In the eyes of Chinese investors, property is transforming from a wealth creator to a wealth destroyer. Western investors ignore this transformation at their peril. The bursting of China’s real estate bubble has huge implications for the global monetary system.
Most areas of China feature a glut of property. Speculators were the driving force behind demand. Now they’re watching the smart money sell, and they’ll flee the market as prices gain downside momentum.
Momentum works on the downside, too — only two or three times faster. Like the crazy software stocks that fell 50% from March to May, empty Chinese properties, yielding no rental income, could fall very rapidly.
The smart money is already bailing out; a high-profile Chinese tycoon just compared China’s property market to the Titanic.
“I think China’s property market is like the Titanic and it will soon hit an iceberg in front of it,” said Pan Shiyi at a financial forum last Friday. “After hitting the iceberg, the risks will not only be in the real estate sector. The bigger risk will be in the financial sector.”
Pan Shiyi is chairman of Soho China Ltd., one of the largest China-based, Hong Kong-listed property developers. Mr. Pan believes there are serious problems in the shadow-banking sector.
Here’s the key quote from Mr. Pan, who was unaware that there were media members in the audience: “When housing prices fall 20-30%, these problems will be all exposed.”
Once the dormant credit market stresses are exposed, China will face a deflationary crisis that it’s never before experienced. In response to the 2008 financial crisis, China ordered state-controlled banks to dramatically expand lending. But that sort of reflationary response has gone as far as it can; total banking assets in China amount to an alarming $26 trillion — more than a third of global GDP.
Moreover, a rising percentage of China’s $26 trillion in bank assets are going bad. Jim Grant explains in Grant’s Interest Rate Observer:
“In addition to being perennially short of capital — one of the consequences of breakneck lending — Chinese banks are caught in a cycle of self-defeating forbearance. If, for instance, a real estate developer can’t meet a scheduled interest payment, chances are that the obliging lender will not write down, let alone write off, the debt. It will rather add the unpaid interest to the outstanding principal. A favorite banker’s gambit is to restructure commercial loans as short-term interbank assets, the latter requiring less regulatory capital than the former. An authority with whom [Grant’s analyst Evan Lorenz] consulted, and who asks to go unnamed, estimates that between 50-60% of banking assets are annually refinanced or reissued [emphasis added].”
That’s an alarming estimate. Even if it’s too high by a factor of two or three, it means China’s banking system is deeply insolvent; it’s turning Japanese. After its real estate market crashed in 1990, Japan failed to acknowledge and restructure bad loans and has suffered stagnation for the past 25 years. China could choose a similar path of procrastination… or rip the bandage off now and salvage some of the economic gains it has made.
Could China’s leadership order the expansion of the shadow-banking sector? Besides the fact that the leadership can’t control the demand for wealth management products, shadow banking has already grown to the point where investors are starting to doubt the return of their principal. It will be difficult for borrowers to find lenders willing to refinance outstanding shadow bank loans, let alone expand lending.
Here’s how China will respond to its growing deflationary crisis: The Chinese central bank (the PBOC) will have no choice but to ease policy. China will likely follow Japan, the EU, the U.K., Switzerland and the U.S. down the path of massive quantitative easing. Its unprecedented growth in lending, which has led to surging nonperforming loans, will result in an accelerating demand for liquidity among Chinese savers and investors. The PBOC will have to allow the renminbi to devalue against the U.S. dollar so it can flood the banking system with the supply of liquidity that investors and savers will demand.
In the meantime, while the property market loses its luster, what asset class might draw more attention as a store of value?
Gold is a natural, logical candidate. Besides land, gold is the oldest store of value in the history of civilization. And unlike land, gold is a mobile and liquid asset. China already has a cultural affinity for gold.
The Chinese government actually encourages the public to own gold. And the central bank is bound to dramatically ease policy. Easier policy would make cash deposits less attractive.
Without a clear catalyst to drive the move, gold prices took a hit this week. The gold bears’ key talking point is as follows: “We are entering a self-sustaining economic recovery. Central banks, including the Fed, can hike interest rates and there will be no negative economic effects.”
The immediate situation doesn’t fit a bearish scenario for gold. Official measures of inflation remain stubbornly high, while sovereign bond yields fall. Real interest rates are falling, which reduces the opportunity cost for holding gold. Plus, the European Central Bank (ECB) is widely expected to unleash another easing cycle next week.
Over the long term, central banks will feel compelled to maintain easy policy because the stock of total debt has reached an unstable level. And the Federal Reserve will stick to its tightening narrative while China debases its currency to bail out its banking system. Other central banks will print and ease policy, too. No country seems to want a strong currency.
If the Chinese property market is the Titanic of today’s global financial system, then gold is an ignored yet inviting lifeboat.
In an interview with The Gold Report, Franco-Nevada (FNV) Chairman Pierre Lassonde discusses gold investing in today’s depressed environment. As a director of the World Gold Council, Lassonde is very familiar with the supply-and-demand factors driving the gold price.
Of all the executives in the gold sector, Lassonde’s track record of creating wealth is unparalleled. He’s earned the reputation as an expert on the gold market, and predicts that Chinese speculators will eventually drive gold prices much higher.
The entire interview is worth reading. Below are a few highlights:
“The Gold Report: After the gold price collapsed last year, many quoted John Maynard Keynes’ assessment of gold as a “barbarous relic.” What do you make of that?
“Pierre Lassonde: Tell that to the Indians and the Chinese who last year bought over 2,800 tons in physical gold, mostly for jewelry and gifting. The last 10 years has seen a huge gold transfer from the West to the East. People in the West look at Western statistics and argue that the price of gold must collapse. They forget we are no longer the No. 1 market in gold in the world. Chindia is: China and India. Those are the No. 1 and No. 2 gold markets in the world.
“Last year, we saw about 900 tons of gold come out of the ETFs. We saw 400 tons of gold come out of the Comex. Goldman Sachs predicted that gold was going to $900 per ounce. But at $1,250 per ounce, the Chinese and the Indians stuck their hands out and said they would take it all. Gold then stabilized at $1,250 per ounce…
“[The] largest gold markets are China and India. China has 300-500 million people entering the middle class, which has a huge affinity for gold. The situation in India is similar. So the Chinese and Indians will determine the gold price.”
Here is where Lassonde predicts a speculative mania on the Shanghai Gold Exchange:
“The Gold Report: Do you believe China seeks a dominant position in world bullion ownership?
“Lassonde: Three points: First, the Chinese authorities very much encourage private gold ownership, for instance in TV ads. Second, 10 years down the road, the Shanghai Gold Exchange is likely to determine the gold price, not the Comex. Third, I have maintained for quite a few years that when we reach the peak in this gold cycle, the SGE will resemble a casino. The Chinese have a huge propensity for gambling, and this is what will likely propel the gold price to levels that we probably can’t even imagine.”
Despite the fact that Western investors see no need to own gold, the Chinese desire to own it today. As Chinese QE proceeds, the desire to own gold will increase.