Check on Your Chinese Neighbour

It’s time to do your civic duty. The nation needs you. A flood of Chinese stand at our nation’s door. They threaten our national wellbeing. They endanger the most valuable asset of our nation – our property. It’s time to act. We just can’t afford to let them leave.

Leave? Yes, we need to stop them from leaving. Chinese property buyers are turning into sellers. They’re heading for the exits. And they could take Australia’s prosperity (i.e. house prices) with them.

But, before you grab your pitchforks and barricade your local Chinese takeaway with the owners inside, let’s start at the beginning.

China’s Minksy Moment is close, say analysts at Morgan Stanley. The Minsky Moment is when debt financed speculation suddenly implodes, leading to a plunge in asset prices. This moment is characterised by slowing and then falling credit creation, because credit creation is the lifeblood of a debt financed speculative boom.

What suggests we’re reaching this point? There are a bundle of hints. But because they’re all interrelated, they’re a pain in the neck to explain. Don’t worry, that won’t stop us.

The amount of borrowing in China surged since the financial crisis. But the debt splurge is seeing its borrowers begin to default. They can’t seem to borrow more money to pay off maturing debt. The latest victim is a large steel producer in Shanxi province which defaulted on three billion yuan of debt.

So defaults are the first hint of credit no longer expanding. There are plenty more hints of trouble. One of the favourite uses for surging borrowing is new construction. But that’s also taking a hit:

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So existing debt is having trouble staying out of the bad books because there’s not enough new debt supporting asset prices.

Some of China’s speculative debt binge was supported by commodity collateral. Speculators used commodities as part of their debt financing. The idea being that lenders would have a claim on warehoused commodities if the leveraged borrower defaulted. This is sort of like banks using houses as collateral via a mortgage during a housing boom. It’s a very dumb but widely accepted idea.

Why is it dumb? When borrowers default en masse, house prices fall as a result. In other words, just when banks need the collateral, it falls in value. So using collateral whose value is related to the nature of your lending is just stupid. When the lending fails, the collateral will fall in value too.

Yet this is just what China did. It used industrial commodities as collateral for speculation in the midst of a construction and investment boom. If the boom ends and credit markets freeze, the value of the collateral will fall just as lenders want to claim it.

The thing is, this process may have begun already. While the defaults mount, the prices of commodities commonly used as collateral are falling. Copper and iron ore are down while agricultural commodities are rising in price.

Trade influences currency markets, so if there’s trouble in China’s trade based economy, it should be reflected in exchange rates. Sure enough, the yuan is very volatile lately. It plunged to a one year low against the US dollar, reversing a year of steady gains in 2013.

Perhaps the biggest giveaway of trouble in China is the stock market, which refuses to go up. All the various Chinese indices have been struggling for years, and the Hong Kong based index of Chinese companies just entered a bear market.

Shanghai Stock Exchange
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Source: Yahoo Finance

China’s response to all this is straight out of the textbook. Bloomberg reports ‘The nation will “seize the moment to roll out already-determined measures in expanding domestic demand and stabilizing growth,” the State Council, or cabinet, said in a statement last night after a meeting. China will “accelerate preliminary work and construction on key investment projects with timely assignment of budgeted funds,” the cabinet said.

But will it be enough to secure the 7.5% growth target? We don’t know. A credit crunch is notoriously hard to offset.

Either way, eventually the borrowing capacity of the economy will be reached. That’s what happened to subprime borrowers in the US. Whether China is at this point is impossible to tell for sure because political will can forestall the moment of truth. And in China, political will counts for a lot.

Even without an economic crisis in China, Australia might be in trouble. The tight credit conditions in China are threatening to hit Australia where it hurts – our property market. The phenomenon that could trigger falling house prices in Australia just began in Hong Kong. Reuters explains that ‘Cash-strapped Chinese are scrambling to sell their luxury homes in Hong Kong, and some are knocking up to a fifth off the price for a quick sale, as a liquidity crunch looms on the mainland.’

In other words, wealthy Chinese are seeing their businesses back home struggle to borrow money. That’s a big problem if you run a highly leveraged operation, because you rely on liquid credit markets to roll over debt. Paying off old debt with new debt is a dangerous business.

To raise cash for their cash strapped businesses, wealthy Chinese businessmen are selling their foreign properties. It’s Hong Kong for now. Sydney could be next.

But how big is the Chinese effect on property in Australia? No two economists will give the same answer. But either way, the figures are remarkable:

‘The Credit Suisse report estimates that Chinese investors and newly arrived immigrants have spent about $24 billion on Australian property over the past seven years.

‘Given the restriction on non-permanent residents forcing them to buy newly built properties, Credit Suisse estimates that Chinese buyers are currently purchasing around 12 per cent of new homes in Australia.

‘However, the report’s authors say that buying is concentrated in Australia’s two largest cities, meaning that an estimated 18 per cent of new dwellings in Sydney and 14 per cent in Melbourne are being purchased by Chinese nationals.’

As always, the data is shoddy. The proportion of Asian buyers could be much higher. Real estate agents explain it’s easy to get around Aussie regulations on foreigners buying houses. Overseas based Chinese get local family members to buy for them, or rort the minimum investment requirements in various ways (which Macquarie Bank supposedly specialises in).

Australia isn’t exactly well placed when it comes to a slowdown in China to begin with. As Societe Generale’s analyst Albert Edwards said, ‘All we have in Australia is, at its simplest, a credit bubble (consumer debt) built upon a commodity boom, dependent for its sustenance on an even greater credit bubble in China‘. And now our marginal real estate buyer looks like it’s pulling out because of trouble at home.

Regards,

Nick Hubble+
for Markets and Money

 

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Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.


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