Is China getting ready for the next big financial crisis?


Vivek Kaul
A famous Central Intelligence Agency (CIA) paper on China is titled “
The Art of China Watching”. In this paper the author Gail Solin concedes that “The art of China-watching is imprecise at best…The explanation, or blame, for this often frustratingly lies mainly with the way the Chinese conduct their affairs. To say the Chinese have a penchant for secrecy is almost an understatement.”
Edward Chancellor and Mike Monnelly of the global investment management firm GMO writing in a white paper titled 
Feeding the Dragon: Why China’s Credit System Looks Vulnerablesuggest that the CIA paper was written sometime in the 1970s.
When it comes to those from the outside watching the Chinese financial system, things haven’t changed nearly four decades later. China watching is still imprecise at best. Or as Stephen Green, head of Greater China research 
at Standard Chartered Plc in Hong Kong recently told Bloomberg “It’s a big black box, and it’s quite scary.”
And a few things coming out of the black box now seem to suggest that things are not as hunky dory as they are being made out to be. The loans given by banks and other financial institutions have reached very high levels. As Chancellor and Monnelly point out in their research paper “Between 2007 and 2012, the ratio of credit(i.e. loans) to GDP climbed to more than 190%, an increase of 60 percentage points. China’s recent expansion of credit relative to GDP is considerably larger than the credit booms experienced by either Japan in the late 1980s or the United States in the years before the Lehman bust.” As of the end of 2012, the total lending by banks and other financial institutions as a proportion of the GDP ratio stood at 198%.
So China has a debt problem, given that the total loans given by its banks and other financial institutions have risen at a very rapid rate. “There is just no way to grow out of a debt problem when credit is already twice as large as GDP and growing nearly twice as fast
,” Charlene Chu Senior Director in the Financial Institutions Group at Fitch Ratings based out of Beijing, told Bloomberg.
What is interesting is that the loan boom in China has been faster than many other countries which have faced severe banking and financial crises in the past. As the Bloomberg story points out “A jump in the ratio of credit to GDP preceded banking crises in Japan, where the measure surged 45 percentage points from 1985 to 1990, and South Korea, where it gained 47 percentage points from 1994 to 1998, Fitch said in July 2011. In China, it has increased 73 percentage points in four years, according to Fitch’s estimates.”
And this loan growth continues unabated. In the period January-March 2013 total loans grew by 20% in comparison to the same period last year. There are two main problems that arise with excessive loan growth.
As Wei Yao of Societe Generale writes in a report titled 
China’s missing money and the Minsky moment “a fast rising debt load of an economy suggests either deteriorating growth efficiency or high and rising debt service cost, or in many cases both. There is clear evidence that China is suffering from both of these.”
What this means is that China now needs more and more debt to create the same unit of growth. Meanwhile the debt service ratio keeps growing. Debt service ratio is essentially the sum of interest to be paid on all the outstanding loans along with the maturing loans that need to be repaid expressed as a percentage of GDP. Wei Yao estimates that China has “a shockingly high debt service ratio of 29.9% of GDP, of which 11.1% goes to interest payment and the rest principal.”
“At such a level, no wonder that credit growth is accelerating without contributing much to real growth!,” she writes.
A lot of the excessive loan growth in China has gone into buying and building property, where no one lives. “Miles upon miles of half-completed apartment blocks encircle many cities across the country. Official data suggest that the value of the unfinished housing stock is equivalent to 20% of GDP and rising..Developments in the infamous “ghost city” of Ordos, in Inner Mongolia, reveal the vulnerability of China’s credit system to an overblown housing market. The Kangbashi district of Ordos is a totem for China’s property excesses. Kangbashi has enough apartments to shelter a million persons, roughly four times its current population,” write the GMO authors.
This basically means that builders who built these homes are not in a position to repay the loans they had taken on, given that the homes are not selling and have been more or less abandoned. This excessive building of homes was driven primarily by demand from speculators. The government has taken various steps to kill ‘speculation’ from time to time but hasn’t done enough and it keeps coming back.
Andy Xie, a former Morgan Stanley analyst, who closely tracks China made a fairly interesting point 
in a column he wrote in late March 2013. As he wrote “The government has introduced tightening measures against property speculation from time to time. These measures have never been serious enough to stamp out speculation. They merely slowed and extended it. The ineffectiveness of the measures keeps up the dream that prices could surge when the government either loosens up or is overwhelmed. That dream keeps speculators in the game. The latest measure – a 20 percent capital gains tax, yet to be fleshed out in detail – is the latest example. In the short term it sparked a frenzy because speculators are rushing to buy before the tax comes into effect.”
This has led to a situation where banks and other financial institutions have ended with a lot of real estate as a collateral against the loans they have given out. “It’s probably fair to say that at least one-third of bank credit exposures are real estate related,” write Chancellor and Monnelly.
Banks have also given a huge amount of loans to local governments and taken on land as a collateral. The trouble is that a lot of this land has been dubiously overvalued by local governments to take on higher amount of loans. “The quality of the collateral held by the banks against their loans has been questioned. Collateral often comes in the form of land, which in some cases has been valued by local officials at a premium to actual market values…Loudi, a little-known city in Hunan province, serves as the poster child for local government funding vehicles excesses. According to Bloomberg, Loudi’s local government borrowed RMB 1.2 billion to finance the construction of a 30,000-seat faux Olympic stadium, gymnasium, and swimming complex. The land collateral for Loudi’s loan was valued at around four times the value of nearby plots zoned for commercial use,” Chancellor and Monnelly point out. So if the banks try to sell the land they have as collateral in case of defaults, they are not going to recover a large portion of the loans they have made.
Also, a lot of local governments have taken on a large amount of loans to spend on trophy projects which are not going to generate returns any time soon. One such project is the famous maglev (magnetic levitation) train that goes from Longyan Road in Shanghai to Pudong International Airport in eight minutes.
Ruchir Sharma, head of Emerging Markets and Global Macro at Morgan Stanley Investment Management, describes his experience of taking the train in 
Breakout Nations. While the experience was fantastic, there were hardly any passengers around. He points out that locals say that the train is usually only half full because it starts in the middle of nowhere and the ticket is very expensively priced.
Such projects are not expected to generate returns anytime soon, making the repayment of loans even more difficult. As Chu of Fitch told Bloomberg “Companies are taking on a lot of debt but not getting comparable returns… If they’re not getting sufficient returns, at some point they will have problems repaying the debt.”
So the situation is tight but this hasn’t started reflecting in loans defaults as yet. The formal banking system has a non performing loan ratio of around 1%. There are several reasons why this ratio is not higher. One simple reason is that the banks have been allowed to roll-over loans, in case the local government bodies which have taken on the loans are not able to pay up. This basically means that when a loan falls due and the borrower needs to repay it, the bank does not demand repayment of the loan and continues to accept interest on it from the borrower.
What has also happened is that banks are selling bonds bundled into wealth management products to their clients. These bonds are supposed to be raising money to finance infrastructure projects. But that is really not the case. As the GMO authors write “Caixin (a Beijing based media group) quotes a source at a major bank claiming that many bonds, which purported to finance new infrastructure projects, were actually being used to pay off old bank debts. While this has allowed banks to reduce their reported exposure to local governments, it is possible they will have to make good any future losses suffered by investors on future bond defaults.” So basically future bad loans of banks have been passed onto bond investors.
Of course such things cannot go for eternity. As Wei Hao of Societe Generale puts it “a number of economies had similar or moderately lower debt service ratios (DSRs) when they were headed towards serious financial and economic crises. Examples include Finland (early 1990s), Korea (1997), the UK (2009), and the US (2009). This is one more data point in China that evokes the troubling thought of a hard landing.”
But not everyone is willing to buy this argument. Those who don’t buy feel that China is in the midst of a ‘credit bubble’ like to point out that most of the outstanding Chinese debt is domestic. And given that there can be no crisis. They just need to look at Japan. Domestic savings fuelled a stock market and real estate bubble in the late 1980s. The bubble started to burst in 1989, and the Japanese economy has never recovered since then.
The other point that China supporters like to point out is that China has a very low government debt to GDP ratio. As Chancellor and Monnelly point out “Many commentators also take comfort from the fact that China’s public debt (another term of government debt) is less than 30% of GDP. The trouble is that the official numbers are misleading…In order to get a proper picture of China’s sovereign liabilities we must add back the loans to local government infrastructure projects, policy bank debt (issued by the likes of the China Development Bank), borrowings by the asset management companies (which acquire non-performing loans from banks and others), and debt issued by the Ministry of Railways to fund the roll-out of the expensive high-speed rail network.” After this is done, China’s government debt to GDP ratio comes close to 90%, which is not small by any stretch of imagination.
So while there might be many out there who would like to believe that all is well in China, the evidence is clearly to the contrary. Chu of Fitch put it best when she told Bloomberg “You just don’t see that magnitude of increase in the ratio of credit to GDP…It’s usually one of the most reliable predictors for a financial crisis.”
The article originally appeared on on June 11, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why realty regulatory Bill is not a panacea it’s being out to be

India-Real-Estate-MarketVivek Kaul

The Union Cabinet cleared the Real Estate (Regulation and Development) Bill on June 4, 2013. The passage of this Bill has been heralded as a move in favour of real estate buyers. The Bill has been in the works for more than six years now, that tells us how serious the government has been on making it a law. 
There are several provisions in this Bill that point out towards the same. Real estate developers can launch new projects only once all the relevant permissions are in place. These permissions are to be displayed on the website of the developer 
and only then can construction begin.
If the promised home is not delivered on time, the buyer will be entitled with a full refund of the amount he has paid along with interest. Separate bank accounts are to be maintained for every project. Developers need to ensure that the money taken from buyers is used for that particular project and not diverted elsewhere. While advertising developers will have to use photographs of the actual site. Failure to do so will attract a penalty. 
The Bill also seeks to establish a central appellate tribunal and individual states will be responsible for establishing state level regulators. Further, the Bill does not allow developers to take more than 10% advance from the buyers without a written agreement. This provision it’s felt will help curtail the amount of black money that goes into real estate. 
All these provisions put together will help the buyers, 
seems to the major view coming out. But as the old English saying goes there is a many a slip between the cup and the lip. 
First and foremost the Bill as and when it becomes an Act will be applicable only on new real estate projects. Hence, the real estate projects which have already been launched will not come under the aegis of the Act. This means that buyers of those real estate projects which have been delayed will continue to face problems. 
The recent past has seen real estate developers launching more and more new projects and use the money thus raised to pay off their past loans. This has led to a situation where there is no money left to build the projects which have been launched. In order to get the money required to build these projects, newer projects are launched. So this modus operandi has led to a situation where projects are rarely delivered on time and are endlessly delayed. 
The buyers who are facing trouble because of this will get no relief as and when the Real Estate (Regulation and Development) Bill becomes an Act. (You can read 
a more detailed argument here). 
The Bill also talks about establishing a real estate regulator in every state. This is a very long term process. It calls for the recruitment of a lot of people who understand specific real estate regulation. The question is are there enough such people going around? 
Also, any regulator takes time to become effective. Take the case of the Securities and Exchange Board of India(Sebi), the stock market regulator, which was established in 1988 and given statutory powers in the 1992, after the Harshad Mehta scam. 
Immediately after Sebi was given statutory powers, the stock market had the vanishing companies scam, where companies raised money through initial public offers (IPOs) and disappeared. Sebi could hardly do anything about it and investors lost thousands of crores. 
Towards the turn of the century there was the Ketan Parekh scam, which again caught the stock market and Sebi off-guard. Its only in the last few years that the stock market regulator has come into its own. So its effectively taken Sebi almost twenty years to become somewhat effective. 
But even then Sebi has had huge problems dealing with Sahara. The moral of the story is that even regulators don’t stand much of a chance against big established business groups. So how will the real estate regulators go against real estate developers, who are known to be fronts for politicians? Then there is the question of whether the regulator will act in favour of consumers. The Insurance and Regulatory Development Authority, the insurance regulator, over the years has acted more in favour of insurance companies as an industry lobby than thought about people who buy insurance.
A major point in the Bill is that the developers will have to open separate bank accounts for each project and ensure that the money from the buyers goes into that particular project and not elsewhere, as is the case currently. On paper, this is probably the most important point in the Bill. But money is fungible, as anyone who has handled it will tell you. So the question is who will ensure that the money going out from the a particular project account is going towards that project and is not being used to by the developer to meet other obligations or simply being siphoned off. 
This seems to be the job of the state level real estate regulators that the Bill seeks to establish. But will state level regulators be able to manage things at such a micro level? Will they have the required expertise? I have my doubts. Implementation of laws has never been a strong point with India and Indians. 
Also this provision in the Bill has been significantly diluted over the years. As Dhirendra Kumar of Value Research writes in a column “Compared to the 2009, the government has weakened the anti-fund-diversion provisions of the Bill. In the 2009 draft, all funds collected from the buyers would have to be kept in a separa
te bank account, from which money could be taken out only for direct use of the project.” This has been diluted and the current version of the Bill allows developers to route only 70% of the money raised from buyers into a separate bank account. “This serves no purpose except to make it easier for developers to divert 30 per cent of the funds,” writes Kumar. 

The Bill does not allow developers to take more than 10% advance from the buyers without a written agreement. This it is said will help in controlling black money. This to me seems like someone’s idea of a joke. When has any agreement prevented Indians from transacting in black money? Scores of developers across this country continue charging money in black separately for car parking, despite there being a Supreme Court order against the same. 
The Bill also says that buyers will be entitled to a full refund along with interest if the developer does not deliver the project on time. This may not be of much help because even with the compensation, the buyer may not be able to buy a home. Home prices may have risen in the meanwhile. Also, after a project is delayed, you cannot expect the buyer to put money in a fresh project, which again promises to deliver a few years later, like the original developer did. 
Buying a fully ready home may turn out to be expensive and beyond the budget of the buyer, even with the compensation. Given this, the buyer should be compensated either the price of buying a similar home in the open market, as promised by the builder, or refunded his money along with interest, whichever is higher. 
Also, it is one thing to make a law which calls for the developer to pay up in case a project is delayed, and it is totally another thing to expect him to pay up. Take the case of DLF. The company was fined Rs 630 crore for abusing its dominant market position by the Competition Commission of India (CCI). 
As an article in Governance Now magazine points out The CCI pronounced DLF guilty for grossly abusing its dominant market position in the relevant market and imposing unfair conditions in the sale of apartments to home buyers in contravention of the provisions of the Competition Act, 2002. The CCI also imposed a penalty of whopping Rs 630 crore.” 
But there has been no damage to DLF. “Ever since the order came out, DLF has paid zero to CCI. Not only that. They have launched four different projects since then, despite of our continued objections to the CCI,” Amit Jain of the federation of apartment owner’s association (FAOA) told Governance Now. So if DLF can get away without paying a regulator, where is the question of developers paying the 
aam aadmi for delayed projects? 
The politicians have already tweaked the provisions of the Bill in favour of the developers. In fact, in the 2009 version of the Bill only those projects which were less than a 1000 square metres and had less than four dwelling units were exempt from the provisions of the Bill. The current version of the Bill is applicable only to projects over 4000 square metres in size with no limit on the number of dwelling units. Also there is a twist in the tale. As Kumar writes “Even more alarmingly…when a project is executed in phases, then each phase will be considered separately. This means that even very large projects could just be broken up into sub-4000 meters phases and escape much of the regulatory oversight of the Bill and the regulator.” So all we know, the developers might exploit this loophole to the hilt. 
To conclude, India does not have independent regulators. And people who head regulatory bodies report to politicians. Even the real estate regulators will report to politicians. And many politicians have significant interest in real estate, ensuring that developers will do what they want to do. The law of the land be dammed. Or as the old saying from the Hindi heartland goes “jab saiyyan bhaye kotwal to darr kaahe ka?(when my lover is the police inspector, what do I have to fear?). So deep runs the politician-builder nexus. 
And the
 Bill does very little to address this. To be fair, one cannot expect any law to end the nexus. But if the Indian real estate scenario has to improve it is this nexus that needs to be broken. And that is not going happen anytime soon. 
(The article originally appeared on on June 6, 2013) 
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Decoding the great Indian real estate ponzi scheme

India-Real-Estate-MarketVivek Kaul
A headline can sometimes tell you the complete story. The May 20, 2013, Hindi edition of the Business Standard had one such headline. “Intehan ho gayi intezar ki, aayi na kuch khabar ghar bar ki (Its been a long time waiting, and there is still no news of the house),” went the headline.
The headline was a play on the hit Amitabh Bachchan-Kishore Kumar song “
Intehan ho gayi intezar ki, aayi na kuch khabar mere yaar ki (Its been a long time waiting, and there is still no news of my love) ,” from the movie Sharabi.
The story which appeared in the English edition of Business Standard as well with a rather drab headline ‘Supply blues persist in realty sector‘, basically made two points:
a) More and more real estate companies were delaying the promised delivery of homes due to various reasons. As the story pointed out “The year 2013 was projected as the year of delivery for residential projects which had been stuck for years. While developers claim they are on course to supply a large number of units this year, sector watchers doubt it.”
b) This delayed delivery had not stopped real estate companies from announcing and launching new projects. As the story pointed out “Notwithstanding the delays in ongoing projects, a number of real estate companies, including DLF, Unitech, SVP and Supertech, are going ahead with launches, to generate cash flow in a tight market situation.” What this means is that people who have paid for homes continue to wait, whereas the real estate companies continue to launch new projects.
These two points basically tell us very clearly that the Indian real estate sector has degenerated into an out an out Ponzi scheme. A Ponzi scheme is a fraudulent investment scheme where the money being brought in by newer investors is used to pay off older investors. The scheme offers high returns to lure investors in and it keeps running till the money being brought in by the newer investors is greater than the money needed to pay off the older investors whose investment is up for redemption. The moment this breaks, the scheme collapses.
The important point here to remember is that in a Ponzi scheme the money being brought in by newer investors is used to pay off the older investors whose investment needs to be redeemed. Lets apply this in the context of real estate companies and understand why they have become Ponzi schemes.
The real estate companies have offered various reasons for the delay in delivery of homes. “Builders cite several reasons — not getting requisite approvals, slowdown in the market, land acquisition and farmers issues, among other,” the 
Business Standard points out.
Anyone who is not familiar with the way Indian real estate companies work would be surprised at this. You would expect a company to have sorted issues like land acquisition and getting the requisite approvals before a project is launched. If there is no land where will the homes be built? If there are no permissions how is the real estate company going to get around building the homes? And given this why is a project even being launched?
But typically this is not how things work (at least in large parts of Northern India, and particularly in and around Delhi). The real estate company first launches a project, collects money for it, and then gets around to acquiring the land and getting the permissions in place. And once it has raised some money, only then does it finally getting around to building homes. So when a real estate company says that homes have not been delivered due to these reasons, then they are largely true though not fair on those who have bought homes hoping to live in them.
However, that is just a part of the problem. The real estate companies loaded up on debt during the few years running up to 2008. Money back then was cheap and the possibilities of what you could do with it were endless.
Take the case of DLF, India’s largest listed real estate company. It had a net debt of Rs 21,350 crore as on December 31, 2012. Interest needs to be paid on this debt. At the same time this debt needs to be repaid as and when it matures.
But the slowdown in the real estate market due to the high prices has ensured that these companies are not selling enough to be able to repay these debts. In case of DLF, the sales for the period between April 1, 2012 and December 31, 2012, were down by 9% to Rs 6,777 crore.
What has happened because of this is that companies are using money that has been raised for new projects to pay off interest on debt as well as repay debt. Hence, there is no money left to build homes. In this situation, the only way left for the company to raise more money to build homes, is to launch newer projects. It can also hope to raise money from big private money lenders, where the interest can be as high as 3-4% per month. So launching newer projects is an inherently cheaper way of raising money.
So the money lets say raised for Project A is used to pay off interest on debt and repay debt that is maturing. To build homes that have been already sold under Project A, a Project B is launched. This money is now used to build homes for Project A, assuming its not used to meet debt payments. So, this ensures that Project A is delayed. Now to build homes promised under Project B, a Project C is launched. And so the cycle continues.
So money being brought in by investors into Project B is being used to build homes for Project A. Money being brought in by investors into Project C is being used to build homes for Project B. A perfect Ponzi scheme is one where money brought in by the newer investors is used to pay off older investors. In this case money brought in by newer investors is used to build homes for older investors.
The important part here like any Ponzi scheme is that it will keep running as long as the money keeps coming in. And the money will keep coming in as long as people continue to have faith in real estate as a great investment that has given fabulous returns in the past.
This faith is built on various myths. The biggest myth is that India has a huge population and hence a large amount of land will be required to house this population. And land is scarce. As the great American writer Mark Twain once remarked “Buy land, they’re not making it anymore”.
Given this scarcity of land, real estate prices will only go up. The argument though doesn’t quite hold against some basic number crunching. As economist Ajay Shah 
wrote in a recent piece in The Economic Times “Some claim that India has a large population and there is a shortage of land. A little arithmetic shows this is not the case. If you place 1.2 billion people in four-person homes of 1000 square feet each, and two workers of the family into office/factory space of 400 square feet, this requires roughly 1% of India’s land area assuming an FSI(floor space index) of 1. There is absolutely no shortage of land to house the great Indian population.”
But as they say perception is reality. And given this money keeps coming into the Indian real estate sector. What helps in keeping this perception going is the fact that politicians have their black money invested in the real estate sector and it is in their interest to ensure that real estate prices do not fall.
One way of doing this is having some sort of a control on supply of new homes. The best way to do this is having a low FSI, which ensures that real estate companies cannot build enough to meet demand. As Shah points out “The biggest story about the future of real estate prices in India is the FSI. In most of India, the FSI is below 2. This is an abysmally small number by global standards. All over Asia, FSIs are above 5, going up to 20 or to no limit….A higher FSI results in lower rental rates for households and firms, as was seen in Hyderabad which was a pioneer in FSI reform. When FSI goes up, this will unleash supply on a big scale. As an example, if Bombay(the city is now called Mumbai) moves from an FSI of 1 to 2 — which would still make it worse than the FSI seen anywhere else in Asia — this would trigger off a doubling of supply.”
The other way politicians ensure that real estate prices continue to remain high is by nudging the banks to give newer loans to cash starved real estate companies. As Ajit Dayal 
wrote in a column in 2009 “Their act of giving the loan to real estate developers gives them badly needed cash. The real estate developers no longer need to sell their real estate to get “cash flow” to stay alive.”
If at that point of time banks hadn’t bailed out real estate companies, they would have had to sell homes at lower prices, and real estate prices would have thus come down. And that would have meant lower returns for real estate investors. This would have led to the real estate Ponzi scheme that is in operation breaking down because investors would have had some doubts before parking more money in real estate. But that was not to be.
What is interesting is that loans that banks give to what the Reserve Bank of India calls commercial real estate(i.e. to companies and not individuals buying homes) continues to grow at a much faster rate than overall bank lending.
Given these reasons, real estate companies will continue to launch new projects and delivery of homes will continue to be delayed.
The article appeared originally on on May 22, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek)