Grant's Interest Rate Observer: 

China Real Estate Bubble?

Red sea

Rising short term interest rates (almost) the world over have been one defining characteristic of financial 2017.  For instance: The yield on China’s five-year sovereign bond, which traded as low as 2.41% in October 2016, briefly topped 4% last week, and has since recovered a bit to 3.91%. As is the case in the U.S., relative weakness in shorter-duration bonds has flattened the yield curve. China’s 10-year note yields a virtually identical 3.93%. 

With that potentially significant rates action as a backdrop, a Reuters investigative piece published this morning serves as fair warning (not the first) to investors that China’s property-and-leverage-heavy financial system may be standing on shaky ground. Detailing an early 2016 apartment sale in the southern city of Shenzhen that fraudulently featured three separate purchase agreements, one for the bank with an inflated home value, one for the taxman with an understated home value, and a third, “real” document (the swindle was unveiled in court but no party was punished). Reuters asserted that the practice was far from uncommon, while noting the potential for far broader implications:

Mortgage fraud like the pair’s flouting of rules designed to protect banks is rampant in China’s roaring property market, according to interviews with buyers, sellers, and dozens of property market insiders including real estate agents, lawyers, bankers, valuers and loan middlemen from three of China’s major cities and four smaller cities. Many of these people declined to be identified because they were familiar with or involved in “re-packed” loan applications, the industry euphemism for these frauds.

“When everyone is doing it, you can’t put everyone in jail,” says [Hu Weigang, a senior partner at Guangdong Shen Dadi Law Firm], who specializes in real estate litigation.

While property prices in China continue to rise, mortgage fraud remains largely a hidden danger, much as subprime loans in the United States remained mostly out of sight ahead of the 2008 global financial crisis. The fear is that in a property correction, fraudulent mortgages would unravel, accelerating a collapse of housing prices in the world’s second biggest economy. This, in turn, would imperil China’s debt-laden financial system.

Writing in the Financial Times today, Chen Zhao, chief global strategist of Alpine Macro, offers a dissenting view to the opinion (held by Grant’s among others) that China is an economic disaster waiting to happen. Zhao argues that a high debt-to-GDP ratio, instead of signaling potential instability, is actually a function of high savings rates, which necessitate credit creation to transform savings into investment.  Speaking of China in particular, Zhao writes:

Looking around the world, the levels of interest rates for different countries are negatively correlated with levels of total indebtedness. Countries that have borrowed aggressively – such as Japan, China and Singapore, have very low or zero interest rates. 

China has a chronic current account surplus and has been a net creditor to the rest of the world for decades. Beijing’s outstanding public sector, valued at $4 trillion, is dwarfed by the vast assets controlled by the various levels of governments. Therefore, China’s sovereign risk is extremely low. Importantly, the balance sheets of the Chinese state-owned banks, the government and the People’s Bank of China are all interconnected. Under these circumstances, a debt crisis in China is almost impossible. 

A high debt-to-GDP ratio may or may not portend trouble on its own, but China’s explosive credit growth has caused Victor Shih, associate professor of political economy at The University of California, San Diego, to sound the alarm.  In a study entitled “Financial Instability in China: Potential Pathways and their Likelihood,” Shih invokes a provocative comparison to describe the Middle Kingdom’s increasing reliance on leverage:

China as a whole is a Ponzi unit. Total interest payments from June of 2016 to June of 2017 exceeded incremental increase in nominal GDP by roughly 8 trillion RMB. [$1.2 trillion]

This was not always the case . . . prior to 2011 incremental nominal GDP roughly matched or even exceeded interest payments.

The advent of high-yielding shadow banking led to the explosive growth in interest payments, and thus the need to capitalize interest payments, starting in 2012.

To be sure, the Chinese government has succeeded in avoiding the bursting of the asset bubble, but this has been achieved by a greater degree of leveraging.

This afternoon, Shih hopped on Twitter to respond to the Reuters mortgage story, commenting that: “That’s not fraud in China. That’s how every borrower, starting from the government, obtains loans in China.”