China’s Ghost

Richard Croft
May 21, 2013
11 minutes read

Word from China is sending mixed messages to the world. GDP appears to be picking up particularly over the last quarter. Good news for a world in dire need of stimulus! At issue is what’s behind the growth?

The debate centers around a massive infrastructure construction boom that has lead to overcapacity in residential real estate resulting in the rise of ghost cities that now dot the Chinese landscape.

From a central planning perspective, it makes sense because directing investment towards infrastructure is one of the easiest ways to boost GDP. But if it leads to a proliferation of residential structures that no one wants to live in, it draws into question the sustainability of the country’s economic boom.

Well known short seller and hedge fund manager Jim Chanos has been warning of a Chinese credit and real estate bubble since 2009, warnings that, so far, have not materialized, although more supporters of his thesis are jumping on the bandwagon! Particularly on the heels of a recent 60 Minutes expose that focused on Chinas’ ghost cities.

Take Kangbashi, a city in northern China, as an example. It was built to house one million people but to date only 20,000 have taken up residence. Holly Williams, Asia correspondent for news.sky.com writes that Kangbashi “was dreamt up by the local secretary of the Communist Party as a monument to the country’s new-found prosperity. The place is dominated by impressive public buildings: a marble-clad library, a state-of-the-art theatre and a giant convention centre. Acres of apartment complexes – many of them luxurious by Chinese standards – are deserted. Store fronts are boarded up.”

The concern is that most of these units were purchased from blueprints by the wealthy middle class. Left with few alternatives, property is seen by many Chinese investors as a store of wealth. These same investors are restricted from making off shore investments, and the only domestic alternative to real estate is a poorly regulated domestic stock market.

But notes Williams; “from the very outset Kangbashi defied all economic logic. There’s no industry in the city, and no real reason to live there.”

The 60 Minutes expose raised even more questions. Citing examples like the city of Zhengzhou where “the apartments are all sold but practically no one lives there.”

Fact is construction has been the dominant driver of growth for the last few years with estimates ranging from 20 or 30 per cent of GDP. Too much too quickly, notes Financial Analyst Gillem Tulloch, speaking to 60 Minutes.

Tulloch notes that China’s government had spent an estimated US $2 trillion to build the cities and to keep the country’s economy going. And while there is little debate around the numbers there is come discussion as to the scale.

If you apply these numbers to the US economy, it would seem overwhelming, but in a country with more than a billion people and a propensity to invest for the longer term, fears of a meltdown may be exacerbated. Mind you that was the same arguments that justified the Japanese property bubble in the 1980s.

The bigger question, notes Tulloch, is that the poorer people who live in the rural countryside are being encouraged to move into the cities but “that doesn’t necessarily mean they can afford these apartments which cost US$100,000. There are multiple classes of people that are going to get wiped out by this. People who invested three generations’ worth of savings into properties will see their savings evaporated.”

Not everyone agrees! Dan Harris in a February 2013 blog posted in China Business thinks that worry over China’s ghost cities are overrated. “The anti-China crowd loves to point at [ghost cities] as proof of China’s inefficiencies and evidence of an eventual and certain economic downfall. Yes, they do evidence inefficiencies, but so what? Go to even the most well functioning economy and you will see pockets of inefficiencies and abandonment.” But again it comes down to scale!

There is also a view that investing in infrastructure – whether we are talking residential construction or roads – provides a foundation for future growth. The build-it-and-they-will-come approach may be flawed but it carries less risk than overinvestment in areas like manufacturing which would have a longer lasting detrimental impact to the private sector.

Veteran China watcher Jonathan Anderson, in an article penned for the Wall Street Journal, defines ghost cities as a relatively narrow slice of investment conducted mainly by local governments, in urban infrastructure and certain types of construction, notably subsidized social housing units rather than commercial housing. Anderson notes that these units have certainly been a black hole “but a hole that has emptied largely into the equally dark vaults of China’s state-owned banks, where bad debts can remain buried for a long time.”

Anderson’s conclusion: “if you’re going to waste capital best to waste it completely where it will do the least damage to everyone else.”

A Tale of Two Ghost Cities

What are we to conclude about China’s ghoulish infrastructure? Will China be able to sidestep the pitfalls that accompany overcapacity or will we discover that the natural laws of economics simply do not apply?

What we know is that should China succumb to a property bubble it will result in a credit crisis that will make the 2008 debacle pale by comparison. But whether a credit crisis ultimately unfolds may come down to timing. How quickly can this overcapacity be mopped up?

Yale Professor Stephen Roach, when interviewed by 60 Minute, noted that China is experiencing “the greatest urbanization story the world has ever seen” and these so-called ghost cities will soon become “thriving metropolitan areas.” If China can meet its new found objectives in a timely fashion, he may be right.

China is trying to shift away from an export driven economy to one that relies on domestic consumption. Central planners believe that an economy with a strong domestic foundation and a growing middle class is more sustainable.

It is one of the benefits of having a central government that is flush with capital and plans in five year tranches. However, for this to work, planners have to maintain growth while the transition works its way through the economy and hope that the Chinese middle class have the patience to absorb any price shocks along the way.

Mr. Chanos takes a harder line arguing that this approach does nothing for investors. In an interview with Yahoo Finance, Chanos notes that while the Chinese economy quadrupled in nominal terms over the last 10 years, western investors in the Chinese stock market have basically made nothing in that same 10-year period. “That’s a staggering indictment of the form of capitalism that exists in China.” It could also indicate that Chinese growth is masking a correction that is already taking place.

Chanos went on to say that “China is adding the equivalent of US $2.5 trillion of new debt annually [which implies] that 30% of China’s GDP growth depends on new credit creation – half outside of normal banking circles – and that China’s excessive credit creation is invested in the wrong sectors. Every new dollar of debt created is yielding less growth in GDP.”

If this is a bubble the challenge is trying to ascertain the point at which it will actually burst. And more importantly what impact that would have on the global landscape? No one questions the dire consequences that a meltdown would have on China. Where there is some debate is the impact it would have on the rest of the world. But given China’s status as the world’s second largest economy, it is hard to imagine that it would not have an impact.

Having said that, Chanos has been talking down China since 2009 and it continues to defy gravity. Some argue that’s because western investors have overstated the scale of the problem and others like Harris and Roach think it is a red herring. Time will tell!

As investors, it is important to be mindful of these kinds of landmines. Make no mistake, if the bubble does burst it will happen when least expected, which is why you would be well served to maintain a conservative approach by focusing your option strategies on Canadian companies with large domestic exposure and solid dividends (note; BCE Inc., Enbridge, any of the Canadian banks, etc.).

Focus on where the puck is going, not where it is, so that you are not forced to evacuate at exactly the wrong time.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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