The End of Cheap China: Economic and Cultural Trends That Will Disrupt the World (15 page)

Most Chinese restaurant and construction workers live in dormitories provided by their employers and often board eight people to a room. Think of pictures you’ve seen of overcrowding in California jails, then double the nastiness factor. California jails are cleaner and probably built of sturdier and less toxic materials.

Simply from a human-rights standpoint, there is a clear demand for more and better housing. The government doesn’t want to have slums and shantytowns pop up, as in America and the Philippines. Overleveraging in the residential sector is not really the problem Chanos believes it to be, either, as for years the government has been limiting the amount of debt one can take out when buying homes to prevent the market from overheating. In cities like Shanghai, home buyers must put 30 percent down for their first home and 50 percent for their second; they cannot buy a third home anymore. Speculation has not hit China as it did in the United States, where people earning $25,000 dollars a year could put zero percent down and buy multiple properties. Even if housing prices were to fall 20 percent or more, panic selling would not occur as it did in the United States or Dubai, because few house buyers have much debt and their mortgages would not be underwater.

The major problem in the real estate industry is not whether there is too much empty housing or too much debt in the residential sector, but whether everyday Chinese will ever be able to afford buying the available homes, and if enough low-income housing will be built. The average Shanghai resident will have to work 50 years at current per capita earning rates to buy a decent home, versus 10 years for a U.S. resident.

Most developers have focused on building more lucrative luxury apartments to earn fatter profit margins and to satisfy the demand of the moneyed class, whose earnings have been rising far faster than average Chinese wages. These blocks often rise up in the middle of poorer areas, raising tensions and increasing dissatisfaction.

Because of the severe limit on the number of homes one can buy now and on who can buy them, there is a massive, pent-up demand for housing. Many home buyers are sitting on the sidelines, expecting prices to soften. Other would-be home buyers who don’t qualify to buy homes now are waiting to do so once restrictions ease.

One serious problem emerging in the real estate sector is there has been far too much construction on the commercial side, where regulations that limit building on credit have been less pronounced. In the first half of 2011, my firm interviewed dozens of real estate developers. The vast majority of residential property developers said they were going to switch and build more commercial projects, because it was easier for them to get credit from banks for those projects. Chinese real estate billionaire Zhang Xin, the chief executive officer of SOHO China Ltd., told the Shanghai Foreign Correspondents’ Club in an August 2011 speech that all of SOHO’s 11.4 billion renminbi of investment in Shanghai was on the commercial side in 2011, because government restrictions on residential development made office buildings a safer bet.

Many commercial projects are ill advised, however, and represent an area where the central government needs to increase its oversight. Many will likely fail, because developers often do not have the management and branding expertise to make their malls fit consumers’ needs. Ultimately they will not be able to charge high rents or get revenue splits, and might not be able to pay off their debt. Too much investment in commercial real estate will also limit the amount of land available for home construction, which will also cause housing prices to rise too rapidly due to fixed supply. Overall, commercial projects only account for about 20 percent of real estate construction, so even a downturn there will not hurt the greater economy in a meaningful way, but it is an area where the government needs to watch closely.

While risks about a dangerous real estate bubble do exist, the benefits of massive construction far outweigh the risks, because reduced congestion will create a more affordable housing supply, make business interaction more efficient, and reduce pollution. It is also better to complete infrastructure projects now, when it is cheaper, because of soaring wage demands that will make it impossible in a decade to launch major infrastructure initiatives, as is currently the case in the United States. Historically, countries like America and Japan spent huge proportions of their GDP on fixed investment, which was critical in preparing those nations for decades of economic growth. Investing in the national highway system under President Dwight D. Eisenhower in the 1950s provided the conditions necessary for efficient manufacturing and service sectors.

Considering how crowded urban areas in China are (Shanghai is the world’s densest city, packing in 24 million people), the government absolutely needs to build more infrastructure projects. Critics like Carnegie Foundation Fellow and Guanghua School of Management professor Michael Pettis agree with Roubini. They both fret that the construction is inefficient and resembles building bridges to nowhere, as the Japanese did at the start of their financial problems in the 1990s. Also like Roubini, Pettis believes that China’s infrastructure spending of about 50 percent accounts for too much of its overall GDP. However, there are huge differences between Chinese and Japanese construction for which Pettis fails to account.

China’s railroads, bridges, and tunnels are increasing economic efficiency for the most part, not only within a city but between massive metropolitan areas. For instance, high-speed rail has cut travel time from 11 hours to 5 between Shanghai and Wuhan, increasing the business capabilities of the 40 million people who live in these cities. Not only is China’s infrastructure spending more efficient than Japan’s, it is helping to jumpstart economic growth. This is very different from Japan, where infrastructure investment was used to connect metropolitan areas to tiny hamlets, representing a desperate attempt to wake from its economic slumber after deflation (despite the low-interest loans made to pay for these projects) damaged the economy. The Japanese government continues to pour funding into these projects, while the residents of these small towns cannot make money on their own and need handouts to survive.

Japan’s overall debt was 225.8 percent of GDP in 2010—the highest in the world, according to the International Monetary Fund—while China’s is around 70 percent. Infrastructure spending in Japan continues largely to be wasteful, while in China it is setting the stage for economic growth.

My son Tom fell asleep for his afternoon nap one day when we were travelling on a bus to Ningbo, a seaport city of 2.2 million people to the south of Shanghai. We had just gotten on a bridge when he fell asleep. I had never been to Ningbo because it used to take five or more maddening hours stuck in traffic to get there.

When Tom woke up 30 minutes later, we were still on that bridge despite having driven at a good clip. A few minutes later, we arrived in Ningbo, three hours after we left Shanghai. The 27-kilometer-long bridge, the world’s largest transoceanic bridge, opened in 2008 and cut travel time almost in half.

Since then, I have travelled to Ningbo repeatedly for business deals and vacation. Business efficiency is clearly being improved by construction projects like Ningbo’s bridge. One of my clients in the food and beverage sector told me that because of increased logistical access to Ningbo, it would become a major investment area for his firm’s outlets. He said, “Until the transportation system opened up, we were not really planning on opening retail outlets in Ningbo. The cost of business was too high. Now it is easy to ship product to Ningbo, and our senior managers can get there more easily, arriving from Shanghai in the morning and returning at night. Before it was a multiple-day trip, but now we expect to increase our investment in Ningbo.”

New investment locations are opening up throughout the country, as in the case of my food and beverage client, precisely because of new infrastructure investment.

On the opposite side of the spectrum from Winnie and Karen’s home are the homes of the truly rich.
The Hurun Report
, which has declared that China’s billionaires might outnumber America’s, has confirmed the identities of 271 of them, but they estimate at least another 200 Chinese have astronomical hidden wealth.

Wealth creation in China over the last decade has caused multimillion-dollar homes to proliferate. Contrary to the emerging conventional wisdom of some economists, however, these homes do not threaten financial stability. Government regulations require buyers of standalone villas to put down a 50 percent deposit and pay hefty transaction taxes if they are flipped in short periods of time. Strict rules supervising debt should eliminate fears that there is too much debt in the marketplace, but surprisingly many analysts do not acknowledge the lack of debt on the residential side of real estate.

I was zooming along in a billionaire’s Ferrari on Beijing’s streets when the owner, Mr. Chen, told me that he was now looking at buying a $15-million-plus home, because restrictions on the number of homes he could buy was forcing him to go more upmarket. Such restrictions on home acquisition were creating a new housing segment—homes ranging in the tens of millions of dollars—and helps explain why overall housing prices in China are continuing to rise, despite the weakening of mid-tier home prices and the collapse of sales volume after the government implemented strict mortgage rules in 2010 to permit a soft landing in the real estate sector.

Wealthy Chinese like Mr. Chen are seeing their incomes rise at a far faster pace than housing prices. Mr. Chen puts 100 percent down whenever he buys a home or auto. The number of U.S.-dollar billionaires doubled between 2010 and 2011, according to
Hurun
, and the number of millionaires is expected to grow to 2.4 million by 2013, up from 750,000 in 2009. Many of these wealthy Chinese are consolidating market share and boxing out competitors who cannot deal with the End of Cheap China. Their fortunes often rise by double or more every year.

My firm’s research suggests that many of the wealthy prefer to buy real estate because it is a tangible asset; they do not trust equities due to accounting scandals. I was sitting in the enormous living room of Mr. Zhou, one of China’s largest real estate developers, when he started to share his investing strategies and views on real estate with me. “I never buy Chinese stocks. Who can trust the accounting? It is far safer to buy real estate. There are too many Chinese without adequate housing, so demand will always outstrip supply.” He continued, “There are no annual property taxes, so I just buy homes and leave them empty to resell at some point. At the end of the day, if things go wrong, you still have tangible assets if you buy property.”

A cultural predilection for real estate, as well as fears over investing in other asset classes, also helps explain why the real estate sector continues to soar. With little end-buyer debt involved, worries of systemic risk are low. Cash-starved and overleveraged developers might collapse, and a consolidation in the industry (which favors larger and better connected players who have large credit lines) is likely, but this also signals a healthy maturation of the marketplace.

By contrast, the real estate sector in China is far from healthy. Far too many units sit empty, and far too many everyday Chinese do not have access to housing. Concerns about the safety and economic viability of many residential, commercial, and public infrastructure projects are legitimate.

One of the reasons for the ongoing safety problems actually stems from the weak financial system, which makes it difficult for entrepreneurs and small-business owners to tap credit. One real estate developer, Mr. Xu, told me that when he first started his business he had to accept a 75 percent interest rate over three months from an underground bank just to get enough capital to build a small building in southern China. The big state-owned banks laughed him out of their offices. Mr. Xu said he did whatever it took to earn a profit, and built a track record of managing large projects, so that he could get funding from the big banks.

Many smaller real estate developers like Mr. Xu construct buildings as fast as they can so they can sell them and pay back loans. They do not necessarily put up poor-quality buildings intentionally (although many do cut corners to squeeze out more profits), but many simply need to repay their debts. Being burdened by high loans and interest rates are minor concerns when taking loans from underground banks, which explains why so many Wenzhou entrepreneurs started fleeing creditors in the autumn of 2011.

Despite all of the problems in the real estate sector, the reality is that construction has to continue in order to provide adequate housing and improve business efficiency. The challenges that the economy will face if this does not happen—namely, social instability—are far worse than a potential downturn in housing prices. Debt problems have been greatly exaggerated, as have concerns about whether too much construction is taking place. The real issue involves execution and oversight to ensure the highest safety and efficiency. More of both are clearly needed.