Real Estate in Asia: Where are the bubbles, and where is it safe to invest? Far East Forum Special Edition from Ulaanbaatar, Mongolia

People have been talking about it for more than six months. Various and sundry predictions as to when it is going to happen have floated around analysts desks, newspaper editors ears, and even across the coffee or tea table. Yet, thus far, there has been scant definitive, damning evidence and even less written on the subject. I am of course referring to the Mainland Chinese real estate boom (soon to be bust).

Last week’s WSJ article did a tidy job of explaining where the market is heading in Beijing. There is really no telling how fast this is going to happen. Prices have been skyrocketing in Shanghai and Beijing (in particular) as well as Hong Kong over the past few years. Just this past fall the Beijing government attempted to cool the market via restricting home ownership to two properties per person.

This has a number of important implications for the world, as it could be a burst as opposed to simply a ‘deflation.’ Real estate risk is substantial in China because much of the growth has been predicated on increasing land and property values. This will no doubt have an impact on commodity prices for things like sheetrock, steel, copper (as pointed out in the WSJ article), as well as numerous other building supplies.

In addition to the commodity price downturn, Chinese banks holding mortgages could face problems similar to those experienced by US banks during the financial crisis. If the property values decline by 10-20% (as this article suggests), there could be a drastic increase in default risk.

In Hong Kong, the local government is taking up a number of measures including building public housing, re-zoning land, lowering the mortgage amounts that can be borrowed, penalizing back-to-back sales (they have a multi-tiered penalty system within 2 years, and a 15% penalty if a property is re-sold within 6 months!), and increasing the cost of buying for non-residents. (See the South China Morning Post’s article entitled. “Tough Measures to cool homes market”). All of these measures are designed to slow a market whose prices have gone up 18% in the last year (See SCMP’s “Market boom leads to gloom”).

Even across the Strait in the de-facto independent Taiwanese market, prices are still on the rise (somewhere between 10-20% depending on location). There was a lot of speculation about the sharp price increases after Taipei opened the Taiwan home market up to Mainland Chinese in June 2010. The government in Taiwan has also acted to cool the prices by introducing a luxury tax on properties that reach a threshold value. This has apparently worked to some extent because brokerages reported a 20-30% decline in sales after the announcement of this policy (See the China Post’s article entitled “Home prices rise in May despite luxury tax: real estate firms”).

All this begs the question, where should real estate investors send their money in Asia? Based on my own recent experience, I suggest Ulaanbaatar, Mongolia as a destination. Rent prices here are comparable to many American cities (depending on the place). Even more lucrative than this is a business known as ‘mediation.’ Exactly as it sounds, this involves someone fluent in both English and Mongolian that acts as a go-between for foreign tenants and local landlords. They often charge tenants and landlords $500 US each for ‘facilitating and managing the transaction.’ It strikes me that the value-added of this kind of service is extremely low, and offers huge potential for anyone willing and able to provide similar services.

Offices, luxury brand shopping, and a complete (excepting a single Kenny Rogers Roasters) dearth of western food chains in the city are three of the most lucrative opportunities I have witnessed since moving here. Next to Sukhbaatar Square the Central Tower claims a Louis Vuitton, Armani, and Hugo Boss store. People in UB claim that for at least a short period of time the LV Store was the highest grossing in all of Asia. Right across the street is another new gleaming building, the Blue Sky Tower, which according to MAD investment solutions is the tallest structure in Mongolia (Article). Yet, there is not a single Starbucks, McDonald’s, Pizza Hut, or KFC. Not that any one brand is necessary, it is striking that most developing countries have at least one of these to offer whereas Mongolia has not even one.

Up Next: China’s New Conflict in the South China Sea

Law and Financial Sector Development in China

A few days back, over at Naked Capitalism, Yves had a guest blogger discussing why China is different. Readers of Rogoff and Reinhart will cringe, as Yves notes in the comments section, but the post's extended discussion of the unique features of China's economic development is certainly thought provoking. However, for now I just want to focus on a few points made on financial sector development:

What everyone should be watching is what China is doing in its finance system, and it is moving very fast (and the shadow banking system is moving even faster). It has reformed the four key banks, allowed foreign banks to come in a limited way, managed its SOEs, started to develop a securities industry, started to develop a corporate bond market. But it is quite a balancing act. It still lacks the micro-infrastructure, such as accounting law, securities law, governance structures and so on that are necessary to having a fully functioning cost of capital – that is, capitalism (of a twentieth century type, as opposed to the much sicker, twenty first century type appearing in the West). The aim needs to be to stop the heavy dependence on various forms of lending, by instigating a shift to a better balance between shares, bonds and bank deposits as the capital structure (in developed economies they are roughy in balance). Big equity and bond markets are much safer than a system that depends mostly on bank lending because equity markets and bond markets can reprice without the system breaking, whereas banks break. So it is an issue of national security for the Chinese leadership.

Main takeaways: 1) China has reformed the big four banks, 2) allowed some foreign access to financial markets, 3) started to develop non-equity capital markets, 4) lacks the legal and regulatory framework necessary for these capital markets to full develop and 5) should do all this with the aim of creating financing options outside of the banking sector.

I don't think anyone would contest points 2), 3) or 5), so we can leave them for now and focus on 1) and 4). Has China really reformed its big banks in a meaningful way? Are the legal obstacles just due to a lack of proper laws or institutions? I find it difficult to agree on these points.

With regards to 1), yes, its true that the Big Four banks no longer have massive non-preforming loan (NPL) ratios, but that is hardly due to any substantial reform. Government financed Asset Management Companies (AMCs) bought the NPLs at face value, despite the fact that they are bad loans. While this certainly helped remove the problematic loans from Chinese banks' balance sheets, it did nothing to reform their lending standards. In fact, by creating such a serious moral hazard problem, it may have made them harder to reform. Sure, the introduction of western banks as minority shareholders might help improve lending practices, but the most recent stimulus package has restarted the cycle of reckless lending. Perhaps, as this round's bad loans begin to surface the Chinese government will handle them differently, but its starting to look like a regular cycle.

This, of course, leads us to point 4) regarding the legal and institutional framework for deeper capital markets. It is true that the government is playing catch up, developing new laws and regulatory structures where none exist. However, the problem is not simply a lack of laws: there is an active effort to manipulate the laws they do have. Take, for example, the July 2009 Chinese Supreme Court ruling against UBS (PwC has a great summary in their 2009 NPL Asia Newsletter). In March 2009 the Supreme Court issued a guidance clarifying when courts can rule on investors' claims on NPLs purchased from the AMCs (the answer: when the claims are not on state owned enterprises). While the original guidance was not great, it did clarify when investors could make claims on NPLs and when they couldn't. However, just four months later, in the UBS case, the Supreme Court changed its position indicating that all NPL claims require consent to be transferred to foreign investors, citing older laws and regulations, which the 2009 guidance had appeared to supersede. Why did the Supreme Court change its position? The PwC newsletter speculates it was a political message to foreign investors. Regardless, the result was predictable: most major players left what was a promising and growing market in the financial sector because of an unpredictable legal framework. The point is that while China may still be lacking in the laws and regulations needed for deepening capital markets, it is not making a serious effort at using what laws it does have.

This is important because the post goes on to explain that the top-notch leadership in China is working on filling in the holes:

It would be a fool who thinks the Chinese don’t understand the challenge; they do. Having your life on the line if you get it wrong does rather tend to concentrate politicians’ minds. To get to the top in China on your merits when there is a billion people ensures some serious quality; we can safely assume that some of the Chinese leadership has significant intellectual grunt. It would be worthwhile to listen very closely to what the Chinese say about their understanding of capitalism and what it is doing at the micro, institutional level with its financial system, not so much what it does with the macro-economic levers.

This position seeks to mitigate criticism of Chinese leadership. In essence it says "The problem is a lack of good laws, but very smart and responsible people are working on fixing that." Yet when they make new laws to address these problems they have no problem casting them to the wind for arbitrary political purposes. That this arbitrary change in law closed a potential venue for the government to recover something on its existing NPLs only shows how self-defeating these efforts can be.

China claims to be serious about developing deeper capital markets, and I am confident that many in the government are serious. However, China will be confronting some major structural problems if it cannot properly address financial sector reform. This can't happen until leadership stops using the legal system for political ends.

Unrest in Egypt: Will It Spread to China?

The Wall Street Journal points out that China "isn't immune to Nile fever". China's GDP per capita is one-third of Egypt's, and scores worse on income inequality. The main catalyst for the Cairo riots seems to be the high inflation that has consumed the country for years now. Should the Chinese inflation rate rise, it's entirely possible that we will see the same reactions there. Already, the real-estate bubble in major cities across China is one of the hot topics and biggest sources of friction.

As is usual with instability abroad, the Chinese government has responded to the event by censoring news about the riots. Weibo (China's more "harmonious" knock-off version of Twitter) and Sina.com have blocked any mention of the riots from their search results. (Baidu, another major Chinese search engine, does have some articles about the riots). Government-run media like Xinhua, People's Daily, and the English-language China Daily report only that the UN has called for "order" in Cairo.

Beijing is right to be worried. Nearly every dynasty in China's history has been undone at least in part by popular uprisings. A rebel army led by peasant soldier Li Zicheng took over Beijing in 1644, precipitating the fall of the Ming Dynasty. The Qing dynasty was weakened by both a pseudo-Christian Taiping rebellion and ethnic minority revolts, leading to its complete collapse in 1911. The list goes on. There is no reason to think that the current regime is immune to the patterns of history.

I don't think that the riots in Egypt will directly influence Chinese citizens. As a recent article in Time points out, the Chinese do not view citizens of faraway Egypt as brethren and are unlikely to pay particular attention to the riots going on there. While internet censorship in China is fairly easy to get around (and none of the English-language coverage is blocked), it is unlikely that the majority of Chinese will care enough to look. However, the catalysts that led to the Cairo riots--high unemployment and inflation--could occur in China very soon.

China Wikileaks: GDP numbers are false; alternative measures available

To a Sinophile or anyone who has spoken with a university economist in China, this is not news. In fact, this is less than news. To any brave traveller who has made it past the east coast cities and poked around the Chinese interior, this is also not particularly interesting.

What is interesting is to hear this from the man who will be China’s next Premier in 2012. (See the WSJ 12/6 article entitled, “Chinese Leader Called Data 'Man-Made'”).

Here are the facts from the cables as reported by Ambassador Clark Randt:

1. Li Keqing refers to China’s GDP numbers as being ‘manmade’, and “for reference only”
2. He further suggests looking at electricity consumption, rail freight volume, and lastly loan disbursement/ interest rates charged
3. The reason for selecting these is based upon supposed accuracy over-and-above other measures.

A number of large firms in the US that track Chinese data use similar measures to estimate actual economic growth in China. A recent working paper published by the School of Public Policy at George Mason University suggested focusing on satellite imagery and urban lights as a way to measure growth. The WSJ also wrote about this in their "Real Time China Report" (See "Bright Lights, Big Cities: A China GDP Alternative?")

The nagging question: how can one accurately measure GDP growth?

There is clearly a need for stand-in indicators. Ideally, these should take into account the present/ immediate past, the short-term future, and medium-term outlook. Electricity consumption might be a fairly robust present or immediate past indicator. Rail freight seems like it could be a good stand-in for the short-term future (it could represent commodities to be sold in the near-term like foodstuffs, agricultural products, or intermediate goods). Finally, the loan disbursement represents the medium-term (or longer term) investments that should compose GDP growth.

How about other potential measures? Water consumption? Water is the bottleneck of industrial production. It follows that the government and industry would want extremely accurate figures on water. Water consumption is a good way to measure certain types of industrial production.

A friend of mine recently suggested looking at loan defaults. This would provide a good barometer of economic trouble.

How about using satellites to count the number of large industrial ships that enter and leave China in a given period? This could then be compared to historical trends.

There are all sorts of interesting possibilities.