I spent the past three days in Chengdu and so was unable to keep up my blog. I have to say that Chengdu, which is one of my favorite cities in China, was bustling and all the shops (and shopping malls) were packed, although I am not sure whether or not people were actually buying anything -- I purchased a small component for my camera (RMB 180) and I managed to attract the help of at least five attendants. Nonetheless the article excerpted below, which comes from the Christian Science Monitor, certainlyringstrueforBeijing.
Needless to say Simon Montlake hits on one of the things that most concerns people like me. There is a huge amount of direct and indirect lending to shopping malls, among other commercial developments, and it is not clear to me that most of these are profitable eough to service loans indefitely, let alone repay principle.
The missing factor in mainland malls: shoppers
Developers keep building but thrifty consumers are not biting
Simon Montlake Sep 02, 2007
...As investors continue to pour money into malls, analysts say the signs of a real estate bubble are growing, as are predictions that some retailers may be heading for trouble. Empty malls are just one indicator of an overheating economy - growing at its fastest clip in over a decade.
To curb rising inflation, led by food prices, the central bank raised interest rates recently for the fourth time this year. Property companies were also ordered in June not to borrow offshore. But the race to build goes on.
"The problems of overheating are already apparent," says Wang Yao, director of the information department at the China General Chamber of Commerce. "The commercial real estate industry is facing problems. After some buildings are finished, nobody wants to rent space."
Since 2002, the mainland has built hundreds of malls, each trying to get a slice of a retail pie worth US$800 billion last year. Captivated by the promise of a vast consumer class itching to spend, foreign brands have jostled for space at the table, only to find a scarcity of customers. Now, retail occupancy rates in Beijing are 8 per cent and rising as more malls enter a crowded market.
Mr Xu, who pulls in US$266 a month - below Beijing's US$400 average - is typical. He socks away a quarter of his pay packet, as does Chen Ping, his girlfriend, who earns a similar wage as a store assistant. Asked if he isn't tempted to save less and spend more, he shakes his head. "If we enjoy life now, what about the future? We need to think of our future," he says.
The rising cost of living is one reason why many here are reluctant to splurge in fancy malls. Mainland workers opt to save, knowing that a feeble welfare system is unlikely to provide for them. As a result, consumption accounts for only 37 per cent of the mainland's economic output, about half the rate in the US. Such stinginess bodes ill for Beijing's mall developers.
Golden Resources Shopping Mall was the world's largest shopping centre, with 550,000 square metres of retail space, when it opened in 2004 (though a new mall in southern China has since taken this title). But it has struggled to generate enough sales to justify an investment of nearly US$500 million and is fast being overshadowed by newer, glitzier retailers. An additional 2 million square metres of retail space will be added this year, according to the Mall China Information Centre, an industry association.
"The question is not whether people can afford [luxury] products," says Mr Wang, "but how many big malls a city like Beijing should have. If there are too many malls, some will fail." It's a common problem that points to the inexperience of mall operators and the readiness of state-run banks to lend to prestige projects with political backing, say analysts and industry sources.
"I think that the issue is not that we've misjudged consumption," says Michael Pettis, a finance professor at Peking University. "It's just been too easy to borrow money and build these things." He warns that a real estate downturn on the mainland will saddle banks with dud loans to empty malls.
In recent years, policymakers have cautioned banks against excessive lending to malls, to little avail. As well, the authorities have long sought to lessen dependence on exports by stimulating domestic spending. But private consumption lags far behind investment in real estate and factories, fuelled by a horde of savings in state banks. New bank loans reached US$364 billion in the first seven months of this year, exceeding last year's total lending, state media reported. Property remains a favourite bet: housing in Beijing is fetching 10 per cent more than last year.
However, industry sources say many first-time mall operators aren't borrowing money but reinvesting profits from their other businesses. That's partly why they don't always make the smartest decisions, says Victor Guo, president of Mall China. "The developers aren't so professional in China; they don't know how to develop and market their product," he says...
Courtesy of the weekend's AsianWallStreetJournal, I found some interesting numbers on Chinese corporate fundraising. In 2003, 4.3% of corporate fundraising came from the equity markets. That figure went up to 5.8% in 2004, then dropped to 3.8% in 2005, during which year the market reached its bottom. In 2006, not surprisingly given the strength of the Shanghai and Shenzhen stock markets, the equity markets rose in importance to account for 6.0% of total corporate fund raising. I expect this share will be larger in 2007, even though loan growth has been rapid.
The figure for bond markets shows even more variability. In 2003 bond markets accounted for just 1.1% of total corporate fundraising. In 2004 this rose to 1.3%, and then shot up to 7.3% in 2005 before declining again to 6.1% in 2006. Over this time the importance of banks as a source of corporate financing declined steadily from 94.6% in 2003 to 87.9% in 2006.
In an earlier posting I had assumed that bond and equity markets together accounted for about 5% of total fundraising over the past several years (my figures included government fundraising, which has a far greater bond component). It is hard to get very good figures because there is some evidence that many smaller and family-run companies borrow largely from the informal banking sector, whose loans are not included in these figures. Nonetheless I suspect my estimate no longer applies.
As I have noted many times (although some of this blog's readers don't necessarily agree), in my opinion the growth of alternatives to banks is an unambiguously good thing for China. The more moving parts there are to the financial system -- i.e. the more independent ways companies can finance themsleves -- the less susceptible the economy is to a financial shock that closes down one or more major sources of funding.
Chris Keogh, a good friend who heads capital markets activities at Gaohua Securities, the Goldman Sachs joint venture in China, was recently very upbeat about the growth of the bond markets in China during a lecture to my class. He guesses that bond markets will grow by about 30% or more a year. If we assume that loan growth slows to 15% (from its current 20% or more), then bonds and stocks might each account for about 10% of total corporate fundraising in about five years. This is good, but still not enough to give the sufficiently flexibility to the Chinese markets.
As an aside, Chris also said that the growth of the bond markets was being fueled by the fact that top-rated companies in China can borrow in the markets at anywhere from 1.5% to 3.5% cheaper than they can from banks. The AWSJ article also discused the big spread -- 2.5-3.5% according to them.
This suggests one of the dangers of the bond market to the banking system. If bond markets are so much more generous to top-rated companies than banks (whose lending rates are constrained by a minimum benchmark set by the government), one of the consequences of the growing bond markets may be a migration of the better credits out of the banking system. This happened in the US in the 1970s and 1980s and in Europe in the 1990s. It was not a very easy process for the US and European banks to learn how to adapt to a loss of their prime credits and I do not expect the process will be much easier for Chinese banks.
From my former Tsinghua student and investment banker Henry Zhang I got the following phone message today:
I am in the bank now and I am shocked by how many crazy people there are buying funds, stocks, etc. Most of them are old people, and how they decide on what to buy is based on their discussions with each other, which is totally clueless.
Coincidentally Kobain Wang, another one of my former Tsinghua students, who trades for a foreign investment bank, wrote me an email today under the heading "This is going NUTS":
A study by the Shanghai Securities News and Shenyin & Wanguo Securities found that investor deposits for trading local currency A shares reached RMB 1.3 trillion by the end of August, up by RMB220 billion from the end of July.
Brad Setser in his latest posting (http://www.rgemonitor.com/blog/setser) wonders about the real exposure Chinese institutions might have to subprime mortgages. Chinese institutions -- largely the PBoC and the largest banks -- have had to invest over $800 billion abroad just in the past two years and it would be surprising if very little of this was exposed to assets adversely affected by the crisis. He is a little skeptical that we have heard the end of the story, and I can't help but agree.
The official numbers suggest, as best I can remember, that total subprime exposure is under $15 billion. That is not a lot, but I want to suggest two reasons for caution.
The first and most obvious is that in a very complex financial market it is not always clear where the exposure lies. I remember in 1995 that one of the US investment banks most severely hit by the Mexican crisis was caught completely by surprise over the extent of its exposure. It had assumed that the bulk of its exposure to Mexico would be on the Latin American trading desk, and an examination of the books indicated that its losses there were manageable.
It turned out however that the repo desk, an area of the firm that had almost no expertise in or knowledge of the risks of trading Latin America, had been doing a roaring business in Latin debt and had been earning very high spreads largely, I suspect, because they had unwittingly underpriced risk. They had no idea that their "good" collateral could turn bad so quickly. When the bank's managers finally realized the extent of the losses on the repo desk, the bank came close to failure.
This story is all based on market gossip and rumors because very little of this was made public, but any experienced trader recognizes the story. While managers were diligently monitoring risk in the area where it most obviously belonged, they hadn't noticed that a completely separate business had taken on the same risk, and that this businessdid not fully realize its extent. I don't know for a fact that this has occurred in the case of China, but I assume and hope that financial authorites and bank risk managers are looking not just at the desks that are formally permitted to take subprime exposure, but also any desk that may have indirectly assumed such exposure.
The second reason for caution is that I suspect there have been a lot of subprime-related losses in other non subprime areas that have not been recorded or explained. For example based on anecdotal evidence I believe Chinese institutions have been big buyers of structured notes. Many of my former students from Peking University and Tsinghua University have joined trading or capital markets desks at major foreign and Chinese investment banks, and from what they tell me the structured products groups have been among the most profitable and active groups in each of their banks. In fact there is one French bank for which, I understand, most of their revenues comes from the sale of derivatives and structured products.
Without knowing exactly what these products are, I have no way of knowing whether or not there have been big losses, but I do know that at least one European bank (I spoke to one of my students there) has booked huge profits in the last few weeks from being on the sell side of the product, and unless the buyers were hedged (almost inconceivable, for many reasons) they must have equivalent or greater losses.
What would explain this? Most investors buy structured notes for their high coupons, especially in a market in which interest rates are low and investors eager for a spread. It is very easy to structure a note with a high coupon. All you have to do is imbed options into the structure such that the buyer of the note is effectively selling the note-seller one or more options. The higher coupon is, in effect, the price of the option amortized in the coupon.
That means buyers of most structured notes are effectively short options -- or short volatility, in the lingo. If there is little volatility in the market, the buyer keeps his higher coupon and gives up nothing in return. Therein lies happiness. If volatility spikes upward, however, or the underlying asset moves in the wrong direction, the value of the option immediately rises and, since the buyer of the structured note is "short" the option, the value of his note drops.
Without knowing exactly what Chinese institutions have purchased, it is tough to say whether or not the fair market values of their structured notes have dropped, but I would be very, very surprised if there wouldn't be some pretty substantial losses on a mark-to-market basis. I don't think most of the buyers mark to market and in fact there really is no market for most of these notes. I suspect that the buyers also don't have the pricing formulae needed for figuring fair market value (no selling bank would give away the pricing formulae because these are usually proprietary and very valuable), but I would bet heavily that if they asked the selling banks to buy them out of their positions, they would book very large losses.
It is the impact of the subprime crisis on underlying volatility that probably will account for the biggest losses Chinese institutions (and non-Chinese institutions too, for that matter) will take from the events of this summer. Unfortunately we don't really know how much that is.
The PBoC has raised minimum reserve requirements for the seventh time this year, after three increases last year, from 12% to 12.5%, which is expected to drain about $25 billion from the banking system (equal, by the way, to a little more than two week's reserve inflows). In a televised speech two days ago premier Wen Jiabao said the government needs to prevent the economy from overheating. Yesterday Zhou Xiaochuan, the PBoC governor, said in a speech that the central bank hoped to see positive real interest rates, although he also made the very reasonable comment that inflation is not just what has happened this month but must be measured over a longer period of several months.
I am not very optimistic that inflation numbers will come down dramatically in the near term, so I interpret this to mean that rates are going to go up quite a bit over the next few quarters. But here is the conundrum. If rates do go up sharply, the speculative profit from investing in China also goes up and, perhaps more importantly, the incentive for Chinese to invest abroad goes down. This measn that capital inflows are going to get worse, not better.
If you believe, as I do, that it is the monetary expansion caused by the currency regime that is at the root of China's money problems, it is hard to see how this can possibly help. I believe the PBoC is very worried about capital inflows and the currency regime, but it is an indication of how much inflation terrifies the government that they are willing to do something that just six months ago seemed almost inconceivable -- increase the incentive for speculative inflows.
I am convinced more than ever that until the government allows a rapid increase in the value of the RMB -- and perhaps the least damaging way would be to engineer a sudden, maxi-revaluation of around 15% -- there will be no good way of dealing with the problems. I was interviewd on CCTV's Dialogue Thursday on the subject of inflation and one of the things both my co-guest, Tang Min, the Deputy Secretary General of the China Development Research Foundation, and I agreed is that the combination of rising inflation and previous and current excess money growth -- which in the past had been deflationary thought its impact on expanding industrial production -- was something new, and it wasn't clear what impact it might have on subsequent inflation. If inflation keeps up, as I suspect it might, it may be tough for the PBopC to engineer sufficiently high positive real rates anyway.
...Commercial lenders earn only 1.89 percent in interest on required reserves, compared with a benchmark one-year deposit rate of 3.6 percent. That means banks pay the price for China's refusal to let the yuan strengthen faster to make exports more expensive and ease the inflow of money, according to Paul Cavey, an economist at Macquarie Securities Ltd.
"In the long term, the banks will be the biggest victims of the exchange-rate policy,'' Cavey said in Hong Kong. ``With a more flexible currency, China wouldn't have to move so often to absorb the liquidity.''
China has resisted U.S. pressure to allow the yuan to strengthen more quickly. The currency has gained 9.8 percent versus the dollar since a fixed exchange rate was scrapped in July 2005. The yuan closed 0.15 percent higher at 7.5384 against the dollar in Shanghai today...
I think Paul Cavey makes an important point and it indicates one of the dilemmas facing China. One of the few tools available to rein in money growth is to raise minimum bank reserve requirements. This hasn't had much effect in the past because banks had so much liquidity that they ran excess reserves anyway, but little by little the PBoC is eating away at the excess.
Of course the problem is that the banks lose money on reserves because their return is lower than their cost of funding. Reducing their profits reduces the amount of capital they have to absorb NPL losses. Fitch estimated earlier this year that total losses on existing NPLs would likely amount to 50% more than total capital and reserves, and this does not take into account the recent explosion in lending and the impact of a possible economic slowdown or contraction. If interest rates rise, as I discuss in the previous entry, this exacerbates the problem by accelerating principle payments, for reasons I discuss in an entry on August 22.
Therein lies the problem. One the one hand, it is crucial to strengthen the financial sytem before allowing the currency to aprreciate much, because one of the great risks is the possibility that an adverse shock may lead to a breakdown in the banking system. On the other, postponing the currency adjustment actually weakens the banking system in a number of ways.
The current issue of the Economist has an article on global food prices, which I excerpt below. It underscores the difficulty China is going to have in reining in food inflation. It seems that help will not be coming from abroad.
THE long cycles of agriculture are seldom associated with gripping suspense. But on September 12th farmers, grain traders and investment managers around the world will be awaiting news that is generating greater excitement the higher grain prices rise. The monthly report of America's Department of Agriculture (USDA) is so sensitive that department staff go into what they call a “lockup” period for days in advance, often working all night just before its release.
Prices of global wheat futures hit records during the first week in September, about double what they were a year ago. Corn (maize) prices have also surged. Consumers are already paying higher prices, forking out more money for products ranging from bread to noodles—although the cost of something in the shops has many components in addition to the price of a commodity. Wheat, for instance, accounts for only about 5% of the cost of an average loaf of bread. But although a jumble of subsidies clouds the precise picture, a long period of higher food prices is beginning to show up in inflation numbers around the world...
...Crop prices are increasingly intertwined because they influence what farmers decide to plant. Higher wheat prices are driving up the price of corn, which is even more sought-after as an animal feed when wheat is too pricey to be a substitute. Corn prices are also pushed up by growing demand for biofuels. In America, one of many countries encouraging the use of such alternatives, biofuel distilleries account for about one-fifth of the corn crop—thanks in part to subsidies. The lack of acreage for other crops, such as soyabeans, pushes their prices up too.
Given the price volatility, the upcoming USDA report is keenly awaited. The data's impact was particularly acute earlier this summer when the department reported that farmers planted 19% more land with corn this year than last, while soyabean acreage fell by 15%. Markets briefly sent prices of these two commodities in opposite directions. The report covers all the big exporting and importing markets. No one else does such a comprehensive job and it is hard to guess the outcome. However, dearer food is likely to be on the menu for some time yet.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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) wonders about the real exposure Chinese institutions might have to subprime mortgages. Chinese institutions -- largely the PBoC and the largest banks -- have had to invest over $800 billion abroad just in the past two years and it would be surprising if very little of this was exposed to assets adversely affected by the crisis. He is a little skeptical that we have heard the end of the story, and I can't help but agree. 
December, 2007