China's Real Estate: Black-Hole Capital Trap (July 14, 2010)
Chinese citizens have poured their life savings into speculative real estate. This is not just misallocation, it is an inescapable capital trap.
China's citizens have few options for investing their immense savings. Chinese households are prodigious savers: China boasts a savings rate of 38%, fully ten times that of the U.S. But Chinese savers have few choices on where to invest their money: they can either leave it in a savings account which draws 2.25%, less than the inflation rate of 3.1%, or invest in real estate or domestic stocks.
The money pouring into property has created a worrisome asset bubble in housing, which rose 12.4 percent year-on-year in May, according to China's National Bureau of Statistics.
Chinese authorities' attempts to cool the housing market have so far yielded little result. With no other choice of where to put their savings other than domestic real estate and the volatile Chinese stock market (the Shanghai Stock Exchange Composite Index is down more than 21 percent this year), then there is little wonder why both the Chinese stock market and housing market have both experienced massive bubbles.
Despite the general mood of optimism fueled by rising property prices in China, history suggests that all bubbles end badly. The bubble in Chinese stocks certainly did; the Shanghai Index has fallen over 55% from its late-2007 peak.
The restrictions which effectively funnel China's vast savings into savings accounts that don't even match inflation or into speculative asset bubbles in stocks and real estate boosts the risks of serious losses for Chinese savers and investors, many of whom have relied on the savings of three generations to buy investment homes.
The key problem is that owning a few flats, purchased with cash, is perceived as equivalent to a savings account. But property is not like cash; it is illiquid, and it deteriorates to zero value if it is not well-maintained. This is especially true for highrises, which are the primary residential building type in China.
If the elevator stops working and is never repaired, what's the market value of a flat on the 12th floor?
Speaking of elevators, there is no need for an elevator to reach the 12th floor in this building: it fell over and is flat on the ground.
While the quality of construction has risen over the years in China, it suffers from various shortcuts and a cultural blind spot to the need for consistent maintenance. I addressed this issue in China's Towers and U.S. McMansions: When Things Fall Apart (Literally) (April 14, 2010).
I think people in China, for obvious reasons, don't often think long term. People are more worried about things that may happen tomorrow or in the next two or three years, than they are about what may happen in 50 years. But at some stage in the future, people will start to think more about the long term.
The apartment owners won't have any money to do so because they make $8,000 a year and paid $200,000 for their apartment. Here is Jim Chanos in BusinessWeek:
They (China's leadership) are on this treadmill to hell because 50% to 60% of GDP is construction. And if they stop construction, you'll see GDP growth go negative quickly. That's not going to happen because in China, people are rewarded at almost every level of government for making their economic growth numbers. The easiest way to do this: put up another building. So they're really hooked on this sort of heroin of real estate development.
You get rough concrete walls for your $150,000--no finished walls, no plumbing except stub-outs, no wiring except the panel box, no interior walls, and concrete floors. Even in China, where labor is still quite cheap, constructing your dwelling will cost a lot of money--$50,000 is a good ballpark number but it would be easy to spend more.
So the apartment costs 25 times the household's gross income. For a U.S. household making $40,000 a year, that is the equivalent of buying a $1 million condo.
The after-market for new flats in China is near-zero. Very few investors are interested in an "old" flat when there are thousands of brand-new ones available. The net result of this strong preference for new buildings and the widespread practice of owning mutliple units for investment is that there is virtually no market for residential properties that are even a few years old. Turnover in Chinese residential real estate is extremely low, on the order of 1% or less annually.
That means all residential properties in China are fundamentally illiquid; if you want to sell your three flats, there are few buyers. Should several million owners wish to sell their flats in a short time frame, the supply would completely overwhelm the feeble demand.
Dumping hundreds of billions of yuan into illiquid, mostly luxury dwellings is a catastrophic misallocation of capital in a country with an average per capita income of $3,000 per year. But that gross misallocation of capital is only part of the problem: since the vast overhang of luxury flats is illiquid and cannot be sold, these "investment properties as savings" are a black-hole capital trap: the invested capital cannot be turned back into cash.
Once the cash has been dumped into the black hole of illiquid real estate, it cannot escape; as with physical black holes in space, there is an event horizon beyond which the capital cannot be recovered. In China's real estate market, that is the moment when the buyer's funds are transferred to the developer.
This trapping of China's vast private capital in illiquid, rapidly depreciating investment properties will have far-reaching negative consequences going forward. When the time comes to transfer their "savings" back into cash, owners will find that their flats are worthless due to deterioration and/or the inability to find a buyer at any price.
All these luxury flats are speculative; many are empty and will never be inhabited. When the citizenry finally understand that the Central Government cannot stop prices from falling, or provide a deep, liquid market for re-sales, then panic will take hold, just as it does in the collapse of every bubble.
Unfortunately, investors in China will discover too late that luxury flats are not equivalent to cash in savings accounts, for the money only flows one way near a black hole: over the event horizon and into an inescapable capital trap.
Though many in China see foreign machinations at the root of every problem China
faces, the real estate bubble/capital trap is entirely the result of domestic policies
of the Central State. As the citizenry realize their savings have vanished down the
black hole, authorities will be unable to plausibly blame foreign "hegemony."
To the long-suffering subscribers to oftwominds.com: To the question, what the heck am I getting for my $5/month contribution other than the usual swill I could get for free, I now have an answer: completely random special reports when I feel there is some outstanding opportunity to challenge your thinking on an important financial topic. These reports will only be available to subscribers and those who have made outrageously generous contributions to the maintenance of the site ($100 or more annually). This will be my way of occasionally offering a token of appreciation to the hardy souls who subscribe/ contribute despite the inconsistent quality and overly-eclectic topic selection of the site. There may only be one such special report issued a year; it is a random "thank-you for your support," not a monthly or quarterly report.
I should also mention that the suggested subscription rate will nudge up to $10/month
in January 2011. As always, the site remains free, and any subscription is a
voluntary donation in support of the site.
Of Two Minds is now available via Kindle: Of Two Minds blog-Kindle
"This guy is THE leading visionary on reality.
He routinely discusses things which no one else has talked about, yet,
turn out to be quite relevant months later."
NOTE: contributions are acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.
Or send him coins, stamps or quatloos via mail--please request P.O. Box address.
Your readership is greatly appreciated with or without a donation.
For more on this subject and a wide array of other topics, please visit
All content, HTML coding, format design, design elements and images copyright © 2010 Charles Hugh Smith, All rights reserved in all media, unless otherwise credited or noted.
I would be honored if you linked this wEssay to your site, or printed a copy for your own use.
|Survival+||blog fiction/novels articles my hidden history books/films what's for dinner||home email me|