By: Sam Baker

Despite generally sanguine sentiment and the recent month-on-month stabilization in China’s property market, anecdotal evidence indicates there is a considerable possibility that prices are going to slide again.

Chinese-language newspapers, for instance, reported this week that there are 150,000 unsold flats in Guangzhou totaling nearly 20 million square meters of space  Overall, January-February land proceeds across 300 cities were RMB281.5 billion – 48 percent of the same period last year. Given the oversized percentage of the Chinese economy accounted for by the property sector – 15 percent of gross domestic product – if property prices continue to decline as we expect, this scenario suggests further downside for growth.

Last year, the government pump primed aggressively and credit growth still posted a double digit increase, yet growth faltered.  Evidence of weak loan demand, amid declining productivity and marginal product of capital, suggests that additional monetary easing and/or fiscal pump priming will not be enough to stabilize China’s economy, which is already likely weaker than suggested by official statistics.

Reform is real this time, but so is the likelihood of an extended period of structurally slower growth. This is the first time since the 1999-2000 period when Zhu Rongji began pushing SOE reform, WTO accession and a major bank recapitalization that we have returned  from a research trip to China with the sense that policy makers are serious about implementing major supply side reforms.

Three key reform areas are President Xi Jinping’s anti-corruption campaign,  the unwinding of financial repression, and the dynamic rise of non-bank (internet) financing. Policy makers appear to be finally getting serious about reforms, mainly because they have to. China’s debt-fueled growth model has finally hit a wall as evidenced by a combination of an explosion of the total debt to GDP ratio, now at 282 percent and rising, alongside evidence of a significant secular decline in the productivity of labor and capital. China is headed for slower growth with or without reforms.

There is consistent overconfidence about the worst being over for the real estate sector, which suggests to us that there will be further downside for both property prices and for the economy. The failure of the major property company Kaisa Group Holdings Ltd. to make a coupon payment in early January, and the company’s still uncertain future despite a white knight bailout, is a microcosm of China Inc’s reliance on a brittle “confidence game” superstructure built upon hidden debt, risky political connections, opaque finances and fragile balance sheets.

Kaisa wasn’t alone. Shares of the Shanghai-based Glorious Property Holdings Ltd. fell by as much as 35 percent and those of Shenzhen-based Fantasia Holdings Group Co. ,ost 16 percent of their value. Stocks of other privately owned property companies are also taking a pounding, partly because the economy is slowing, but also over concerns that government investigators may be snooping into corruption. 

Such unresolved risk suggests that things may not be as encouraging as the government says. Li Keqiang, the prime minister, told the 2,900-odd delegates to the National People’s Conference today that the economy will grow by 7 percent in 2015. But three different sources, including the Conference Board, Medley Advisors and Wigram Capital, all of which participated in our recent research agenda, estimate China’s GDP grew well below the official 7.2 percent figure in 2014 – repeating a pattern of overstated official GDP figures in 1998 in the wake of the Asian Financial Crisis and in 2008 during the global financial crisis.

Imploding shipping container rates and commodity prices reflect weak domestic demand in China, underpinning weak global trade dynamics.  That isn’t necessarily China’s fault, given the Eurozone stagnation,  a relatively weak US economy and thus historically weak global trade. Nonetheless, that  suggests China will not be able to export its way out of the current slump, especially with recent yuan appreciation as evidenced in the sharp appreciation of the real effective exchange rate.  A 3.3 percent decline in exports in January underscores weak external demand. The 17 percent decline in January imports highlights a weak (and weakening?) internal demand environment.

The explosive surge in China’s debt to GDP ratio over the past seven years is a key factor forcing Xi Jinping’s hand toward what we believe, following our latest trip to China, is meaningful structural reform program. Xi must see the writing on the wall for the end of China’s debt fueled growth boom. Otherwise he would still be avoiding tough choices – just like his predecessor Hu Jintao. 

The trillion dollar question is whether Xi will have the necessary political will and power to keep China on the reform path even as growth continues to slow into painful economic rebalancing.

In 2012 an economist from the China Academy of Social Science asserted to us that “Chinese policy makers can get growth whenever they want.”  However, evidence of declining loan demand suggests that policy makers will not be able to boost growth as easily as has been the case in recent history merely by taking the brakes off of credit supply  –no matter whether this involves increasing loan quotas, cutting rates or reducing reserve requirement ratios.

A secular decline in total factor productivity has already begun. This TFP adjustment is due to credit-fueled imbalances created during China’s historic credit boom, which reigned from 2006 to last year.  Combined with a slowing population growth and shrinking growth in the work force, a declining marginal product of capital, and a high and rising debt overhang, China is headed for a significant downgrade in economic performance going forward — no matter if Xi sticks to his reform guns or not.

The question is whether the president will stick to his pain-for-gain, supply-side reform agenda and build a foundation for a new cycle of high growth or whether he will backtrack in an effort to boost growth in the short term thus short circuiting necessary reform and rebalancing process. 

If the government sticks to its reform path, growth will be slower over the next three years or so – we see a 3 percent average – but reforms should pave the way for another sustained period of above normal growth in the 7 percent average range. If Xi abandons his reform path,  GDP growth will average 6-7 percent in 2015-2017 period, with growth targets met through capital spending, but will slide to an average of 3 percent in 2020- 2025.

The property market is scary. China built 37 sky scrapers that 200 meters tall or taller in 2013, 58 in 2014 and plans to build another 100 this year. Note that in South Korea and the Middle East the skyscraper boom has settled down since 2011, but the boom in China continues unabated, despite slowing economic growth, suggesting either a collapse in planned construction or a glut in new construction – either way, this is more bad news for growth.

Chinese cities accounted for 58 of 97 skyscrapers completed globally in 2014, far outpacing the total built in any other single country. Its plans for this year would total three more than the entire global total in  all of 2014!

Unofficial survey data from the China Real Estate Index System (CREIS) published by Soufun showed prices improved marginally in January, up 0.21 percent month-on-month.  January’s data marks the first monthly improvement since prices started falling in May 2014. However, on an annualized basis, prices declined  by3.1 percent in January, which is more than the year on year decline in December 2014 when prices fell -2.7 percent compared to a year earlier.

Chinese nationals uniformly forecast that property prices in China would recover in 2015. We are not so sure given slowing growth dynamics and massive supply coming on line. Unaffordability was rising in China compared to developed markets already by 2011, well before the latest surge in Chinese prices in the 2013-14 period.

The sharp increase in EB-5 visas, which offer green cards to families who invest at least US$500,000 in US projects reflects the voracious Chinese appetite for US dollar-based property investment – outside of China. Chinese nationals are the biggest source of EB-5 funds, making up more than 85 percent of visas approved in the 12 months ended in September 2014.

Is “third time a charm?”  Yuan weakness proved temporary in 2012 and again in early 2014. We believe policy makers have less scope this time around for engineering a sustainable reversal of yuan weakness compared to 2012 because reflating the economy is likely to be even more difficult this time given adverse trends over the past two years, including the higher debt to GDP ratio, falling productivity and declining loan demand. The latest yuan reversal in early 2014 lasted about six months, whereas the reversal in 2012 lasted over 12 months.  This suggests to us that it is getting more difficult for policy makers to prevent a weaker yuan.

Is third time a charm for hot money outflows as well?  Outflows have surged in recent months. Large outflows in 2012 and again in 2014 correspond with currency weakness. China reported capital outflow of $91 billion in the fourth quarter of 2014.  This is the largest such quarterly capital account outflow since records began in 1998.

Foreign direct investment used to be a large contributor to China’s consistently large capital account inflows. A surge in outbound FDI targeted to the US since 2010 has helped drive an overall surge in China’s total global outbound FDI .In 2006, FDI inflows totaled $69 billion while outbound FDI totaled $16 billion for a net capital inflow of $53 billion.

In 2014, China’s net capital inflows barely broke $18 billion as FDI rose a relatively tame 1.7 percent to $119.5 billion, while outbound direct investment surged by 14.1 percent to a new high of $102.9 billion according to official Commerce Ministry data.  The bottom line is that an important source of capital inflows into China has reversed

The monthly trade surplus has exploded over the past seven months, breaching $40 billion in six of the past seven months, $50 billion over the past three months, and then hitting a record $60 billion in the latest data release for January 2014.  Without these surpluses, China’s forex reserves would be declining at a much faster rate than they already are .Unfortunately, China’s trade surplus is a function of weak domestic demand and collapsing imports.

With domestic growth softening, global trade at historically weak levels, and with the yuan’s real effective exchange rate appreciating rapidly in recent months, we see growing depreciation pressure to continue to mount on the nominal yuan exchange rate. 

Note how forex reserve accumulation stagnated during the same 2012 period where previously there was a combination of currency weakness and increased official and hot money capital outflows. Policy makers actively reversed yuan weakness  in 2012 and in turn forex reserves began accumulating again – until they finally peaked in July 2014.

This latest  round of yuan weakness seems different — more ominous — for two reasons.  For one, FX reserves are declining outright, not just stagnating, and two, it will be harder for policy makers to reverse yuan depreciation pressures as the economy continues to slow. 

If forex reserves have peaked, as we expect, this suggests a new theme for China’s economy, characterized by a confluence of  net capital outflows, sticky depreciation pressure on the yuan, tightening domestic liquidity conditions and slower economic growth.

Sam Baker is a longtime China watcher and the founder of Global Frontiers Inc. a firm offering custom macro-research trips to emerging and frontier markets for leading institutional investors.