Here we are, ten years after the bankruptcy of Lehman Brothers, and one would be hard pressed to find evidence of meaningful lessons learned. Chuck Prince's utterance, "As long as the music is playing, you've got to get up and dance," now sounds more like a quaint remembrance than a stark reminder. Ben Bernanke's proclamation, "We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers ..." sounds more like an "oopsie" than a dangerous misjudgment by a top official.
One of the most pernicious aspects of the financial crisis for many investors was that it seemed to come out of nowhere. US housing prices had never declined in a big way and subprime was too small to show up on the radar. Nonetheless, the stage was set by rapid growth in credit and high levels of debt. Today, eerily similar underlying conditions exist in the Chinese residential real estate market. Indeed, a lot of investors might be surprised to hear it called the most important asset class in the world.
China certainly qualifies as important based on rapid credit growth and high levels of debt. The IMF's Sally Chen and Joong Shik Kang concluded [here], "China’s credit boom is one of the largest and longest in history. Historical precedents of 'safe' credit booms of such magnitude and speed are few and far from comforting."
The July 27, 2018 edition of Grants Interest Rate Observer assesses, "Following a decade of credit-fueled stimulus, China's banking system is the most bloated in the world." Jim Chanos, the well-known short seller, adds his own take on RealvisionTV [here], "So comparing Japan [in the late 1980s] to China, I would say Japan was a piker compared to where China is today. China has taken that model and put it on steroids."
One of the lessons that was laid bare from the financial crisis of 2008 (and from Japan in the 1980s) was the degree to which easily available credit can inflate asset prices. This is especially true of real estate since it is so often financed (at least partially) with debt. The cheaper and easier credit is to attain, the easier it is to buy homes (or any real estate), and the higher prices go.
These excesses provide the foundation for one of the bigger (short) positions of Jim Chanos. He describes: "China is building 20 million apartment flats a year. It needs about 6 to 8 to cover both urban migration and depreciation of existing stock. So 60% of that 25% is simply being built for speculative purposes, for investment purposes. And that's 15% of China's GDP of $12 trillion. Put another way, it's about $2 trillion. That $2 trillion is 3% of global GDP."
He summarizes, "And so I can't stress enough of just how important that number is and that activity is to global growth, to commodity demand, and a variety of different things. It [Chinese residential real estate] is the single most important asset class in the world."
Chanos is not the only one who sees building for "speculative purposes" as an impending problem. Leland Miller, CEO of China Beige Book, describes in another RealvisionTV interview [here], "The heart of the Chinese model is malinvestment. It's about building up non-performing loans and figuring out what to do with them." The WSJ's Walter Russell Mead captured the same phenomenon [here], "Chinese leaders know that their country suffers from massive over-investment in construction and manufacturing, [and] that its real-estate market is a bubble that makes the Dutch tulip frenzy look restrained ..." As Miller describes, "Chinese debt is the foundation of the system."
Increasingly too, household debt is becoming a problem. As the Financial Times reports [here], apparently China's young consumers "have rejected the thrifty habits of their elders and become used to spending with borrowed money. Outstanding consumer loans — used to buy cars, holidays, household renovations and other household goods — grew nearly 40 per cent last year to Rmb6.8tn, according to the Chinese investment bank CICC." In total, "Consumer loans pushed household borrowing to Rmb33tn by the end of 2017, equivalent of 40 per cent of gross domestic product. The ratio has more than doubled since 2011."
Again, there are striking parallels to the financial crisis in the US. As Atif Mian and Amir Sufi report in their book, House of Debt, "When it comes to the Great Recession, one important fact jumps out: The United States witnessed a dramatic rise in household debt between 2000 and 2007—the total amount doubled in these seven years to $14 trillion, and the household debt-to-income ratio skyrocketed from 1.4 to 2.1."
The inevitable consequence of unsustainable increases in household debt is that eventually those households will have to cut spending. When they do, "the bottom line is that very serious adjustments in the economy are required ... Wages need to fall, and workers need to switch into new industries. Frictions in this reallocation process translate the spending decline into large job losses."
In addition, just as the composition of consumers of debt affects the ultimate adjustment process, so too does the composition of its providers. For example, debt provided outside of the conventional banking system, such as from shadow banks, is not subject to the same reporting or reserve requirements.
Once again, the landscape of Chinese debt is problematic. Russell Napier states [here], "The surge in non-bank lending in China has clearly played a key role in the rise of the country’s debt to GDP ratio and also its asset prices." Zerohedge adds [here] that the Chinese central government has become "alarmed at its [shadow banking's] vast scale, and potential for corruption."
Further, nebulous practices are not confined to the "shadows" in China. The FT reports [here], "These [small] banks are quite vague and blurry when it comes to investment receivables ... There’s so much massaging of the balance sheet, and they won’t tell you about their internal manoeuvrings."
As it happens, "Problems at small banks matter because their role in China’s financial system is growing." While China surpassed the eurozone last year to become the world’s largest banking system, "small and mid-sized banks have more than doubled their share of total Chinese banking assets to 43 per cent in the past decade."
Nor is the lack of transparency confined to the financial system; it also extends to the entire economy. Miller describes, "We're constantly asked about how good Chinese data are. Is it all bad? It's all bad, but it's bad and different variations." Chanos shared his opinion as well: "As much as the macro stuff has intrigued me ... what's so interesting about China is the lower down you get, the more micro you get, the worse it looks, in that the companies don't seem to be profitable, the accounting is a joke."
Miller makes clear what the challenge is: "[China] is the second largest economy in the world. This is probably the most mysterious big economy in the world. And people have been so willing to work on it based on guestimates." Normally, investors prefer certainty and discount uncertainty. The pervasive lack of discipline and due diligence echoes that of the structured debt products of the financial crisis.
Just as in the financial crisis, all of these excesses and shortcomings are likely to have consequences. Many of them will sound familiar [here]: "[A] crisis of some kind is likely. The salient characteristics of a system liable to a crisis are high leverage, maturity mismatches, credit risk and opacity. China's financial system has all these features."
That said, the "flavor" of China's crisis will depend on uniquely Chinese characteristics. Miller identifies an important one: "I think the problem is that people didn't understand that this is not a commercial financial system. That's one of the major takeaways we stress all the time. This [China's] is not a commercial financial system. What that means is when the Chinese are threatened, they can squash capital from one side of the economy to the other." In other words, China has substantial capability to manage liquidity and contagion risks.
As a result, according to Miller, "We don't spend a lot of time worrying about an acute crisis." He goes on to explain, "If China falls and China does have the hard landing that a lot of people predicted, it's not going to look like it did in the United States or in Europe. You have a state system, a state-led system in which almost all the counter-parties are either state banks or state companies. They're not going to have the same freeze-up of credit that you did in some of these other Western economies."
That said, there are still likely to be severe consequences. Miller reports, "China has gotten themselves into a real difficult situation, because you have an enormous economy awash in credit that is leading to lesser and less productivity based on that capital. And that is why, rather than some sort of implosion, which could happen, or any type of miraculous continued prosperity indefinitely — we think that China's economy is, for the most part, headed towards stasis." More specifically he says, "So I think that we're heading towards a Chinese economy which is going to slow down quite dramatically when we're talking about 10, 15 years time."
Indeed, it appears that process has started. As noted [here], "Housing sales in China will peak this year and then begin a long-term decline, an inflection point that will drag on growth in the construction-heavy economy and hit global commodity demand, say economists."
Throughout the process, Miller expects China to pursue a policy agenda designed to get the country "on a more sustainable track." In particular, "that means cracking down on some of these bad debt problems, cracking down on shadow lending, becoming more transparent, injecting risk and failure into the system, and trying to build a stronger economy from that." He is careful to note, however, "But it's not easy."
Neither will it be easy for investors to judge the puts and takes of various policy measures in a dynamic and opaque system. Henny Sender at the FT warns international investors [here] "to take heed as Beijing continues a war against non-bank lenders and fintech companies that is tightening liquidity and spooking investors in mainland China." The FT also notes [here], "New rules for recognising bad loans in China are set to obliterate regulatory capital at several banks" which will disproportionately affect small and mid-sized banks. Further, as reported [here], "the paring back of a state subsidy programme that provided Rmb2tn ($300bn) in cash support to homebuyers since 2014 is adding to structural factors weighing on the market."
The good news is that investors can take several lessons from China and its residential real estate market. The first is that, like the US subprime market was, the Chinese real estate market is understated and underappreciated. Perhaps it is because the numbers don't seem that big. Perhaps it is because so few people have much clarity at all on what the numbers really are. Or perhaps it is just that people are making enough money that they don't really care to look too hard. Regardless, just like with subprime in the US a decade ago, there are real problems.
Second, those problems will have consequences; investors should expect spillovers. As excesses in the country are unwound, the slowdown in Chinese economic growth will be felt around the world. China has driven global growth for at least a couple of decades. Further, residential real estate, with its strong economic multiplier and high degree of speculation, has been the rocket fuel for that growth. Reversal of those trends will feel like a substantial headwind. Further, lest US investors feel smug at the prospect of Chinese troubles, David Rosenberg warns [here], "There is not a snowball's chance in hell [the Chinese weakness] will not flow through to the US stock market."
Where does all of this leave Chanos? "Interestingly," he describes, "we're less short China now than we have been in eight years in our global portfolio." He goes on to explain, "Because the rest of the world's catching up. Although China's been on a tear recently, Chinese stocks over the eight years are basically flat. And I've noticed that some of the other stocks have sort have tripled." Fundamentals are important, but so are prices paid.
A major complication of figuring out China will be determining the degree to which it's domestic policy agenda influences actions on tariffs and trade and currency. Almost Daily Grants reported the findings of Anne Stevenson-Yang, co-founder of J Capital Research, on July 27, 2018: "China’s credit-saturated economy ... is the primary force behind the recent gyrations in FX ...." She describes, "The reality is that China’s currency is most intimately connected, as with any currency, to the domestic economy – debt, asset prices, real estate prices, and efficiency gains and losses rather than just trade." In other words, don't get distracted by the smaller stuff.
Despite all of these challenges, investors are not without tools to monitor the situation, however. Russell Napier reports [here], "in general the copper price provides a good lead indicator to the market’s assumptions in relation to global growth." He adds, “When it [the copper price] weighs the negative impact from an RMB devaluation and the positive impact from a Chinese reflation ... the current indications are more negative for global growth than positive." The FT goes even further [here]: "The metal [copper] is giving western investors a clear signal to sell risk assets or at least reduce their portfolio weighting."
Perhaps the biggest lesson of all is that increasingly we live in a world of debt-fueled growth that shapes the investment proposition of financial assets. That means business cycles are increasingly overwhelmed by credit cycles. It means wider swings in financial assets — from euphoric highs to catastrophic lows. When the debt spigot turns off, it means the only "safe" assets are cash and precious metals. When the sparks fly, it's hard to tell where they might land. And it means that whichever market has the highest debt and the fastest credit growth will be the "most important asset class in the world". Right now, that is Chinese residential real estate.