This doesn’t happen
Where there is a will, there is a way—especially
very often. It is not meant to happen often. Think of it as a in China.
company requiring CEO sign-off for all travel and entertainment.
TE costs will go down very quickly. Others are optimistic. LGFV net debt barely increased in 2011
because regulators discouraged banks from making new loans,
Where there is a will, there is a way, though—especially in
according to research firm CLSA. This compared with a 19% rise
China. Local authorities have set up special entities to pay for
in LGFV net debt in 2010 and a 62% stimulus-fueled jump in 2009.
infrastructure and other projects. This is perfectly legal. The
CLSA says. Local governments can pocket an increasingly smaller
chart above shows the mechanics of these so-called local
share of land sales because of higher spending on compensation
government financing vehicles (LGFVs).
and relocation. As a result, local revenues from land fees
The bulls believe China has proved again and again equaled just 9% of total national spending on infrastructure
it can fix these problems. in 2011, CLSA notes.

In any case, all local debt is an explicit liability of the central
LGFVs have taken out trillions of RMB in loans backed by land
government—which saw a 30% jump in tax revenues in 2011.
sales. China bears have long argued this represents a ticking
Beijing can pay a lot of bills.


Get Out of Debt Tomorrow Over the Refinancing Hump
A Possible Solution for Bad LGFV Debts Maturities of Local Government Debt

3,000 3,500 35%
30.2%
2,550 600
2,500 3,000 30
600 24.5%
RMB BILLIONS

2,000

TOTAL DEBT (RMB BILLIONS)
2,500 25
600
1,500

PERCENT DUE (%)
2,000 17.2% 20
260
1,000 120
245
1,500 15
125
0 11.4%
9.3%
Local Govt. Revenues
Asset Sales

Recoveries on Projects
Potential NPLs

Local Govt. Bond

Central Govt. Support

Over-Provision for NPLs

Write-Offs
1,000 7.5% 10

500 5

0 0
2011 2012 2013 2014 2015 2016 and
Beyond
Source: Deutsche Bank estimates.
Notes: Assumes 30% of LGFV loans default. Assumes local governments sell 10% of assets Sources: Deutsche Bank and National Audit Office.
and divert 2% of revenue. Note: Data as of year-end 2010.

Even if 30% of all LGFV loans default, the problem is manageable, In addition, most LGFV debt is spread out after scaling a renewal
according to Deutsche Bank. Local government bond issues, hump last year, with almost a third due only after 2016. See
asset sales and diverting 2% of government revenues would the chart above.
solve most of the problem in its view. See the chart above.


Real Estate: Can a Bubble Be Deflated?
The City Beckons
Urbanization and Migration

22 Cities 5 Million = 180 Million
71 Cities 2-5 Million = 216 Million 552 962 1,307 1,427
121 Cities 1-2 Million = 175 Million mln mln mln mln
100%
214 Cities = 571 Million Harbin

467
Shenyang 80 mln

Beijing 745

SHARE OF POPULATION (%)
mln
Tianjian
60 790
490 mln
Xi’an mln

Nanjing
40
Shanghai 960
mln
Chengdu Wuhan
Hangzhou 562
20
mln
Chongqing
172
62 mln
Guangzhou 0 mln

1950 1978 2005 2025
Rural Urban

Sources: ISI Group, CEIC and National Bureau of Statistics.
Note: Numbers in millions of people.

Rapid urbanization drove China’s housing boom for much of the Something’s Got to Give
2000s—and is likely to do so in the future. China is expected to
Some 40%-45% of all residential properties sold in early 2009
have almost one billion urbanites by 2025. It already has 214
were for investment purposes, according to think tank Peterson
metropolitan areas with more than one million people, four
Institute. Other speculative bubbles built in jade, art and gold
times as many as the United States. See the chart above.
prices, but there was nothing like real estate. Beijing inadvertently
Many Chinese already owned their homes, but often these were made it the preferred asset class, egged on by powerful
shacks or rural dwellings. There was definitely a need to upgrade, interests that cashed in on this state-sponsored freebie.
and many households did just that.
Other speculative bubbles built in jade, art and gold
Then savers desperate for yield and “hard assets” started to prices, but there was nothing like real estate.
snap up apartments. Where else could they go? Banks offered
negative real interest rates. The stock market was perceived as
a big high-roller table at best. And offshore markets were—and
are—pretty much shut.


Local governments did their part to support the boom by providing The risk to housing in China is not so much its
infrastructure and sponsoring grandiose projects. They bought imminent collapse, but how ubiquitous other
farmland at artificially low prices and sold it for a profit to segments of the economy are exposed to it.
developers. Over time, local governments became addicted to
Sales volumes and prices fell after government measures to
these land sales as a source of revenues. And the practice to
dampen speculation and prevent prices from spiraling beyond
appropriate land became the root cause of periodic local
the reach of the emerging middle class. There are some tentative
outbreaks of social unrest.
signs of bottoming (see the charts below), especially in second-
Real estate has been a great wealth creator, for companies, local and third-tier cities where people buying homes for themselves
governments and individuals alike. The top source of wealth are a more important source of demand than investors.
among China’s richest 1,000 people is real estate, according to the
latest ranking by Hurun Report Magazine (which was appropriately A Men’s Shirtmaker Diversifies
sponsored by the Hainan Clearwater Bay luxury development).
The real estate market is the biggest risk to China’s economic
No wonder those feasting want the banquet to continue.
growth this year. The tipping point will likely come in the second
quarter, when downside risks to the entire economy will start to
Sales volumes and prices fell after government
measures to dampen speculation and prevent outweigh inflation and affordability considerations. Or will they?
prices from spiraling upward. Our assumption is Beijing wants to take real estate prices down
25%-30% from their highs. With a 10% fall already, there is a painful
Bubbles involving real estate are quite common. This seemed to
additional 15%-20% to go. This is dangerous. The biggest risk
have all the signs, including the endemic involvement of local
is stagflation—when activity drops off a cliff while prices stay high.
governments and the corporate sector. It is clear the boom
In that case, the government may stick to its tightening policy.
cannot last. (Nor does Beijing want it to last.) Consider:

} hina’s residential housing construction equaled almost 10%
C How big is the real estate sector? It makes up 20% of fixed

of GDP in 2011, compared with 6% for the US economy during investments, translating into a 10% share of GDP. But the sector

the height of the boom in 2005. looms much larger in reality. We suspect land is collateral for
more than half of loans. Real estate is interwoven with the
} eal estate accounted for 40% of urban household wealth
R
entire economy. In other words: The risk to housing in China is
in 2010, double the proportion in 1997, according to Peterson
not so much its imminent collapse, but how ubiquitous other
Institute. It is hard to imagine it doubling again in the next decade.
segments of the economy are exposed to it.

That Sinking Feeling
Real Estate Prices and Sales Volumes in Major Cities

12,000 150%

120
Y-O-Y SALES VOLUME GROWTH (%)

10,000
RMB PER SQUARE METER

90
8,000
60

6,000 30

0
4,000
-30
2,000
-60

0 -90
2007 2008 2009 2010 2011 2012 2010 2011 2012
Weekly Sales Prices Volume Growth

Sources: Deutsche Bank and Soufun.
Notes: Price and sales volume trends in 39 major cities. Volumes represent year-over-year growth in four-week periods. Data through March 2012.


Clearing Out Inventory Can We Finally Afford It?
Months to Clear Real Estate Inventory at Current Sales Rates Housing Prices as a Factor of Annual Household Incomes

40 12

35
11

FACTOR OF HOUSEHOLD INCOME
30
MONTHS TO CLEAR INVENTORY

10
25

20 9

15 8

10
7
5

6
0
2007 2008 2009 2010 2011 2012
2008 2009 2010 2011 2012 Housing Affordability
Inventory +1 Standard Deviation -1 Standard Deviation

Source: Deutsche Bank. Source: Deutsche Bank.
Note: Weekly data through March 18, 2012. Note: Estimated data through end 2012.

One example: The CEO of a men’s shirtmaker says he expects Anecdotal evidence abounds: Coffers with cash in Macau and
100 billion RMB in revenue in three years, with the core shirt Hong Kong. Record real estate prices in Vancouver. Australian
business making up just 1%. It is tough to make money in the mines and vineyards snapped up by Chinese buyers.
apparel business, so the CEO is building a 400-meter office
Once people start believing prices will keep falling, they stop
tower—the highest in his city—and outlet malls.
buying. Just 19% of people expected housing prices would go
This particular CEO is not alone. He illustrates how real estate up in the first half of 2012, down from around 45% in 2009,
runs through the entire economy. It is not about a few developers according to a December People’s Bank of China quarterly
going bust. It is about local governments. It is about the entire survey. The same survey showed 21% expected prices to
corporate sector. It is hard to see a happy ending here. We fall and 46% anticipated a flat market.
struggle to find a precedent in history where the bursting
Things looked pretty grim in the first quarter. For example, not
of a property bubble did not lead to financial distress.
one transaction closed in Beijing, a city of 20 million, during
the entire Chinese Year of the Dragon celebrations, according
A Quiet New Year for Realtors
to JPMorgan. Overall, transactions have plummeted and
A slowdown or, worse, a crash in the real estate market inventory has risen to 15 months worth of sales. See the
also would hurt consumer spending. If the US experience chart above on the left.
is any guidance, ever-increasing real estate prices can drive
consumption. Take them away, and consumption plummets. The inventory may be understated as the gap between floor space
under construction and the amount sold is huge: 1.9 billion vs.
Some money is already fleeing the country. China had capital 1.1 billion square meters in 2011. The gap is slowly closing, but
outflows in the fourth quarter of 2011—the first time since the there is a big overhang. And new construction usually lags six
Asia crisis in the late 1990s. Speculative inflows betting on an months behind trends in real estate sales.
RMB revaluation dried up as it became clear China’s economy
was slowing. This put the spotlight on the wealthy taking money Once people start believing prices will keep falling,
abroad. they stop buying.


Commercial real estate is hit hardest, especially in second-tier The question we ask ourselves is: Suppose the
cities. Chongqing, for example, will have nearly 800,000 square government took its foot off the brake; could it
meters of new commercial space in 2012, whereas the annual reignite demand in housing?
take-up has been just 150,000 square meters.
population, or 200 million people, live in cities but do not
The government has started to offer incentives for first-time have a proper registration.
home buyers, including lower mortgage rates combined with
Another avenue is the push toward low-end “social housing.” This
“guidance” to banks to lend to this group. It could ax deed taxes
will not do much for prices of high-end private homes, but it does
and even cut mortgage down payments—although it would not
serve the dual purpose of creating affordable housing for the
resort to the latter measure lightly.
masses and keeping the construction industry going. Expect
social housing construction to almost double to more than seven
Breaking a Vicious Circle
million units this year, according to Bank of America Merrill Lynch.
Some fear it is already too late to re-engineer a real estate
turnaround—even in a command economy such as China’s. The market is starting to believe the magic of policy. Bonds and
These bears predict a vicious circle of lower real estate prices shares of Hong Kong-listed developers rose sharply at the start
and lower activity. of the year. One company even raised new equity. The triumph
of hope over experience? Only time will tell.
On the positive side, China has had much shorter real estate
cycles than the West. Policy measures reversed a downturn It is clear the government is not ready yet to reverse its housing
at the end of 2008 in six months, for example. In the current policy. Premier Wen Jiabao in early March emphasized house
climate, affordability is improving fast. If prices were to fall 20% prices were still too high and that relaxing existing curbs could
from their peak and real wages were to grow 13%, affordability cause “chaos.” This dampened investor hopes for a policy reversal
would improve by one third in one year. In the US market, this and caused stocks to post their biggest daily loss in months.
would take about a decade. See the chart on the previous page. The questions we ask ourselves are: Suppose the government
One way to boost the housing market—and consumption—is took its foot off the brake; could it reignite demand in housing?
reforming or doing away with the hukou system that bars migrant And suppose the paralysis in policymaking lasts long enough
workers without proper urban registration from essential services to destroy confidence in real estate as an inflation hedge?
such as schooling and healthcare. As much as 15% of the

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