Thursday, May 13, 2010

More on the Chinese real estate "bubble"

While reading the comments to M Pettis' excellent latest entry I spotted this:
The loan to value ratio has been between 10-20% from 2005 to 2008, it had increased to 46% in 2009 and further surged to 76% in 1Q10. (I used the incremental increase in mortgage loans from PBoC report and value of commercial residential transacted data from NBS ... I suspect the surge in loan in April further increases this leverage ratio.

I attribute this surge in leverage to two main reasons, 1) speculators have finally realized they can make a lot more $$ if they lever up and the common belief in China is that property prices will keep on going up ... Real demand is forced to lever to buy. To me, this is a sign of the upper bound of the affordibility. (sic)
Ding! ding! ding! If this man is really correct, those are some bubblicious circumstances. And if the LTVs are really as high as the upper 70s, well, 3 words: Balance-sheet recession. This should be really interesting. Outside of that whole thing, Pettis makes some excellent arguments and manages to concisely verbalize thoughts that I could spend hours rambling about and never really get across, so I'll just quote him:

For example, if RMB 100 is borrowed to build a railroad, the debt is sustainable if the railroad creates net economic value to China of RMB 100 or more.  If it doesn’t, the difference must be considered net debt that one way or another must be paid for by Chinese households.  This will of course reduce their future consumption along with the economic growth associated with satisfying that consumption.

Note that net economic value does not mean the total profits of the railroad generated by ticket revenues less operating costs.  We could begin with that number, but the value of the railroad would be increased by associated externalities – i.e. building the railroad might lower transportation costs for a number of businesses, allowing them to grow and to add economic value indirectly.  It would be reduced by certain opportunity costs, for example the alternative use of the land if it had a better use, or the negative impact it might have on the existing highway and airline infrastructure.

But most importantly it would be reduced by distortions in the financing cost.  For example, if the railroad were to be fully financed by 10-year bonds with interest rates 3 percentage points below the “natural” borrowing cost (a very low estimate), the economic value of the railroad would have to be reduced by RMB 19.

This amount is simply equal to the net present value of the hidden transfer from the lender to the borrower.  The fact that the borrower can obtain subsidized funds at an artificially low cost must represent a transfer of wealth from the providers of the funding, and this subsidy is a loss for the rest of the economy equal to the additional value for the entity being subsidized (another way of saying that there is no free lunch*).  By the way if the cost of funding is repressed by 6 percentage points, a perfectly plausible number, the net present value of the hidden subsidy is RMB 34.  These are not small numbers.
 I know that's long, but compared to how much he says, it's not a lot of words. This is the best summary of the problems of cheap credit I have EVER seen. And it's not only applicable to China, it applies to us too! Think about all  the artificially suppressed mortgage rates, the Fed and FDIC backing/guarantee programs, the whole issue of ZIRP etc. There's a ton of liquidity out there and it needs to go *somewhere*. If you lower rates enough, people will start investing in projects with negative NPVs. I know that doesn't make sense, but if you calculate the NPV as the present-value of the probability-adjusted payouts, one might go into a project with the odds against him because you can finance it with a loan, and if it goes bust you can just default. Which is really the problem with ZIRP, that it we end up investing in what essentially is a debt-financed call-option.

This kind of casino capitalism isn't going to get us anywhere. If we ever hope to get back to growth and increasing standards of living we can't all just sit around trading shit back and forth, we need to reduce our speculative activities and get back to funding and working on value creating processes.


PS: I find it fitting that Abnormal Returns (no link for them) linked to this same article when talking about the SSE performance. Way to miss the whole point, assholes. It's fitting that it's part of the "twit" network.

2 comments:

  1. One of the things that I think will make China particularly messy is that new home buyers are borrowing the 40%+ down payments from family members as well as taking a bank loan. A housing crash in China has the potential to wipe multiple generations of savings, as well as blowing up the major banks

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  2. I'm not sure you are correct to say that money lent at a below market rate somehow robs the economy of growth.

    Surely that growth is simply a function of the value of the project funded. And in some long term vision cases, government impetus is required.

    I'd guess you are arguing that in the bigger picture that capital always finds the most efficient way to invest and grow.

    I'd theorize that it is only ever reacting within the government 'guidance' of the time (Laws, taxes, wars, social programs) AND the latest 'corporate fashions' (eg, CEOs bonused for 'growth' whether it be by mergers or by actually expanding the business, and the value of those decisions is influenced by economics ... banks throwing money at some idea).

    So, a long term investment even if funded at 'subsidized' interest rates may still give greater returns in the future.

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