Wednesday, May 14, 2008
Dear readers, I recently began writing for Nouriel Roubini's RGE Monitor Asia blog. The first piece is on the effect of inflation on real estate prices. It is not going to be pretty, and I look forward to any comments on this either here or on the RGE blog.
Inflation equals monetary tightening equals asset deflation
Victor Shih | May 14, 2008
The rumors were correct. April inflation came in at 8.5%, showing no sign of slowing from the 8% range first reached in February. This will not allow the People's Bank of China (PBOC) to relax monetary policies. In fact, we can expect further increases in reserve requirements and quite possibly an interest rate increase before the end of the first half. As soon as the inflation rate was announced, the PBOC announced a 50 bp increase in reserve requirement, bumping it to 16.5%. This means unfavorable conditions will continue for both the equity and real estate markets. The continuation of monetary tightening may create a world of trouble for real estate investors in particular.
First, let's look at the inflation. Most of it still comes from food inflation, which grew by 22.1% YoY. The problem continues to be that once pork prices shot into the stratosphere, other food categories became very vulnerable to even small shocks because substitution puts high pressure on the prices of all foods. The latest fire to watch for is of course grain prices, which grew 7.4% YoY. The increase in grain prices is likely under-counted because of administrative control over grain prices. Non-food inflation remains relatively low at 1.8%. In fact, official figures show a decline in clothing prices in April. I am totally unconvinced of the official figures in this regard, however. A significant part of wage in many work places in China is food provided by the company cafeteria. As the prices of all food categories increase, the in-kind nominal wage of workers is increasing. Even if cash wage does not increase (big if), companies may soon find it necessary to increase product prices to reflect increasing wage costs. Of course, rising energy prices do not help (7% YoY even with price control).
The bottom line is that the food inflation will soon leak into non-food inflation in the official figures, which will sustain inflation momentum into the second half. I don't have a fancy model to predict the precise level, but this game of adjusting annual inflation estimate upward slightly every month because of the "surprising" inflation of that month is getting tiresome. I think major banks, the IMF, and the World Bank should just admit that annual inflation in China will be above 5% and will likely be closer to 7-8%.
Since late last years when inflation emerged as a problem, top policy makers have engaged in a latent debate on whether monetary tightening was a cure of inflation. Premier Wen Jiabao and a group of technocrats who fought the mid 90s war against inflation initially carried the day in the November (2007) Politburo meeting, which announced that inflation was threat number one for the regime. Soon after, we saw a series of increases in reserve requirements, an interest rate increase, and --perhaps most important-- credit ceiling on bank lending and a 30% down payment requirement for second mortgages. We know, however, that there is an opposing voice at the top of the regime. Princeling officials (princelings are children of high officials) with heavy ties to the real estate sector likely form the backbone of the opposing voice. The opposition has formulated an argument stating that inflation is caused by the "structural" problem of an artificially low RMB, which led to the monetary problem. At the March National People's Congress meeting, the opposition came out in the open to criticize continual monetary tightening. Li Yining, a Hayekian economist with ties with the real estate sector, articulated this argument in public. Nonetheless, as my book Factions and Finance in China shows, monetary conservatives--the central technocrats-- gained the upper hand whenever inflation rates were high.
To be sure, 8% is far from the record inflation in the past 30 years (around 30% was the record), but we certainly have not seen quarterly inflation at 8% since the mid-90s. The sustained inflation pressure will give Premier Wen the political leverage with which to continue tight monetary policy. His newly appointed helper, Vice Premier Wang Qishan, is a veteran inflation fighter first promoted by former economic czar Premier Zhu Rongji. At a recent speech given in Shanghai, he made it very clear that he will make fighting inflation a top priority and that fixed asset investment needed to be brought down to "a reasonable level." As long as inflation rates remain at a high level, I do not expect the technocrats to relax their grip on money supply.
The increasingly tight monetary policy coincided with a major correction of the Chinese stock market. I am no expert on this matter, and I leave to Michael Pettis to comment further on whether monetary tightening will continue to exert downward pressure on stock prices. It seems a reasonable conclusion, especially given that price controls are imposing heavy costs on oil, food, and even retail businesses. After the down payment requirement was imposed late last year, the real estate market in China experienced an instant cooling down. By February, month-on-month increases of average housing prices were basically flat in most of China's major cities. The March figures were literally 0s in many of China's major cities and negative in a few cases.
Shenzhen Today, China Tomorrow
We now get to the bottomline--real estate prices will likely get hit substantially in this environment, causing a major decrease in household equity, a substantial rise in non-performing loans, and sluggish real estate market in the medium term. Although official figures from March show declines in only a handful of markets, I would argue that official figures compiled by the National Development and Reform Commission (NDRC) are not reliable and that we will soon see widespread declines in many major markets. On the reliability issue, we focus on Shenzhen, the first major market to show a sizable decline. The NDRC reported a month-on-month decline of 4.9% for new housing in Shenzhen in March. Soon afterward, the housing authorities in Shenzhen reported a 16.53% monthly decrease for new residential housing in Shenzhen. THE NDRC UNDER-REPORTED THE DECLINE OF SHENZHEN HOUSING PRICES BY THREE FOLD! Of course, even the official figure from Shenzhen under-reports the true magnitude of the problem. The press is filled with stories of last-minute discounts, free renovation, free cars, which sum up to a 20+% price fall in Shenzhen residential real estate. Things are about to get worse in Shenzhen because 1 million sq mtr of new residential came on the market in the first quarter, adding to the 5 million sq mtr in stock left over from 2007. April figures from the Shenzhen housing authorities show a decline of ANOTHER 12% for new residential housing, bring prices back to the level exactly one year ago. In the absence of systematic data, the press is reporting stories of highly leveraged investors beginning to resort to the desperate tactic of borrowing from "underground banks" at 5% a month to make payments. Of course, this is unsustainable unless a miraculous recovery of housing prices occur, and inflation makes this more and more remote for 2008.
Will this disastrous pattern be repeated elsewhere in China? The answer is yes with a high probability. The official figures show impressive run-ups of real estate prices in both east coast markets like Beijing, Hangzhou, Ningbo, and Haikou and inland markets like Nanning, Xi'an, Lanzhou, and Urumqi in 2007. These spectacular increases have no doubt attracted leveraged speculators as well as enthusiastic local officials who approved swathes of new projects last year, which will be completed this year. Unfortunately, the housing authorities elsewhere are not nearly as enlightened as those of Shenzhen, so we have no local figures with which to compare with the suspicious NDRC figures. If substantial declines occur in other markets, we will see widespread defaults among both individual investors and developers going into the fourth quarter of this year. At the end of 2007, loans outstanding to developers and buyers combined 4.8 trillion RMB (700 billion USD at current exchange rate). Even 10% of those loans getting into trouble would generate half a trillion RMB of non-performing loans. Although this would not cause a financial panic, it certainly would cause investors to take a much closer look at Chinese banks. Furthermore, expensive write-offs from the CIC may once again be necessary. Finally, this decline of real estate prices, unlike previous such events, will be the first one experienced by a large number of Chinese households. This lesson will (hopefully) instill caution among Chinese real estate investors.
Inflation equals monetary tightening equals asset deflation
Victor Shih | May 14, 2008
The rumors were correct. April inflation came in at 8.5%, showing no sign of slowing from the 8% range first reached in February. This will not allow the People's Bank of China (PBOC) to relax monetary policies. In fact, we can expect further increases in reserve requirements and quite possibly an interest rate increase before the end of the first half. As soon as the inflation rate was announced, the PBOC announced a 50 bp increase in reserve requirement, bumping it to 16.5%. This means unfavorable conditions will continue for both the equity and real estate markets. The continuation of monetary tightening may create a world of trouble for real estate investors in particular.
First, let's look at the inflation. Most of it still comes from food inflation, which grew by 22.1% YoY. The problem continues to be that once pork prices shot into the stratosphere, other food categories became very vulnerable to even small shocks because substitution puts high pressure on the prices of all foods. The latest fire to watch for is of course grain prices, which grew 7.4% YoY. The increase in grain prices is likely under-counted because of administrative control over grain prices. Non-food inflation remains relatively low at 1.8%. In fact, official figures show a decline in clothing prices in April. I am totally unconvinced of the official figures in this regard, however. A significant part of wage in many work places in China is food provided by the company cafeteria. As the prices of all food categories increase, the in-kind nominal wage of workers is increasing. Even if cash wage does not increase (big if), companies may soon find it necessary to increase product prices to reflect increasing wage costs. Of course, rising energy prices do not help (7% YoY even with price control).
The bottom line is that the food inflation will soon leak into non-food inflation in the official figures, which will sustain inflation momentum into the second half. I don't have a fancy model to predict the precise level, but this game of adjusting annual inflation estimate upward slightly every month because of the "surprising" inflation of that month is getting tiresome. I think major banks, the IMF, and the World Bank should just admit that annual inflation in China will be above 5% and will likely be closer to 7-8%.
Since late last years when inflation emerged as a problem, top policy makers have engaged in a latent debate on whether monetary tightening was a cure of inflation. Premier Wen Jiabao and a group of technocrats who fought the mid 90s war against inflation initially carried the day in the November (2007) Politburo meeting, which announced that inflation was threat number one for the regime. Soon after, we saw a series of increases in reserve requirements, an interest rate increase, and --perhaps most important-- credit ceiling on bank lending and a 30% down payment requirement for second mortgages. We know, however, that there is an opposing voice at the top of the regime. Princeling officials (princelings are children of high officials) with heavy ties to the real estate sector likely form the backbone of the opposing voice. The opposition has formulated an argument stating that inflation is caused by the "structural" problem of an artificially low RMB, which led to the monetary problem. At the March National People's Congress meeting, the opposition came out in the open to criticize continual monetary tightening. Li Yining, a Hayekian economist with ties with the real estate sector, articulated this argument in public. Nonetheless, as my book Factions and Finance in China shows, monetary conservatives--the central technocrats-- gained the upper hand whenever inflation rates were high.
To be sure, 8% is far from the record inflation in the past 30 years (around 30% was the record), but we certainly have not seen quarterly inflation at 8% since the mid-90s. The sustained inflation pressure will give Premier Wen the political leverage with which to continue tight monetary policy. His newly appointed helper, Vice Premier Wang Qishan, is a veteran inflation fighter first promoted by former economic czar Premier Zhu Rongji. At a recent speech given in Shanghai, he made it very clear that he will make fighting inflation a top priority and that fixed asset investment needed to be brought down to "a reasonable level." As long as inflation rates remain at a high level, I do not expect the technocrats to relax their grip on money supply.
The increasingly tight monetary policy coincided with a major correction of the Chinese stock market. I am no expert on this matter, and I leave to Michael Pettis to comment further on whether monetary tightening will continue to exert downward pressure on stock prices. It seems a reasonable conclusion, especially given that price controls are imposing heavy costs on oil, food, and even retail businesses. After the down payment requirement was imposed late last year, the real estate market in China experienced an instant cooling down. By February, month-on-month increases of average housing prices were basically flat in most of China's major cities. The March figures were literally 0s in many of China's major cities and negative in a few cases.
Shenzhen Today, China Tomorrow
We now get to the bottomline--real estate prices will likely get hit substantially in this environment, causing a major decrease in household equity, a substantial rise in non-performing loans, and sluggish real estate market in the medium term. Although official figures from March show declines in only a handful of markets, I would argue that official figures compiled by the National Development and Reform Commission (NDRC) are not reliable and that we will soon see widespread declines in many major markets. On the reliability issue, we focus on Shenzhen, the first major market to show a sizable decline. The NDRC reported a month-on-month decline of 4.9% for new housing in Shenzhen in March. Soon afterward, the housing authorities in Shenzhen reported a 16.53% monthly decrease for new residential housing in Shenzhen. THE NDRC UNDER-REPORTED THE DECLINE OF SHENZHEN HOUSING PRICES BY THREE FOLD! Of course, even the official figure from Shenzhen under-reports the true magnitude of the problem. The press is filled with stories of last-minute discounts, free renovation, free cars, which sum up to a 20+% price fall in Shenzhen residential real estate. Things are about to get worse in Shenzhen because 1 million sq mtr of new residential came on the market in the first quarter, adding to the 5 million sq mtr in stock left over from 2007. April figures from the Shenzhen housing authorities show a decline of ANOTHER 12% for new residential housing, bring prices back to the level exactly one year ago. In the absence of systematic data, the press is reporting stories of highly leveraged investors beginning to resort to the desperate tactic of borrowing from "underground banks" at 5% a month to make payments. Of course, this is unsustainable unless a miraculous recovery of housing prices occur, and inflation makes this more and more remote for 2008.
Will this disastrous pattern be repeated elsewhere in China? The answer is yes with a high probability. The official figures show impressive run-ups of real estate prices in both east coast markets like Beijing, Hangzhou, Ningbo, and Haikou and inland markets like Nanning, Xi'an, Lanzhou, and Urumqi in 2007. These spectacular increases have no doubt attracted leveraged speculators as well as enthusiastic local officials who approved swathes of new projects last year, which will be completed this year. Unfortunately, the housing authorities elsewhere are not nearly as enlightened as those of Shenzhen, so we have no local figures with which to compare with the suspicious NDRC figures. If substantial declines occur in other markets, we will see widespread defaults among both individual investors and developers going into the fourth quarter of this year. At the end of 2007, loans outstanding to developers and buyers combined 4.8 trillion RMB (700 billion USD at current exchange rate). Even 10% of those loans getting into trouble would generate half a trillion RMB of non-performing loans. Although this would not cause a financial panic, it certainly would cause investors to take a much closer look at Chinese banks. Furthermore, expensive write-offs from the CIC may once again be necessary. Finally, this decline of real estate prices, unlike previous such events, will be the first one experienced by a large number of Chinese households. This lesson will (hopefully) instill caution among Chinese real estate investors.
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