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The Straits Times
Oct 10, 2011
CAI JIN
A credit crunch brewing in China?
Growing number of SMEs going bust prompts fears of wider financial distress

By Goh Eng Yeow

THE financial problems in Greece and other debt-burdened European countries continued to dominate the headlines but it was concern over China's financial health that triggered a plunge in regional stock markets early last week.

While the Shanghai market was closed last week for China's National Day holiday, the smart money was fidgeting nervously over the growing number of bankruptcies reported among mainland firms and wondering if it was a sign of wider financial distress.

At the epi-centre of China's debt crisis is the coastal city of Wenzhou - a major manufacturing hub - where almost 20 firms have gone bankrupt this year, spurring some businessmen to run away with debts unsettled.

It led to Chinese Premier Wen Jiabao making a two-day visit to the city last week, with Finance Minister Xie Xuren and central bank governor Zhou Xiaochuan, and ordering banks to lend more to cash-strapped firms.

Yet, despite fears that China may be headed for a crash landing, there is little evidence that a major slump is under way.

A key economic indicator - the September purchasing manager's index - showed that its mighty manufacturing sector is back on the growth trajectory for a second straight month after declining from March to July.

Still, investors preferred to take a better safe than sorry attitude.

On Monday and Tuesday last week, they sold out of the Hong Kong market - host to many giant mainland companies - sending the Hang Seng plunging 1,342 points, or 7.6 per cent, to its lowest level since May 2009.

Singapore's Straits Times Index failed to escape lightly either, falling 144 points, or 5.4 per cent, to a 25-month low.

Given the growing influence of China's economy in the region, it is not surprising to find foreign investors had taken fright.

Among the worst-hit counters from the sell-off were the Macau casino operators, which have benefited enormously from the growing number of Chinese high-rollers to the territory.

These included billionaire Stanley Ho's SJM Holdings, which dived by 25.5 per cent, and Sands China - the Macau unit of casino giant Las Vegas Sands - which fell 14.3 per cent on Monday last week.

But local investors ought to exercise caution too, given the exposure which Singapore lenders and firms may have to China.

As of the second quarter, DBS Group Holdings lent $36.9 billion to Hong Kong companies and another $19.1 billion to companies in the rest of Greater China, which include China and Taiwan.

Over the same period, loans to Greater China firms came up to $14.6 billion for OCBC Bank and $7.26 billion for United Overseas Bank.

About 150 mainland firms - or S-chips as they are known here - are listed here and some may be suffering from the same funding stress encountered by Wenzhou firms.

And according to a Goldman Sachs report, Chinese buyers accounted for 8.8 per cent of all sales in Singapore's residential property market in the third quarter, and 28.3 per cent of all transactions by foreigners.

Therefore, if financial stress back home affects their buying here, property prices will suffer.

Still, the jury is out among economists as to whether the credit crunch faced by cash-strapped small and medium-sized enterprises (SMEs) in China would be serious enough to cripple the entire economy.

Credit Suisse economist Dong Tao noted in a recent report that developers and small firms on the mainland had to turn to the grey market to get loans after being frozen out of the banking system.

But to get much-needed credit, they were charged between 14 per cent and 70 per cent in interest, well above bank lending rates.

Although there is no data that captures the size of the shadow banking system, Mr Tao believed loans of up 4 trillion yuan (S$815 billion) could have been made.

Originally, the lenders were businessmen who wanted to get a better return on the paltry deposit rates but this has now spread to include the 'entire industrial chain involving banks, guarantee companies, pawnshops, investment guarantor companies and even state-owned firms'.

Mr Tao noted that what makes the problem worrying is that about 60 per cent of the loans might have been taken up by small and medium-sized property developers.

'Most Chinese developers have never experienced a bear market cycle. They refuse to cut prices in a time when transaction volumes have fallen sharply and continue to pay the high interest rates, hoping that the Chinese government's tightening policy will ease soon,' he said.

CIMB economist Pauline Loong, however, believed that Beijing loses nothing from media coverage of a 'crisis'.

'Anecdotes of fleeing debtors make good colour but colour is not data. The very nature of private lending and the size of China, in our view, means that accurate estimates are next to impossible. And in China where numbers tend to be big, it is easy to lose perspective,' she said.

These loans are short term in nature and are usually raised for working capital needs. 'If a borrower goes bust, the lender soon knows about it. There is no long-term hidden risk,' she added.

So investors can conclude from her analysis that the crisis over an SME credit crunch in China may well be a case of much ado about nothing.

The next few months will tell which economist is right. For investors, a sudden crash in China's economy will be the last thing they want on their lengthening list of worries.

engyeow@sph.com.sg

Some more China-related reading for those following the issue.

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China's epic hangover begins (link here)
By Ambrose Evans-Pritchard, International business editor
10:20PM GMT 14 Dec 2011

It is hard to obtain good data in China, but something is wrong when the country's Homelink property website can report that new home prices in Beijing fell 35pc in November from the month before. If this is remotely true, the calibrated soft-landing intended by Chinese authorities has gone badly wrong and risks spinning out of control.

The growth of the M2 money supply slumped to 12.7pc in November, the lowest in 10 years. New lending fell 5pc on a month-to-month basis. The central bank has begun to reverse its tightening policy as inflation subsides, cutting the reserve requirement for lenders for the first time since 2008 to ease liquidity strains.

The question is whether the People's Bank can do any better than the US Federal Reserve or Bank of Japan at deflating a credit bubble.

Chinese stocks are flashing warning signs. The Shanghai index has fallen 30pc since May. It is off 60pc from its peak in 2008, almost as much in real terms as Wall Street from 1929 to 1933.

"Investors are massively underestimating the risk of a hard-landing in China, and indeed other BRICS (Brazil, Russia, India, China)... a 'Bloody Ridiculous Investment Concept' in my view," said Albert Edwards at Societe Generale.

"The BRICs are falling like bricks and the crises are home-blown, caused by their own boom-bust credit cycles. Industrial production is already falling in India, and Brazil will soon follow."

"There is so much spare capacity that they will start dumping goods, risking a deflation shock for the rest of the world. It no surpise that China has just imposed tariffs on imports of GM cars. I think it is highly likely that China will devalue the yuan next year, risking a trade war," he said.

China's $3.2 trillion foreign reserves have been falling for three months despite the trade surplus. Hot money is flowing out of the country. "One-way capital inflow or one-way bets on a yuan rise have become history. Our foreign reserves are basically falling every day," said Li Yang, a former central bank rate-setter.

The reserve loss acts as a form of monetary tightening, exactly the opposite of the effect during the boom. The reserves cannot be tapped to prop up China's internal banking system. To do so would mean repatriating the money – now in US Treasuries and European bonds – pushing up the yuan at the worst moment.

The economy is badly out of kilter. Consumption has fallen from 48pc to 36pc of GDP since the late 1990s. Investment has risen to 50pc of GDP. This is off the charts, even by the standards of Japan, Korea or Tawian during their catch-up spurts. Nothing like it has been seen before in modern times.

Fitch Ratings said China is hooked on credit, but deriving ever less punch from each dose. An extra dollar in loans increased GDP by $0.77 in 2007. It is $0.44 in 2011. "The reality is that China's economy today requires significantly more financing to achieve the same level of growth as in the past," said China analyst Charlene Chu.

Ms Chu warned that there had been a "massive build-up in leverage" and fears a "fundamental, structural erosion" in the banking system that differs from past downturns. "For the first time, a large number of Chinese banks are beginning to face cash pressures. The forthcoming wave of asset quality issues has the potential to become uglier than in previous episodes".

Investors had thought China was immune to a property crash because mortgage finance is just 19pc of GDP. Wealthy Chinese often buy two, three or more flats with cash to park money because they cannot invest overseas and bank deposit rates have been minus 3pc in real terms this year.

But with price to income levels reaching nosebleed levels of 18 in East coast cities, it is clear that appartments – often left empty – have themselves become a momentum trade.

Professor Patrick Chovanec from Beijing's Tsinghua School of Economics said China's property downturn began in earnest in August when construction firms reported that unsold inventories had reached $50bn. It has now turned into "a spiral of downward expectations".

A fire-sale is under way in coastal cities, with Shanghai developers slashing prices 25pc in November – much to the fury of earlier buyers, who expect refunds. This is spreading. Property sales have fallen 70pc in the inland city of Changsa. Prices have reportedly dropped 70pc in the "ghost city" of Ordos in Inner Mongolia. China Real Estate Index reports that prices dropped by just 0.3pc in the top 100 cities last month, but this looks like a lagging indicator. Meanwhile, the slowdown is creeping into core industries. Steel output has buckled.

Beijing was able to counter the global crunch in 2008-2009 by unleashing credit, acting as a shock absorber for the whole world. It is doubtful that Beijing can pull off this trick a second time.

"If investors go for growth at all costs again they are likely to find that it works even less than before and inflation returns quickly with a vengeance," said Diana Choyleva from Lombard Streeet Research.

The International Monetary Fund's Zhu Min says loans have doubled to almost 200pc of GDP over the last five years, including off-books lending.

This is roughly twice the intensity of credit growth in the five years preceeding Japan's Nikkei bubble in the late 1980s or the US housing bubble from 2002 to 2007. Each of these booms saw loan growth of near 50 percentage points of GDP.

The IMF said in November that lenders face a "steady build-up of financial sector vulnerabilities", warning if hit with multiple shocks, "the banking system could be severely impacted".

Mark Williams from Capital Economics said the great hope was that China would use is credit spree after 2008 to buy time, switching from chronic over-investment to consumer-led growth. "It hasn't work out as planned. The next few weeks are likely to reveal how little progress has been made. China may ride out the storm over the next few months, but the dangers of over-capacity and bad debt will only intensify".

In truth, China faces an epic deleveraging hangover, like the rest of us.

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Chinese property hits lofty ceiling (link here)
The crash, when it comes, will have dire implications for the global economy at a time of deepening gloom
by Jamil Anderlini

In a showroom built to resemble an ancien regime palace, a platoon of salespeople stands idle on the frontline of a looming Chinese property bust.

The luxury apartments of Versailles Residentiel de Luxe La Grand Maison, located next to a polluted river in the third-tier coastal city of Wenzhou, have not yet been built but are already on sale for as much as 70,000 yuan (S$14,415) a square metre. That is more than double the annual income of the average Wenzhou resident, who would have to save every penny for 350 years to buy a 150 sq m home in this development.

But even the few who can afford it seem to be having second thoughts. "We have been told to say publicly that everything is going very well and our apartments are selling even though none of the other developments in the city can sell theirs," says one sales assistant who asks not to be named for fear of losing his job.

Prospective owners have paid deposits on only a dozen or so of the 198 apartments on sale at La Grand Maison. "Prices are dropping fast and everyone is waiting for them to fall further before they think about buying," says the sales assistant.

Across the country, from the big cities of Beijing and Shanghai to the smallest regional towns, countless such complexes have sprung up in recent years as developers and local governments have rushed to capitalise on the frenzy for property. But now, following a decade-long boom and nearly two years of attempts by the central government to cool the overheated sector, the market appears to have turned. Sales volumes have slid and prices are falling as developers try to tempt reluctant buyers with discounts.

"China's property bubble is bursting," says Mr Andy Xie, an independent economist. From their current elevated levels, "prices may fall by as much as 25 per cent soon and by another similar amount in the following two to three years".



KNOCK-ON EFFECT

The downturn comes just as the market expects a wave of new supply, particularly in smaller cities such as Wenzhou, on China's prosperous eastern seaboard. The country's 80,000 property developers own enough land to build nearly 100 million apartments. Add this to vacant apartments for sale, according to estimates by Credit Suisse analysts, and China already has the capacity to satisfy housing demand for up to 20 years.

The consequences of a crash would be dire for the wider Chinese economy and for the economies of many other countries that rely on China to fuel their own growth.

Last year, property construction accounted for 13 per cent of gross domestic product, and for more than one-quarter of all investment in what is the most investment-dependent economy in history. Property directly accounts for 40 per cent of Chinese steel use; the country itself produces more steel than the next 10 producing countries combined, making it by far the most important buyer of inputs such as iron ore.

Construction in China is also important for a host of other industries, from copper, cement and coal to power generation equipment. The sector "matters to an extraordinary degree for overall Chinese growth, for commodity demand, household expenditures, external trade and underlying heavy industrial profitability", says Mr Jonathan Anderson of UBS.

He calls it "the single most important sector in the entire global economy, in terms of its impact on the rest of the world".

The increasing prospect that this sector could come to a screeching halt has serious implications for the global economy at a time of deepening gloom and uncertainty. It is especially important for commodity exporters that have seen their economies boom on the back of Chinese demand for raw materials.

"The growth model China has followed for the last few years, which has involved a whole lot of property construction, is running out of steam," says Mr Mark Williams of Capital Economics. "People have not priced in the coming re-balancing of China away from commodity-intensive development and this has to be bad for economies like Australia, Brazil and Chile."



PUBLIC UNHAPPINESS

Chinese housing prices have soared so high and so fast that the dream of owning an apartment is now out of reach for almost anyone who does not already have one. Growing public dissatisfaction prompted the government early last year to start introducing increasingly tough restrictions, such as higher deposit requirements and outright bans in some cities on the purchase of more than one apartment. But the measures have started to work only in recent months.

According to government figures -which most analysts believe understate the reality - average housing prices more than doubled in the last four years nationwide, while in Beijing and some other regions, the price increase was more like 150 per cent. Data are incomplete but analysts say the price of an average apartment in a Chinese city is now about eight to 10 times the average annual income nationwide; in cities like Beijing and Shanghai, the ratio is closer to 30 times.

Even at the height of the United States real estate bubble in 2005, the price-to-income ratio for the whole of America peaked at about 5.1, while cities such as Las Vegas, where the bubble was biggest, saw the ratio reach 5.6, according to Zillow, a real estate information company. Historically, US home prices have tended to be about three times average annual incomes and they are close to that level again now, six years after the bubble burst.

Government policy over the last decade set up perverse incentives that almost seem designed to create a bubble, say Chinese analysts and economists. To start with, all land belongs to the state and local government officials have monopoly power over its supply. In an autocratic, opaque and corrupt system, that gives them enormous authority to decide who gets to use that land and how.

Faced with chronic revenue shortfalls but forbidden to run deficits, local governments have come to rely on land sales (the "sales" are actually only of land-use rights of up to 70 years) for up to 40 per cent of their income. Analysts say the tax system encourages real estate speculation by wealthy Chinese who have few other investment alternatives and face negative real interest rates if they deposit their money in the bank.

Apart from pilot projects in Shanghai and in Chongqing to the west of the country, nowhere is an annual property tax levied and the property transaction tax that exists is derisory.

"Right now the high housing price is not due to limited supply - it is because of endemic speculation but the government doesn't combat speculation because high prices keep GDP growth and revenues high," says Professor Yi Xianrong at the China Academy of Social Sciences, a government think-tank.

"China's real estate bubble is undeniably the biggest in history but our property taxes are lower than Zimbabwe's; the situation is laughable."



FINANCIAL SYSTEM AT RISK

China's domestic financial system, which sailed through the global financial crisis mostly unscathed, is also vulnerable. When Beijing unleashed an enormous stimulus package in late 2008 to combat the effects of the crisis, much of the money went into construction.

The government says developers and mortgage borrowers account for about 20 per cent of all loans but senior regulatory officials admit that figure probably significantly understates the true exposure of the broader financial system to a downturn in the sector.

A banking stress test conducted this year by China's biggest banks concluded that non-performing loans would tick up only slightly if real estate prices halved. But analysts say the test did not take into account a steep fall in transaction volumes that has already hit much of the country or recognise how falling prices would affect the wider economy when construction inevitably slowed down. Nor did the test try to estimate how falling land sales and prices would affect the value of bank collateral, even though the vast majority of collateral in the system is land or property.?

In Wenzhou, often seen as a bellwether for the wider economy, house prices fell 5.2 per cent in October from the same time a year earlier and dropped 4.6 per cent from a month earlier. Prices have not yet fallen as much elsewhere - but transactions across the country were down 11.6 per cent from a year earlier in October, compared with a 7 per cent fall in September, and in the 15 largest cities the drop was 39 per cent.

"The volume of land transactions has also dropped sharply as developers hold off on new projects and will probably continue to weaken as home-buyer sentiment falls further," says Mr Du Jinsong, China property analyst at Credit Suisse.



GOVERNMENT IN TOUGH POSITION

So far, the government has stood firm on its commitment to bring down property prices and has refused to roll back any of its restrictions. This year, it unveiled a plan to build 36 million subsidised housing units for low-income families in just three years, in the hope that this would make up for the slowdown in commercial house-building.

But there is some evidence this plan is already faltering, because of opposition from developers and local governments who are expected to build and pay for units on land they would have otherwise been able to earn big profits from.

"The subsidised housing is all very poor quality and in terrible locations," says Professor Cao Jianhai, a real estate expert at the China Academy of Social Sciences. "Local governments are not willing to build affordable housing that can compete with commercial residential developments."

Given the importance of the sector to the overall economy, most analysts believe that if prices drop too far, Beijing will step in to save the market by lifting purchase restrictions and pumping more credit into the economy.

But others warn that saving the property sector would require another flood of liquidity into the system and would only re-inflate the bubble, leading to higher inflation and an even bigger crash in the future.

"The government is in a very difficult position," says Professor Tao Ran, an economics don at Renmin university in Beijing. "If they relax macroeconomic policy the bubble will get worse. But if they don't relax policy then the bubble will pop and the economy will stall."

It is an eventuality that may already be confronting the backers of the faux French development in Wenzhou. The Financial Times Limited

Jamil Anderlini is the FT's Beijing bureau chief and has been a correspondent covering China since 2003.

More China property-related reading.

This time one by Patrick Chovanec from Tsinghua University (China's Real Estate Bubble may have just popped) and one on the magnitude of hidden local government debts by Bloomberg (China Debts on Local Projects Dwarf Official Data)

The next round after the property crash will be the overcapacity of industries in China. With the decline of demand for it's exports, e situation can be pretty bad for e next decade.