Is China’s Credit Bubble Beginning To Unwind?

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!”