Archive for May, 2010

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Significant slowdown for Australia ahead?

Sunday, May 30th, 2010

How to buy and invest in physical gold and silver bullion

Recently, we noticed a trend emerging in the Australian economy- retail discretionary spending seems to be falling off significantly. As this news article reported,

But conditions in the retail sector are savage. Consumers are buying less, despite one of the most ferocious discounting wars in history. With the two department store heavyweights, Myer and David Jones, battling it out for customers, the smaller retailers are caught in the crossfire, forced to match the prices or do better.

The latest Australian Bureau of Statistics figures show the household goods sector posted a sharp fall in prices, down 3.6 per cent, making it the second-biggest quarterly fall over the past 11 years. The first-quarter CPI showed particularly large price falls for furniture and furnishing, down 3.8 per cent, and audio visual and computing down 5.9 per cent. The next figures will be even uglier for retailers, whose margins are being cut to ribbons.

Elsewhere, Virgin Blue suffered a big fall in share price as it warned that

… earnings could plunge as much as 75 per cent due to a ”rapid deterioration” in demand from leisure travellers.

It seems that the retail industry is doing it tough. Sectors of the Australian economy related to consumer spending are in pain. Like the US economy, most of the Australian economy are related to consumer spending (say around 60%). Therefore, this trend, if continued, indicates that a major slowdown in the Australian economy is coming. A recession cannot? be ruled out.

The mainstream media will quote mainstream economists and put the blame on rising interest rates, Greek contagion and China? slowdown and so on. Blame will be laid on these “shocks” to the economy that cause consumers to “lose confidence.” That implies that to reverse this trend, consumers will have to be brainwashed to be ‘confident’ in order to spend their way to economic prosperity.

This is an example of voodoo economics for the masses. If this is the correct diagnoses for the ills of the economy, then we have a better idea for an economic ‘stimulus’ package (that will be much far more effective than the Rudd government’s $900 cash splash during the GFC)- distribute $900 worth of Myers/David Jones vouchers (that? will expire in 3 months time) to the masses. We can guarantee that within 3 months, consumers will regain their ‘confidence’ and spend, spend and spend.

Since consumer ‘confidence’ is the wrong diagnosis, then ‘stimulation’ is the wrong cure.? As we wrote in Will governments be forced to exit from ?stimulus??,

In fact, the word ?stimulus? is the most misleading word in economics lexicon because it conveys the idea of a surgeon ?stimulating? a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch.

What is the root of the problem?

Remember, back in Australia?s credit growth is still falling, we wrote that

… for an economy that is addicted to debt, all it needs to tip it into a recession is for credit growth to slow down- no contraction of credit is required. Also, as Professor Steve Keen explained, at this stage of the debt cycle, the aggregate spending in the economy is made up of income plus change in debt.

To understand why, consider this highly simplified hypothetical situation in the economy:

$80 (income) + $20 (change in debt) = $100 (Aggregate spending)

As you can see, of the $100 of economic activity, $20 is the result of an increase in debt. Assuming that next year, the situation looks like this:

$83 (income) + $15 (change in debt) = $98 (Aggregate spending)

Income goes up, but people decide to borrow less. Note that when there’s less borrowing, it does not mean that the total amount of credit in the economy has declined. Instead, it means that credit is still growing, but it is growing at a slower pace.

As you can see from this example, if income remains stagnant and credit growth slows down, the total amount of aggregate spending in the economy will decline, tipping the economy into recession (unless it is the government which increase the spending to fill the gap).

What if next year, everyone decides to stop borrowing (i.e. total credit remains the same)? The equation will look like this:

$83 (income) + $0 (change in debt) = $83 (Aggregate spending)

If aggregate spending falls from $100 to $83, it will be a depression for the economy. What if everyone decides to save, and thus repay their debts? The equation will then be:

$83 (income) + $ -5 (change in debt) = $78 (Aggregate spending)

The situation is worse!

Thus, you can see that for an debt-addicted economy like Australia, if wage growth is constricted, the only way for the economy to grow well (in nominal terms) is for debt to grow at faster and faster rate. Obviously, this is unsustainable because if debt grow faster and faster than wage growth, it will be only a matter of time before the entire economy becomes sub-prime. When that happens, there will be an almighty crash, which in Australia’s case, is likely to result in a currency crisis (see Serious vulnerability in the Australian banking system).

If the government decides to borrow to supplant the private sector’s decline in borrowing in order to maintain economic growth, then the budget deficit will continue to grow. Again, this cannot go on indefinitely because Australia will end up like the PIIGS countries.

One more point, up till now, all these growth are in nominal terms. But what about in real terms?

As we know, it wasn’t long ago that there were media reports of “skills shortage” in Australia. Also, it is clear that Australia requires more “nation building” due to lack of infrastructure. This means that Australia is at the limits of its productive capacity. That means that even if Australia somehow manages to grow in nominal terms, it will be achieved at the expense of higher price inflation. That will attract more interest rate hikes from the RBA. As we wrote two years ago in Why does the central bank (RBA) need to punish the Australian economy with rising interest rates?,

The Australian economy was already running at full steam. Accelerating price inflation is a sign that there are insufficient resources in the economy to allow for all investment projects to succeed and all consumptions to carry on. If this trend is not arrested, the economy will run out of resources, resulting in a crash. Therefore, in order to put the economy back into a sustainable growth path, consumptions and investments have to slow down in order to allow for the economy to catch a breather for the rebuilding of its capital structure. The rebuilding of capital structure is necessary for the economy to replenish its resources for the future so that growth can continue down the track. Unfortunately, this rebuilding itself requires resources now. Therefore, current wasteful consumptions have to be curtailed and mal-investments have to be dismantled to make way for the rebuilding. The curtailment of consumption involves consumers spending less and saving more, while the dismantling of mal-investments involves retrenching workers, liquidating businesses, e.t.c. These involve pain for the people of Australia.

As we all know, the RBA raised interest rates 6 times already and that is the probable reason consumers are de-leveraging (i.e. borrow less and/or repay debts).

To put it simply, a glass ceiling is blocking the Australian economy. If you can feel that the quality of your life is also hitting the glass ceiling, then you know this is the reason.

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Posted in Economics/Finance, Looking Forward | 4 Comments »

How will the market perform from now on?

Thursday, May 27th, 2010

This is what Marc Faber thinks:

Note the last part of the interview- currencies are on the race to the bottom.

How to buy and invest in physical gold and silver bullion


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Posted in Currencies, Looking Forward | 2 Comments »

Apologies for malware

Thursday, May 27th, 2010

Today, as we loaded our own site, we were horrified to find that it was blocked by our Firefox web browser. It turned out that Google found malware on this site.

How did it happened?

The BidVertiser advertising network that we used had one or more 3rd-party rogue advertisers who served up malware.

Immediately, we scrubbed all references to BidVertiser network. We had also informed Google to review this site.

We apologise for this fiasco. Lesson: if you are a web site owner, avoid BidVertiser!

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Posted in Announcements | No Comments »

Why central banks are forced to raise interest rates in a currency crisis?

Tuesday, May 25th, 2010

We will continue from the currency crisis theme today. As we mentioned in our previous article, the threat of a currency crisis in Australia is not something we will dismiss out of hand. We rather be prepared for one and for nothing to happen than be unprepared and be caught with our pants down.

Now, what can the government do if currency speculators launch an assault on the AUD?

For one, the Reserve Bank of Australia (RBA) can use its foreign currency reserves to buy up its domestic currency in order to ?support? the AUD. This strategy works until the reserves are used up. Australia, being a chronically current account deficit country, does not rank well in terms of quantity of reserves for an advanced country. As you can see from this list, Australia has less than US$40 billion of reserves. Even tiny Singapore has 5 times as much as Australia.

But what if the speculators? assault prove to be too strong for the RBA to intervene? In that case, it would be forced to raise interest rates. As we quoted the Bank for International Settlements (BIS)?s 79th Annual Report in Bank for International Settlements (BIS) warning on stimulus spendings,

External constraints could also bind for some countries. Particularly in smaller and more open economies [e.g. Australia], pressure on the currency could force central banks to follow a tighter policy than would be warranted by domestic economic conditions.

When a currency is rapidly depreciates, it is a tempting target for hedge fund to short it. This can be done by borrowing large amount of money in that currency and selling it. In the absence of capital controls, the central bank, in its attempt to defend its currency, will have to raise interest rates to make shorting as expensive as possible.

How does this work out in reality? For that, we managed to find this old 1997 article from the South China Morning Post.

Why hedge funds cheer as Asian rates explode

If central bank wins, funds make money in lending market and if it buckles they make hay in currency market, says Larry Wee

If there were any doubts that hedge funds had a big part in East Asia?s currency chaos, the word in the market is that at least one major fund was behind the carnage in Hong Kong last Thursday when the key Hang Seng Index plummeted 10.4 per cent.

The story goes that one fund professional?George Soros?s name is inevitably mentioned?had let it be known that he was heavily short on HK$. The reaction of the Hong Kong Monetary Authority (HKMA) was predictable: determined to defend Hong Kong?s peg to the US$, it forced interest rates sky-high.

What the HKMA did not realize, however, is that this hedge fund had borrowed massive amounts of Hong Kong dollars in the money market. On top of this, it also shorted the Hong Kong stock market in a big way. So when overnight interest rates skyrocketed to 250 per cent, and stocks collapsed, the fund was overjoyed.

The cruel irony is that, when HKMA governor Joseph Yam spoke with bravado last week that he would charge HK$ short-sellers punitive rates, the funds that had already loaded up with HK$ laughed all the way to the bank.

This story explains just how the multibillion dollar hedge funds?the vast pools of money managed by the likes of Mr. Soros?have operated to get the best returns. Their blitzkrieg starts behind the scenes, in the money market where funds are borrowed and lent.

The strategy is simple: Well before they mount an assault on a currency, the hedge funds borrow huge amounts of the very currency they want to bring down. Often they borrow as much as ten times the amount they intend to sell. When they start selling the currency, they know for sure that interest rates will spike up as a result?often from below 10 per cent to well past 100 per cent. Lending at, say, 150 per cent when you borrowed at 7-8 per cent is a nice business; it yields huge profits when you?re lending in the billions.

Often these funds?apart from Mr. Soros Quantum Fun, other big ones include the Tiger and Omega funds?corner all available liquidity in the money market, so they become the only major lenders of the currency they have attacked.

The art in this strategy is this: Even if the central bank succeeds in defending its currency and inflicts forex losses on speculators, the hedge funds would have made many times more in the lending market. What if the central bank buckles and allows the currency to fall? Then the funds hit a double jackpot, and wins in the currency market too.

When the baht was attacked this way in June-end?again said to be led by Mr. Soros?the major funds walked away with profits of up to US$1 billion (S$1.58 billion) each, sources say. Not bad for a couple of months? work. Four months later, it?s the turn of the Hong Kong dollar. The question on many people?s minds is whether the peg to the US dollar will be broken. But whether or not it does, the hedge funds have already made a pile by now.

Sources say the big funds entered the money market a month ago to borrow Hong Kong dollars at around 7 per cent; they are now on-lending those dollars at sky-high rates. Last Thursday, when the speculative attack was at fiercest, overnight HK dollars cost as much as 250 per cent to borrow. The benchmark three-month HK interbank offered rate (Hibor) was fixed at 17.3 per cent, while six-month HK dollars funds cost 33 per cent. So the hedge funds will surely wind up this Christmas with record profits for the year. But they leave in their wake Asian economies with mountains of bad debt, crippled stock markets and surging inflation.

When interest rates explode with the force witnessed in Asian markets, the first to plunge are the stock markets. The next to come under pressure are the real estate markets. And if interest rates stay high, the whole economy slows down as companies hold back expansion plans and individuals cut back on spending. Inflation inevitably rises and we get what economists call ?stagflation??a sticky combination of economic stagnation and inflation.

What comes next?as Malaysian Premier Mahathir Mohamad warned over the weekend?is the threat of recession, where economic activities not just slow down but actually shrink. There is a good reason why economies are invariably left wrecked: the hedge funds target economies with serious and often hidden structural imbalances. Their currencies are usually most vulnerable to a sell-off and will topple with a hard shove.

And before they launch their currency attack, they short-sell the stock market too, knowing that other, less agile, market players will have to sell stocks to get their hands on local funds. This stock sell-off frightens genuine foreign investors into selling out too; when foreigners sell off, preferably in a frenzy, they have to convert their foreign currency for repatriation?which only starts another round of selling on the besieged currency.

That?s how it all snowballs. That?s how currencies collapse. And that?s how hedge funds like Mr. Soro?s Quantum make megabucks.

One thing to note: hedge funds don?t wake up one day and decide to attack currencies out of the blue. They prepare beforehand.

How to buy and invest in physical gold and silver bullion

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Posted in Currencies | 2 Comments »

Serious vulnerability in the Australian banking system

Sunday, May 23rd, 2010

Last week, we witnessed one of the most rapid falls on the Australian dollar (AUD). In a matter of a couple of weeks, the AUD fell around $0.10 relative to the US dollar (to a low of above US$0.80).

There were many reasons offered for this rapid depreciation- one of them blames the Rudd government?s resource super-profit tax (see Why Rudd?s mining super-profit tax will encourage more commodity speculation). In reality, there?s probably no specific reasons why AUD fell so quickly for this specific instance. As we wrote in our report, How To Foolproof Yourself Against Salesmen & Media Bias, the desire to pin-point a specific reason is part of the human trait of falling for the narrative fallacy. The simplest explanation laid the blame on ?hedge funds? and ?speculators.?

In any case, in the minds of most lay-people, the AUD is seen as a barometer for the health of the Australian economy. If the AUD goes into a free-fall, many people will see it as a sign that the Australian economy is in trouble. Conversely, if the AUD appreciates strongly, it is seen as a sign of a ?strong? economy. In reality, the foundations for the strength/weakness of the economy has been set long before the currency appreciate/depreciate. Nowadays, with the rise of lightening-speed money, the currency exchange rate is more as a result of capital inflows/outflows from money shuffling and less as a result of the fundamentals of the economy.

For Australia, we are getting more and more nervous about a currency crisis someday (see Will there be an AUD currency crisis?). Jimmy Rogers concurs with our worry. As he said in a recent interview,

If the Australian economy keeps taking on debt, the next time there’s a bear market, the Australian dollar will collapse. And he sees a bleak future for any currency backed by massive debts. Top of his list of bad currencies is the once mighty greenback.

?

The only disappointment I’ve had is that your politicians are as bad as the ones in America. If the Australian government keeps running up such gigantic debts, the lucky country is going to run out of luck.

However, he reiterates his belief Australia will not be prepared for the next economic shock and for a commodities bear market if it keeps taking on debt.

One thing you have to note is that Jimmy Rogers is probably not talking about Australia?s government debt. Relative to basket case countries like US, UK, Japan and the PIIGS in Europe, Australia?s government debt is tiny. The problem for Australia is its private debt, which is reflected in the foreign debt. As long as foreigners wants to invest in Australia, it will be fine. But the moment foreigners change their mind, Australia will be in trouble (a crashing AUD will be one of the symptoms).

We believe Australia has a serious structural problem that can easily turn this lucky country into an unlucky country very quickly. Recently, we saw this presentation (that explains the problem) making its round around web sites:

How to Profit From the Coming Aussie Property Crash (and Banking Crisis)

Please note that we:

  1. Are not making any investment advice based on this presentation.
  2. Are not making any predictions based on this presentation (see Failure to understand Black Swan leads to fallacious thinking to understand what we mean).

There?s one point made in this presentation that we have not covered in this blog- there are AU$13 TRILLION worth of off-balance sheet liabilities in Australia?s banking system (you can see the figure yourself from the link to RBA?s web site). Inquiring minds should be asking questions about what these liabilities are all about. Does the Australian regulators and central bank (and perhaps the banks themselves) fully understand what sort of hidden risks the Australian economy is subjected to from these ?off-balance sheet? liabilities?

For us, the basic point to take away from this presentation is that:

  1. There is a serious vulnerability in Australia?s banking system.
  2. This vulnerability is simply too colossal to be bailed out by the Australian government (hence the threat to the AUD).

We are not trying to scare anyone here. But these are the sorts of questions investors have to ask.

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Posted in Currencies | 2 Comments »

News report of Chinese crowd buying gold

Thursday, May 20th, 2010

A few years, we advised one of our Chinese friends to buy gold. Back then, there was a craze among Chinese investors to invest in stocks (and mutual funds). Our friend queued up at the bank and asked to buy gold. The lady behind the bank counter then laughed at our friend.

?You want to invest in gold?? she asked, being amused. ?Nobody invest in gold!?

Fast forward to 2009.

The property bubble in China was powering ahead, after a brief disruption in 2008. Then in 2010, the Chinese government began to crack down hard on property speculation (see What if China crashes?). Hence, as we wrote before in Will a crashed Chinese property market lead to an embrace of gold? Part 2- Store-of-value function, it becomes very logical for the Chinese to move their speculation from property into gold.

Today, we see this news report (notice what one of the lady said about one property of gold that is not present in property):

As Paul, one of our readers said,

Any hint of softness in price will cause the Chinese to stop buying. Conversely, any hint that the price is set to rise, and they will rush in.

Once gold enters the mainstream imagination of the Chinese people, you can imagine what will happen to gold prices. This could be the beginning of the trend.

How to buy and invest in physical gold and silver bullion

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Posted in Gold | 4 Comments »

If we are going to be doomed, why don’t we head for the cave and stop investing?

Wednesday, May 19th, 2010

As we all know, Marc Faber is an ultra-bear, as you can see from this clip below:

You may ask: if we’re going to be doomed, why don’t we pack our guns and canned food and head towards the hilly caves RIGHT NOW. Or should we just ignore the doomers crackpots? Here, Michael Yoshikami, in a debate with Marc Faber, offers this piece of insight (which Marc Faber concurs):

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Posted in Looking Forward | 4 Comments »

Will a crashed Chinese property market lead to an embrace of gold? Part 2- Store-of-value function

Sunday, May 16th, 2010

Today, we will continue from Will a crashed Chinese property market lead to an embrace of gold? Part 1- Chinese characteristics of property market. As we discussed in that article, our question was,

What if the Chinese government succeeded (whether accidentally or deliberately) in smashing the store-of-value function of property?

There?s no guarantee that the Chinese government will be strong-willed enough to let the property bubble burst. Some China pundits reckoned (e.g. Michael Pettis) that its policies will vacillate from one extreme to another, switching between the brakes and accelerator quickly, as the reality on the streets veer from inflation to deflation and back to inflation. If this is so, the developments will become unpredictable and volatile, which is where we will expect negative Black Swans to spring surprises.

Also, there is a risk that the Chinese government may react one second too late, letting the property market fall into a tipping point whereby price deflation becomes irreversible. This can happen because according to Patrick Chanovec (an associate professor at Tsinghua University’s School of Economics and Management in Beijing), supply and demand do not drive property prices in China (see China: gigantic property bubble in the midst of exploding supply of vacant brand new homes). Instead, property serves a store-of-value function, which is a function that is supposed to be served by money (traditionally gold, but it?s fiat currency today). Once property no longer serves this function, prices will fall to reflect supply and demand.

The problem is, if the Chinese currency does not serve the function as store of value, and there are limited investment avenues (e.g. stocks are too volatile), then what else can take that function? Logically, the answer is gold. Already, according to a recent report from China?s CCTV, some Chinese investors are switching from property to gold. In a recent interview, this is what Patrick Chanovec commented regarding this new development:

It?s open knowledge that since last year, the Chinese government encouraged its people to invest in physical gold, even to the point of letting TV ads do the talking. Will the Chinese turn their attention to gold as a store of value? This is a very interesting question. We will see.

How to buy and invest in physical gold and silver bullion

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Posted in Gold | No Comments »

China: gigantic property bubble in the midst of exploding supply of vacant brand new homes

Thursday, May 13th, 2010

Today, we planned to continue from our previous article (Will a crashed Chinese property market lead to an embrace of gold? Part 1- Chinese characteristics of property market). But one of our readers, Paul, emailed us a couple of very informative comments (which we’ve posted on the comments section of that article). With his comments, we feel that we have further points and observations to add, which requires a separate article. Please note that our observations of the Chinese property market are made from the point of view of a foreigner, which may not be entirely accurate or correct. So, please feel free to correct us if we are wrong.

In Paul?s second comments, he wrote

Personally, I find it amazing that they would not want to have a tenant in the apartment and collecting rent on their investment, but no, most private landlords look only at the long term capital appreciation.

To add to his comment, we have some interesting observations that may perhaps explain such strange behaviour in China’s property market. You see, in Australia, when you buy a brand new home, it is mostly done up (e.g. complete with kitchen, oven, tiles) and ready to move in. In China, brand new homes are usually ‘raw’ (e.g. no tiles, concrete walls)- you need further renovations before that home is ready for moving in. Obviously, landlords cannot rent out ‘raw’ homes because they are unliveable. That’s where the Chinese mindset differs- if the ‘raw’ home gets renovated (so that it is ready for moving in), that ‘raw’ home is no longer ‘brand new.’ As our reader said,

… it is very difficult to negotiate deals in the secondary market or rental market.

Once a home loses its ‘brand new’ status, it loses value and goes to the secondary market. Given that the secondary market is extremely weak in China, it explains why Chinese property speculators rather keep their apartments ‘raw’ and un-renovated than to renovate it and rent it out (unless the rent is high enough to offset the loss in value).

Furthermore, we guess that the domestic rental market in China must be very weak because of the “account” system. In Chinese cities, families must own an city residency “account,” which qualifies them for government services, school enrolment, etc. The “account” is defined by the address of your owned home. The implication is that if you sell your only home (and consequently, have to rent another home to stay), you lose your “account,” which will be very disadvantageous to you. That probably explains why the rental market seems to be non-existent in China (except for foreigners and maybe for migrant workers who don?t have their own ?account? anyway). These characteristics explains why in China, there can be a gigantic property bubble in the midst of exploding supply of vacant brand new homes. It is very similar to what we wrote in Why oil cannot function as currency reserves?

Then the demand for tooth pastes will rise to the moon, not because the demand for oral hygiene increases, but because the demand for tooth-pastes as money increases. Not only that, no matter how much tooth-pastes Colgate produces, there will always be shortages because there will be mass-hoarding of them as money.

That is the consequence of monetary inflation, which undermines the store-of-value function of money. When residential property takes on the store-of-value function, the result is a gigantic price bubble in the midst of over-supply.

In the next article, we will continue the story from the previous article. Keep in tune!

P.S. Paul has this comment regarding this article:

Your comments about the condition of the home or office when sold new are true.?? For homes however, it is more usual to dress them.?? For offices, no.

But I want to pick up on your second part.?? By “account” I assume you mean “hukou”.?? If so, your facts are wrong.?? It is not based on the address of your owned home, but on where you were born.?? The original purpose of the hukou was to identify and control peasants.?? A person’s hukou identifies
whether they are a city person or a rural one, and is based on the province in which they were born.?? My Chinese wife was born in Xinjiang, but her parents came from Anhui and Henan.

Every Chinese citizen has a hukou.?? Rural migrants coming into the cities to find work still have a hukou.?? But it identifies them as being not from the city, making them ineligible for social security, schooling or other benefits.?? People with hukous from outside a city can buy property in that city.??? But the vast majority can’t afford to, because they are rural migrants looking for work.

One more point.?? Anecdotal evidence, but I present it just the same.?? My Chinese friends, and indeed my wife’s family, all wonder why I rent instead of buy.?? If possible, Chinese people will buy, as they see renting as a waste of money.??? They would rather scrape together the money from the family to buy a modest place than to rent.?? By the way, my wife’s brothers
own their own homes here in Beijing, despite them all having Anhui hukous.

If I may make one final observation, based on the work I do here.?? In a falling market, the Chinese will stay away in droves.?? They much prefer to wait and see how far it will fall, before making an investment or purchase decision.?? I consult to the global primary aluminium industry, and I see the same thing when it comes to raw materials.?? Any hint of softness in
price will cause the Chinese to stop buying.?? Conversely, any hint that the price is set to rise, and they will rush in.?? Hence why the Shanghai index has such wild swings.

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Posted in Market Observations, Property | 4 Comments »

Will a crashed Chinese property market lead to an embrace of gold? Part 1- Chinese characteristics of property market

Tuesday, May 11th, 2010

In our previous article, What if China crashes?, we wrote,

? the Chinese government seemed to be getting really serious about cracking down on property speculation, even to the extent that it is giving the impression that it wants the property bubble to burst.

Will the Chinese then rush to gold should their government succeed in cracking down in property speculation? To answer this question, we must first understand some things about the Chinese mindset on property and investments. Currently, interest rates in China are pathetically low- so low that they are below the price inflation rate. Because of their currency peg, the People?s Bank of China (PBOC) is constrained from raising interest rates (see Can China raise interest rates to control its property bubble?). Also, the Chinese are known to be savers.

So, that creates a problem. Imagine you are a typical Chinese saver. What if you want to save and the cash at bank is yielding returns that are below the rate of price inflation? That results in a very great disincentive to save your money in the bank and pushes you to ?invest.?

The next question is where can you ?invest? your money? Remember, a lot of other people are facing the same problem because the Chinese government?s policy of force feeding credit into the economy is creating a gigantic rain of freshly printed money- a lot of people are having too much money on their hands. Unfortunately, in China, with its underdeveloped financial system, there is not much avenue to ?invest? your money.

The range of financial instruments in the stock market is limited. There are hardly any derivatives available for you to short the market (but currently, stock index futures are on the trial phase). Not only that, the standard of disclosure and reporting has too much to be desired. Most average mum and dad stock investors in China can only take long positions on a stock market that is highly volatile and speculative (due to lack of disclosure). No wonder investing in stocks is not that popular in China.

Thus, the only investment outlet for this mountain of freshly printed money is the property market. There are a few characteristics of the Chinese property market that most foreigners will not know. Perhaps these characteristics explain why the property bubble in China is so enduring.

Firstly, the Chinese property bubble is definitely bigger than the property bubble in Australia. But you may be surprised to learn that the consumer leverage in the residential property market in China is in fact smaller than Australia. In China, you need at least 40% deposit to qualify for a mortgage loan. As Patrick Chovanec wrote here,

According to the latest statistics I?ve seen, approximately 50% of all residential purchases in China today are financed with mortgages, which are mainly provided by the big state banks.  That?s a sharp increase from just a few years ago, when nearly all such purchases were made in cash.  In theory, the rules allow 30-year mortgages, but anything longer than 20 years is rare, and the presence of high prepayment penalties tend to push buyers towards mortgages with even shorter terms (our own mortgage was, believe it or not, 3 years, which is more like an instalment plan!).

A lot of residential real estate transactions in China are made in cash!

Secondly, the secondary market for residential real estate in China is extremely weak. As Patrick Chovanec wrote here,

What we see in China, though, is an extremely weak secondary market.  In the U.S., the ratio of secondary to primary residential property transactions for the first half of 2009 was 13.45; in Hong Kong it was 7.25.  In China as a whole, that ratio was 0.26 (four times as many new home purchases as secondary sales).  Even in China?s most developed markets the ratios were just 1.30 for Beijing, 1.56 for Shanghai, and 1.35 for Shenzhen.

If you combine these two characteristics together, you can conclude that a lot of real estate purchases in China are made with relatively little borrowing (or none at all) on brand new homes. As a result, the Chinese are, as Patrick Chovanec wrote,

? in that sense, the people using real estate as a store of value, a place to stash their cash?

That explains why there is a lot of idle and empty apartments in China as more and more of them are being built by property developers.

But the fact there is relatively little consumer leverage in the Chinese property market does not mean that there?s little leverage in the property sector. In China, the leverage is placed on the shoulders of property developers. In other words, the Chinese property ?investors? are de-leveraging the developers!

Now, what if the Chinese government succeeded (whether accidentally or deliberately) in smashing the store-of-value function of property? We will go into that in the next article. Keep in tune!

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Posted in Gold, Market Observations, Property | 3 Comments »

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