A Large Real Estate Developer Collapses

The bond default of solar company Chaori apparently was just the proverbial canary in the coal mine. As we pointed out last week, it struck us as rather troubling that analysts didn't seem to take the Chaori default very seriously. It is worth repeating a quote from a Financial Times article in this context:

Rather than billing Chaori as an alarm bell in the credit markets, many analysts see it as a trial balloon being floated by the authorities as they seek ways to cut overcapacity in certain sectors of the economy.

“The government is trying to send a signal to the market that there are risks to buying investments. They are doing it carefully,” said Christopher Lee at Standard & Poor’s. “This company is so small and in trouble anyway – even if it defaults it is not going to impact the market much.”

In view of the sheer size of China's credit and real estate bubble and the many signs pointing to a perfect storm being on its way, such comments seem quite naïve. A slightly bigger flesh wound is now about to be inflicted.According to Bloomberg:

“A closely held Chinese real estate developer with 3.5 billion yuan ($566.6 million) of debt has collapsed and its largest shareholder was detained, government officials familiar with the matter said yesterday.

Zhejiang Xingrun Real Estate Co. doesn’t have enough cash to repay creditors that include more than 15 banks, with China Construction Bank Corp. (939) holding more than 1 billion yuan of its debt, according to the officials, who asked not to be named because they weren’t authorized to discuss the matter. The company’s majority shareholder and his son, its legal representative, have been detained and face charges of illegal fundraising, the officials said.

The collapse of the company, based in the eastern town of Fenghua, adds to concern of strains in the nation’s real estate sector and comes less than two weeks after the first bond default by a Chinese company. Shanghai Chaori Solar Energy Science & Technology Co.’s inability to repay its debt may become China’s own “Bear Stearns moment,” prompting investors to reassess credit risks as they did after the U.S. securities firm was rescued in 2008, Bank of America Corp. said March 5.

“Chinese developers are extremely exposed to the easy credit that is used to finance purchases and investment,” said Patrick Chovanec, the New York-based chief strategist at Silvercrest Asset Management Group LLC, which oversees $14.1 billion in asset, by phone. “When credit is reined in even slightly, it undercuts demand. This is potentially an inflection point.”

This was a long time in coming of course. The first signs that China's enormous real estate bubble may be about to unwind came in 2011, but ahead of the leadership handover it was evidently decided to step on the gas just one more time. Last year once again saw real estate prices rise significantly in the biggest Chinese cities. However, things appear finally to be coming to a head.

A Giant Bubble

A recent shareholder letter by Fairfax Financial summarizes several of the relevant data points of China's real estate boom. It is probably no exaggeration to state that it represents one of the biggest such bubbles that have ever formed in the history of the world:

1. China added 5.9 billion square metres of commercial buildings between 2008 and 2012 – the equivalent of more than 50 Manhattans – in just five years!

2. In 2012, China completed about 2 billion square metres of residential floor space – approximately 20 million units. For perspective, the U.S. at its peak built 2 million homes in a year.

3. At the end of 2013, China had about 6.6 billion square metres of new residential space under construction, around 60 million units.

4. Yinchuan, a city of 1.2 million people including the suburbs, has 30 million square metres of available apartments – roughly 300,000 units that could house 900,000 people. This is in addition to the delivered but unoccupied units. The city of Guiyang, capital of Guizhou Province, has roughly 5.5 million extra units for a city of 5 million.

5. In almost every city Anne has visited, pretty much the whole existing housing stock has been replicated and is empty.

6. Home ownership rates in China are estimated to be over 100% versus 65% in the U.S. Many cities report ownership over 200%. Tangshan, near Beijing, is one.

7. This real estate boom could only be financed through unrestrained credit growth. Since 2009, the Chinese banks have grown by the equivalent of the entire U.S. banking system or 15% of world GDP.

8. The real estate bubble has resulted in companies extensively borrowing and investing in real estate or lending on real estate in the shadow banking system. This is exactly what happened in Japan in the late 1980s.

9. And one observation of our own: Since 2009, the easing by the Federal Reserve combined with the explosive growth in China, backed by higher interest rates, has resulted in huge inflows (‘‘hot money’’) into China. The near unanimous view that the renminbi would strengthen has resulted in a massive carry trade where speculators have borrowed at low rates across the world and invested in China, almost always backed by real estate. The shadow banking system in China – i.e., assets not on the books of the major Chinese banks – is estimated by Bank of America Merrill Lynch to be approximately $4.7 trillion or 51% of Chinese GDP. Oddly enough, prior to the credit crisis, the U.S. had $4.5 trillion in asset-backed securities outstanding or approximately 31% of U.S. GDP. You know what happened then. When the flows reverse in China, watch out!”

Readers should pay close attention to the remarks included in point 9. There are now strong signs that the 'one way street' trade in the yuan is in fact about to end. If so, then China could indeed experience a big outflow of so-called 'hot money'. We already see many indirect signs of credit stress emerging, such as e.g. the recent sharp sell-off in copper. The metal serves as a highly popular form of collateral in China's 'shadow banking' system.

The Fate of the Yuan

Keep in mind that China's authorities are letting the yuan decline on purpose (since it is not a convertible currency, its trend depends on official whim). It is widely assumed that they want to discourage speculators. However, as we have previously stressed, this had to be expected on the grounds that the yen has weakened considerably, and with it a number of emerging market currencies. Thus China is suddenly at a big disadvantage versus its competitors in international trade, and the recent collapse in its exports underlines that fact. It was therefore only a question of time before China's authorities would respond by weakening the yuan. Here is a line chart of Wisdom Tree's Chinese yuan fund that illustrates the recent move in the currency nicely:

CYB, Wisdom Tree Yuan Fund: a sharp decline, cutting through both the 200 and 50 day moving averages. The fall in the Japanese yen began in a roughly similar manner – click to enlarge.

To be sure, the move has been quite small so far in a historical context. But we have little doubt that policy on the yuan is undergoing a change. In fact, we believe that China's authorities are preparing for making the currency eventually convertible, perhaps even in the not-too-distant future. We believe that a fully convertible yuan would almost certainly weaken dramatically in light of the huge money supply growth in China in recent years and the fact that an opening of the capital account would immediately spark large outflows from Chinese citizens eager to invest abroad. There are not only economic, but also political reasons to expect that to happen. China's citizens are surely acutely aware that new freedoms can be taken away again quickly; China's history demonstrates this rather clearly. They will therefore immediately make use of any window that opens in this respect for precautionary reasons alone.

Deliberate Bubble Deflation?

It appears that China's authorities seem now not only willing to let the yuan decline, but also to let real estate developers and other firms in financial trouble enter bankruptcy. According to recent press reports, some two thirds of all new Chinese developer bonds denominated in US dollars are now trading below par. The probability that the bubble will indeed finally collapse has undoubtedly increased considerably.

Arrayed against this are a great many vested interests in China, which presumably continue to exert considerable political power. Whether they will once again prevail remains to be seen, but as you can see below, a bailout of the troubled real estate developer Zhejiang Xingrun is already discussed.

Interestingly, the PBoC saw fit to deny its rumored participation in an 'emergency meeting' over the collapse of Zhejiang Xingrun Real Estate:

“China’s central bank said it didn’t participate in an “emergency meeting” today on the collapse of a developer with 3.5 billion yuan ($565 million) of debt.

The People’s Bank of China, in a statement posted to its official microblog, said it’s not involved in dealing with risks from the collapse of Zhejiang Xingrun Real Estate Co.

Officials from PBOC and China Banking Regulatory Commission branches in the eastern city of Ningbo joined meetings today on how to contain risks from the collapse, said three government officials with knowledge of the matter, who asked not to be identified as they weren’t authorized to speak publicly about the matter.

Creditors including China Construction Bank Corp. (939) and officials from Ningbo and Fenghua, where the developer is based, also participated in the discussions on possible resolutions including a bailout of the developer by the local government, the officials said.

The Financial Times earlier today reported the PBOC’s participation in the meeting. Chinese news website Sina.com cited an unidentified person from China Construction Bank as saying the lender had participated in meetings today for “communication and coordination” with officials from the local branches of the PBOC and CBRC participating. They weren’t emergency meetings, Sina cited the person as saying.”

We would tend to think they actually were 'emergency meetings'. Local governments in China are under great pressure. Much of their income depends on land sales to developers. The collapse of a big developer reflects quite negatively on the prospects of obtaining such income in the future. Unfortunately many municipalities and local governments themselves are up to their eyebrows in debt. It is therefore somewhat questionable how many bailouts they can actually afford.

One thing seems certain though: China is at a cross-roads. The central government seems finally willing to wring out the worst excesses, but it may well overestimate its ability to 'keep things under control'. Once the ball starts rolling downhill, it usually doesn't stop until it has done considerable damage (or let us rather say: until it has unmasked all the damage that has already been done by years of malinvestment). We can be certain that a lot of unsound credit and unsound investment in China needs to be liquidated – and it probably won't be pretty when that happens. However, as can be seen below, there are also a few bright spots.

Chinese Stocks – a Decidedly Mixed Picture

Everybody is aware of the dismal performance of the Shanghai stock exchange composite index (SSEC). What is less well known is that the Shenzen composite index (which doesn't contain the big banks) is performing much better. The Shenzen B-shares index is also doing quite well.  First a look at the long term chart of the SSEC, showing the major lateral support lines:

A very long term chart of the Shanghai stock index. It trades close to near term support, but should that support fail, the 2008 low may prove a price attractor – click to enlarge.

In the short term, the lows of 2013 in the SSEC index so far continue to hold. However, the chart looks weak and a break of these lows can probably not be ruled out, especially if the authorities continue to let the real estate developer bust play out. China's banks are deeply involved in shadow bank financing via 'wealth management' products, and losses in that area will eventually hit their loan books as well. It is also widely suspected that their current low NPL ratios are largely the result of dubious accounting schemes. In short, a lot of delinquent loans are probably already on their balance sheets, but are hidden by various tricks, such as refinancings or altered repayment terms, etc.

SSEC daily – so far, last year's lows have not been broken - click to enlarge.

Contrast this with the Shenzen Composite Index – obviously, not everything is bleak in China's stock markets:

Shenzen Composite, daily. The index has been in a solid uptrend since the 2013 low – click to enlarge.

And finally, a 5 year weekly chart of the Shenzen B-shares index, an index of domestically listed foreign investment shares traded in foreign currencies. Obviously, this index has benefited from the strong yuan, thus its performance may suffer going forward if the yuan should decline further.

The Shenzen B-shares index, weekly over the past five years. This index has performed quite well, but that can partly be attributed to the strong yuan – click to enlarge.

Conclusion:

China's real estate bubble and the associated financing schemes increasingly appear to be in trouble. This could obviously have widespread repercussions, especially for China's banking system, real estate developers, shadow banking firms and its highly indebted local governments. A reversal of 'hot money' flows may also be imminent, although it is not yet possible to come to a definite judgment regarding this particular development. However, there are good reasons to believe that the authorities would prefer the yuan to weaken further. A sharp weakening of money supply growth over the past year suggests that a bursting of the credit bubble has become highly likely.

On the other hand, industrial companies appear to be doing better, at least in terms of their stock market performance. This is revealed by the dichotomy that has developed between the Shanghai and Shenzen indexes. A coming bust of the credit bubble may therefore create opportunities for alert investors in this sector.

Charts by: StockCharts, BigCharts