Formula for a hard landing

A huge spike in speculative real estate values, a corrupt banking system, and a rigged stock market — no, I’m not talking about Eliot Spitzer’s view of New York City; I’m talking about China.

Unsustainable Real Estate Boom

Let’s start with real estate. That’s always a good investment; the wags say they’re not making any more of it. But what happens when three quarters of the real estate demand is fast-buck speculation at unsustainable prices? Tulips, anyone?

Average prices in the city’s residential market nearly doubled between 2000 and 2004. Last year, they jumped by 28% in the city centre. Relative to urban incomes, residential property in Shanghai is now as expensive as it was during China’s 1994-95 economic bubble (see chart) and is much less affordable than in other big Chinese cities, reckons UBS, a bank. CB Richard Ellis, a property-services firm, ranks two Shanghai districts, Pudong and Puxi, among the 50 most expensive office markets in the world.

Wondering where all this will end, a few forecasters are doom-laden. Dong Tao, an economist at Credit Suisse First Boston, an investment bank, says that Shanghai property is the biggest risk to the Chinese economy in 2005. Speculative buying from both China and abroad—accounting for 75% of transactions in the city—is too big, he says. “When price expectations turn, this money will disappear overnight,” he says, citing interest-rate rises and corporate scandals as possible triggers.

Widespread corruption in the banking system

How about banking? A robust, well-capitalized banking system could deal with a real estate crash. How does China’s fare? Not too well, I’m afraid. Everyone has his hand in someone else’s pocket.

[I]t is not every day that the head of the third-largest bank is turfed out for graft. The removal of Zhang Enzhao as chairman of China Construction Bank (CCB), allegedly for taking bribes either in exchange for approving soft loans or for manipulating purchases of computer equipment, was reported in the Hong Kong press on March 15th. The bank has confirmed Mr Zhang’s resignation, and has appointed Guo Shuqing, a central-bank official, as its new party chief—a job that tends to go with the chairmanship.

Mr Zhang’s fall comes at a bad time for China’s state banks. CCB already faces four other embezzlement cases, all uncovered since September. More than 50 staff are accused of stealing a total of over 700m yuan ($85m). Mr Zhang’s predecessor, Wang Xuebing, was sentenced to 12 years in prison in 2003 for misdeeds when he was a junior official at the Bank of China (BoC)….

The government plans to list three banks on the Hong Kong, Shanghai or possibly New York stockmarkets this year. Bank of Communications (BoCom), the fifth-biggest, is set to raise $2 billion, followed by a $5 billion-10 billion flotation of CCB and a $4 billion-5 billion offer from BoC. But investors, particularly foreigners, may now demand a delay, a lower price or both. Mr Zhang’s case “has an enormous impact,” says one senior banker in China. “How do you convince foreign investors that this is a one-off?”

Dysfunctional equity markets

Hmmm. The real estate boom shows there is a need for functional equity markets as an alternative to real estate as well as for its use as a deleveraging mechanism. The corruption in the banking system, as well as its need for external capital, also show that China needs the safety valve of a vibrant equity market. How is that working out for them? Ouch — not well; it almost looks like a depression.

[A] full two-thirds of the market’s $460 billion capitalisation remains tied up in non-tradable or “legal person” shares held by state-controlled entities. This continues to distort valuations. The average A-share trades at a still-expensive 25 times earnings, even when precisely the same asset, listed in Hong Kong or New York, is priced at half that. Captive domestic investors are disillusioned, while any Chinese enterprise that can do so seeks a foreign listing.

And the market’s inexorable decline has pole-axed the Chinese broking industry, which not only guaranteed investors double-digit returns but also often speculated corruptly with their funds. Most of the 130-odd securities firms are, in effect, insolvent, says Stephen Green, an economist…

“It can’t happen here”

There is no doubt that China is going to be a powerhouse over the next decade or so. But we’ve seen this hypergrowth story before, not only in Japan, Brazil and Russia for a period of time, but in the US during our industrialization. From time to time, the excesses in value and the financial corruption that inevitably accompany them, come a cropper. None of us can say when that will happen in China, only that it will. Here’s a key danger sign, from the article on the Shanghai real estate boom:

Mr Tao is right that “hot” money, particularly from Taiwan and Hong Kong, has boosted prices, especially for top-notch residential property. Four out of five luxury flats are being purchased by non-residents, say some analysts. However, even a sudden reversal of the market, says Mr Anderson, would be a local problem, not a threat to China’s economic stability. In such a vast country, not even Shanghai is big enough to be that.

It can’t happen here. Famous last words.

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