Welcome back everyone, just a quick video today on the Chinese property market and the
fallout of the Evergrande collapse, where we will look at what is going on at Chinese
land auctions over the last few months and how this is affecting local government revenues.
The Chinese governments push in the last year or so to reduce leverage across the property
sector in China and increase affordability has driven Evergrande and other private-sector
Chinese developers to the brink of bankruptcy, and I’ve covered that story fairly extensively
here on my channel.
Property development in China is estimated to make up about one-third of total economic
output in the country.
Now, one of the many problems being caused by the rapid real estate slowdown is that
the biggest source of income for local governments in China is the money they raise when they
auction off land for development, and the right to develop this land has typically been
bought up by private property developers like Evergrande.
In China, the history of private home ownership is quite short.
When Mao took power in 1949, the state seized all private property and the state continued
to own all property up until the 1980s, when Deng Xiaoping, began experimenting with private
property ownership in select cities.
Since then, Chinese real estate prices have skyrocketed, such that China today has some
of the world’s most expensive real estate relative to income.
In some Chinese cities, the average home costs over twenty-five years of average household
income, that compares to eight years of average household income in New York City.
The real estate boom has widened the country’s wealth gap and is leaving many people, particularly
the young, out in the cold.
Chinese leaders have talked for quite a while about reducing property speculation, but very
little has been done, as real estate development made up such a huge chunk of Chinese GDP.
Now, amid a broad effort by President Xi Jinping to promote what he calls a “common prosperity,”
we are seeing Beijing step firmly on the brakes.
In China, all land is still owned by the government, but it is leased out to those willing to develop
the land.
When citizens “buy” homes from developers, they are essentially taking over the lease
on the land, which for residential property lasts 70 years.
If the lease was granted to developers 15 years ago but the land was only recently developed,
home buyers might only have 55 years left in the home.
There have been very few tests as to what the expiration of leases in China might look
like, as this approach is quite new.
In 2002, some 20-year land leases in Shenzhen expired, and property holders there had to
pay 35% of the assessed value of the property for a 40-year extension on their lease.
Those unwilling to pay faced losing the property with only the depreciated cost of any development
on the plot as compensation.
It is easy to look at the collapsing property market in China through a critical eye and
blame the current leadership, and maybe argue that they should do something to stabilize
prices, but the real problem is the bubble, which has been rapidly inflating for the last
twenty or more years.
The government has attempted to slow things down in the past, but there has never been
the political will to really step on the brakes, so the bubble inflated and inflated based
on more and more leverage.
I can’t think of an example of a bubble in market history that slowly deflated, in
most of these situations, prices either rise rapidly or fall rapidly when people lose faith.
Governments around the world talk about the problem of housing affordability, but it is
very rare to see anything being done about it, as homeowners vote, and most politicians
know that they would quickly be voted out of office if home prices fell on their watch,
but there are few places in the world where real estate speculation has gotten as out
of control as it has in China.
Crushing the big privately owned property development firms or doing anything to increase
the affordability of real estate in China has this knock-on effect of slashing local
government revenues as I mentioned earlier.
The less the land is worth, the less revenue local governments bring in through selling
leases to developers, so this is a difficult balancing act for Beijing.
In China, while there is an annual tax on commercial property, there is generally (with
a few small exceptions) no annual tax on residential real estate, and this means that local governments
must fund themselves through land lease sales.
There have been some property tax trials in China and the Chinese government appears to
like the idea that such taxes would reduce the incentive for people to buy homes and
leave them empty as investments.
Such a tax might in the long run help local governments break their reliance on land sales,
But obviously these property tax trials are controversial – in the way that new taxes
always are.
And if you think about it, if you are paying twenty five times your annual household income,
to buy a home, on land that you don’t even own, and then you have a property tax tacked
on to this, it all becomes a bit much.
The biggest problem for local governments with funding themselves through a property
tax is that even if these taxes were rolled out nationwide, the revenue raised would only
reach a fifth of the $1 trillion a year that land sales currently bring in to local governments.
So, one way or another local governments in China might be getting squeezed a bit going
forward.
Ok, So, what is being done by Beijing to remedy these problems?
Well, what we are seeing right now, is that Chinese state-owned developers are stepping
in to take the place of the private sector to buy up land at land auctions, which will
be providing revenue to local governments.
Over the last three months state developers have bought three-quarters of residential
land sold at auctions in 22 big cities by value, according to a Financial Times analysis
of public records.
They had previously purchased only around 45 per cent of land plots sold at auctions.
So, this is a big increase in activity.
But is it enough?
Well, not really, as since September, almost a third of all auctions have failed, with
no bidders turning up willing to pay the minimum price.
Previously the auction failure rate was 6.5 per cent.
So really what we are seeing here is a total disappearance of private sector bidders at
land auctions, and a lot of land auctions failing altogether.
In Beijing, which has historically been a hot auction market 60% of the plots on offer
at the most recent auction in October failed to attract any bidders at all.
This is a stark contrast with the auctions from a year and a half ago – before the
government interventions - where at some auctions land sold for 130 per cent above the asking
price.
There has been a flip from a red-hot property market to an almost dead, market where the
only buyers are state owned enterprises.
While the Chinese government has eased some policies to relieve the pressure on China’s
property sector, it has shown no sign of backing down on the strict “three red lines” that
limit leverage amongst property developers and pushed Evergrande and a few other developers
to the brink of bankruptcy.
China’s central bank recently published data showing a strong year-on-year increase
in mortgage lending in October, and it appears that the governments current approach to stabilizing
the property market is to increase mortgage lending, but this is not enough to keep things
moving.
It is not really clear what can be done at this point, as obviously a property collapse
is not good for the Chinese economy, but any intervention to prevent one right now just
pushes it out to a future date.
Chinese private sector developers who were active bidders at auctions a year ago are
now entirely focused on reducing their leverage to comply with the three red lines policy
and so they are unlikely to return to land auctions any time soon.
– They are just hoping to survive the downturn.
So, who are these state-owned firms that are now stepping in at land auctions?
Well, many of them are what are known as Local Government Finance Vehicles (or LGFVs).
These are highly leveraged state-owned businesses, which have traditionally focused on infrastructure
projects rather than on residential real estate.
LGFVs have accounted for about a third of land purchases by value at auctions since
September, compared with just over 10 per cent earlier in the year.
Many Chinese cities and provinces rely on LGFVs to raise capital on their behalf to
get around official restrictions on taking on leverage.
Prior to the real estate crisis LGFV borrowing made up almost half of China’s new business
loans and a third of corporate bond issuance, according to official data.
As a group they were China’s biggest spender on construction projects prior to the real
estate meltdown, and now they seem to be the only buyers left.
These State-owned enterprises were struggling to raise money last year after a series of
defaults by state owned groups like Yongcheng Coal & Electricity rocked the country’s
credit markets in November 2020.
The defaults last year at State owned enterprises shattered a long-running perception among
investors that authorities in China would always step in to rescue financially imperiled
state-owned groups.
This relates somewhat to the Evergrande situation, where investors in China are realizing that
certain investments that they believed were government backed are not.
Chinese LGFV’s were experiencing their own credit crunch this time last year, so it is
a bit interesting to see them stepping in as land buyers, providing cash to struggling
local governments.
If we view LGFVs as overleveraged state-owned firms that are used by cities and local governments
to get around official restrictions on taking on additional leverage, the fact that these
are the only buyers at land lease auctions, might be viewed as local governments taking
money out of one pocket and putting it in another.
Foreign investors who invest in China have seen China confront many difficulties in the
past with great success.
But Xi’s China may not be the more capitalist version of China they are used to.
The goal of Xi’s common prosperity campaign in China, appears to be to rebalance income
levels in the country through transfers from those who are rich to those who are not.
There is a lot to be said for the creative destruction of allowing bloated and overleveraged
companies to fail, but it would appear that Xi, regards all Chinese companies as instruments
of a one-party state.
The failing companies may not be replaced with more efficient and better managed companies
as you would hope, but instead with overleveraged state-owned companies, who make investments
based not upon their expected return but for political reasons.
It is too early to know right now, but investors must ask themselves if Xi is putting in place
an updated version of Mao’s party.
If that is the case, investors will need to be very careful.
If you enjoyed this video, you should watch this one next.
See you again soon, bye.