Monday, 17 September 2018

On China's (putative) real estate construction bubble... facts vs narratives

The consensus opinion in many parts of global financial markets is that China's economy is little more a giant leveraged real estate and infrastructure construction site at present, coupled with an export manufacturing sector that is soon to have its competitiveness undercut by US tariffs. Most value managers will not touch iron ore stocks, for instance, despite low valuations, believing that it is only a matter of time before steel and iron ore demand collapses as an unsustainable pace of Chinese debt-fueled real estate and infrastructure construction comes to an inevitable end.

It's a seductive narrative. TV show exposes have been aired showing ghost cities.* China consumes 50% of the world's steel and 60% of the world's cement.** Surely something is amiss. This is one reason why Chinese stocks are so cheap, as are many commodity producers (especially coal and iron ore), Chinese materials companies, and Chinese real estate companies. Current levels of earnings, it is argued, are simply unsustainable.

I believed in this narrative for a while too, until I actually started to look at some facts/statistics. So let's look at some facts, instead of anecdotes. China's residential real estate starts last year were about 1.3bn sqm.*** China also has about 1.3bn people. Consequently, this pace of new starts (which has been roughly flat over the past 5 years) represents a run-rate of new residential starts of only about 1sqm per person. Interestingly, in Australia - a market where the faithful continue to deny there is a property bubble, and that analogies to the pre-GFC US are inappropriate because - amongst other things - 'we have no overbuild', new residential starts in 2017 were running at a bit over 50m sqm, or about 2sqm per person - twice the rate of China (albeit that higher levels of immigration/population growth distort the comparison somewhat, and dwelling sizes are larger in Australia).

In Australia, the average dwelling size per residence/household is about 250 sqm. Let's assume 150 sqm is more appropriate in China, where apartment living is more common, and let's assume an average household size of 3 people (roughly the global average). In the long run (i.e. once China becomes developed and everyone can afford a modern residence), China will therefore require, shall we say, about 50 sqm of modern residential real estate per capita. That means that China's current pace of new residential real estate starts is consistent with building a new living space for every person at a pace of roughly once every 50 years. Furthermore, China has abolished its one child policy, and population growth is currently running at about 0.6% pa. About a quarter to a third of the new supply is therefore required to meet population growth. Consequently, the actual construction run-rate is actually closer to building a new dwelling for every existing person every 60-70 years.

That's doesn't seem unreasonable to me - even though construction is running at 3-4x the rate of population growth, because it is worth remembering that private property ownership was forbidden in China until the late 1990s, and that much of the housing supply before then was communist-era. Half of the population was also still living in rural areas, and so we are talking about about half a billion people urbanising. That's billion with a capital B. China's major cities are also rapidly evolving and developing (witness Shanghai's skyline now vs. 20-30 years ago), and so a lot of old buildings need to be ripped down and redeveloped, as economic growth proceeds apace and land values rise.

Part of the problem China faces is that the world has never before seen economic growth and urbanisation happen at this pace in a nation as large as China. Consequently, aggregate numbers seem extraordinarily large, but they are much less so when reduced to per-capita measures. For instance, even at 0.6% growth, China's population growth is about 10m a year. That means they have to build one new Australia every 2.5 years, and one new UK every 6 years, just to keep pace with population growth, let alone upgrade existing Chinese living standards. China has half a dozen cities with urban areas of approximately 10m people that most people have never heard of (see here).**** The numbers are truly mind-boggling and unintuitive. Perhaps the Chinese are not as stupid and reckless in their management of the economy as many Westerners would like to believe?

Now let's look at overall steel demand. China comprises about 50% of global steel demand, and 30% of that goes into residential and commercial real estate construction; 30% into infrastructure development; and the other 40% into 'other' (cars, appliances, industrial machinery, etc). Even if we were to assume that Chinese demand for steel for use in infrastructure and real estate construction were to decline by a third in the next decade, that would reduce global steel/iron ore demand by only about 10% (50% x 60% x 33%). Meanwhile, it is reasonable to expect China's 'other' 40% of demand to continue to grow, as middle class demand for home appliances, vehicles, etc, rises (China's PPP GDP per capita is about US$10k - there is a long way to go). Even if it grew only 25% cumulatively over the next decade (i.e. only 2-2.5% pa), this would offset half of the decline in demand from construction, and boost global demand by 5% (50% x 40% x 25%).

Furthermore, other countries like India and ASEAN nations can be expected to increase their steel demand materially as they move up the economic development curve in coming decades as well, while steel demand in the EU and US are also at a relatively low economic ebb (and any migration in manufacturing from China to the US, due to trade tariffs, will also boost US steel demand and offset any negative impact on Chinese steel demand in machinery). It is therefore reasonable, in my view, to expect 'rest of world' steel demand to continue to grow at say 2-3% pa (global population growth alone is >1%). Rest of world steel consumption should therefore grow by perhaps a cumulative 25% over the next decade (at least), which would add 12.5% to global demand (50% x 25%). This would more than offset a modest decline in Chinese consumption. After adding in growing supplies of recyclable steel, global demand for iron ore should be approximately flat over the next decade, even if China's pace of real estate and infrastructure construction falls 1/3rd from current levels (which would be about 40% per capita, adjusting for Chinese population growth).

Perhaps this is why the iron ore price remains stubbornly resilient, and refuses to settle below US$60/MT? In the past few months, the share prices of many commodity producers, including iron ore suppliers, has fallen sharply on growing pessimism about the outlook for China's economic growth, and yet the iron ore 62pc benchmark fines price itself has actually risen from US$60/MT to US$65/MT. To many people's ears, narratives speak louder than data, but it is the data we should focus on, and iron ore price suggest that the facts are not conforming with the narrative - at least not yet. Indeed, because China is likely to heavily stimulate from here in response to US trade measures, it is even arguable that short term Chinese iron ore/steel demand may even surprise on the upside.

Time will tell. I don't pretend to be able to predict something as complicated as global steel demand; Chinese growth; or the iron ore price. That's not how I invest. I don't try to predict the future. I also would not deny that there are material cyclical risks in China, as there are in any economy - particularly because the build-up in debt over the past decade has indeed been uncomfortably fast. I'm much more bullish on China structurally over the long term than I am cyclically in the short term.

However, what I look for is low expectations and asymmetry, where (1) the bear case is already widely believed and priced in; and (2) where there is a plausible case that this prevailing bearish narrative could prove wrong. And it is interesting to me that markets are projecting such a dark future for iron ore/steel demand, and yet it is not clear that such unqualified pessimism is warranted. And the same can also be said with respect to Chinese growth and China/HK stocks generally.

I own a 1.9% position in Ferrexpo (which trades at 3.5x earnings), which I have owned since 2016 at an entry of about 70p, and also a 0.4% position in Fortescue Metals (which trades at a 5-6x cash spot P/E @ US$45/MT 58pc, although closer to high single digits after including accounting depreciation in excess of maintenance capex requirements), most of which I accumulated fairly recently (at an average a little below A$4). I also have a much larger and growing exposure to HK/China stocks overall, which I believe are also being heavily discounted on the basis that China's economy is merely a debt-fueled ponzi scheme.


*Such as Ordos. Interestingly, reporters went back several years later and were surprised to see that many of the empty buildings were now occupied, and streets bustling with traffic.

**The gross Chinese cement consumption statistics look much scarier than the steel stats, but they are partly distorted by the fact that Chinese often uses concrete in roads, rather than asphalt. 

***1,280.98m sqm, according to the National Bureau of Statistics of China (see here). 

****The following Chinese cities have urban (not greater metropolitan) areas of between 8-12m people: Harbin, Wuhan, Hangzhou, Xi'an, Shenyang, Dongguan, and Nanjing. I'm willing to bet most Westerners (excluding those who invest in or do business in China) have not heard of at least some, if not most, of these cities.


  1. Another excellent post. Makes me feel all the better about my substantial exposure to PAI and somewhat lower exposure to PTM.

    1. The Platinum guys are very smart. I'm sure they figured this all out a long time ago.

  2. Hi LT3000, a few observations:

    1. I'm sure Chinese would love to live in bigger (Australian style) houses but the problem is how they will pay for them. Urbanisation only creates wealth if the difference in productivity between jobs in cities and jobs in the countryside exceeds the cost of building the additional housing and infrastructure to house rural migrants. Judging by China's falling capital productivity over the past decade and the large gap between cost of housing and wages, it seems that this condition has not been met, which is why authorities are urgently reining in debt growth. The fear is that at some point the debt overhang will force a sharp reduction fixed asset investment.

    2. Urbanisation is not inevitable. Just as rural migrants flock to cities when employment prospects are good they may also leave cities when employment shrinks. In fact, the level of urbanisation in China is already relatively high for an economy at its level of GDP per capita. There have been some studies produced by Chinese academia using survey data that suggests that the country is close to reaching the limits of its urbanisation, i.e. that most people who can be productively employed in cities have already moved.

    3. While property developers have been destocking, a substantial percentage of properties sold in the past few years have been bought by speculators, some of whom may leave them empty or who upgrade to the new property, leaving their former residence empty. If you have a chance to visit lower tier cities (lower than those you mention) you'll soon see the level of overbuilding that has occurred all across the country. As someone who travels every year to fifth and sixth tier cities, I would estimate that on average in county-level centres a third of properties are unoccupied.

    4. And that's not even to go into the substantial overinvestment in infrastructure and associated high local government debt. The problem comes back to the fact that emerging economies simply cannot make productive use of the same levels of capital that developed economies can. Given the degree to which China has overbuilt over the past decade, it's possible that global demand for iron ore could fall by as much as 30% if its financial system hits a wall. My view is that we'll eventually get to that level, the main question is how and over what period.

    1. Thanks for your thoughts. Some comments:

      On #1, look I would be the first to agree that it is entirely possible that from a cyclical perspective, supply outruns demand and they have a sharp downturn. That is entirely possible. Debt levels are too high and they have risen too fast. However, from a structural point of view, the pace of overbuilding is not necessarily as overdone as is commonly argued.

      In addition, China is experiencing very real productivity growth. The country is a highly internationally competitive manufacturer and has innovative domestic technology companies. It is building the supply side factors necessary to make it a developed economy in the long term (infrastructure, technology know-how/upgrading, education, etc). Domestic consumption is only just getting started and has a long way to go. So I think it is quite possible China will 'grow in' to its real estate build over time - albeit with undeniable cyclical risks.

      On #2, on a cyclical basis I would again agree with you, but on a structural long term (i.e. multi decade) point of view, that China will continue to urbanise is virtually inevitable. Urbanisation continues to rise almost everywhere in the world. And as consumer incomes rise, more people will be able to afford modern lifestyles, including modern apartments.

      On #3, I agree that there has been an overbuild in many parts of the country, and vacancy rates are high. However, with capital controls in place, real estate functions in China a little bit like gold functions in the west - its used as a store of value that is inflation protected. The willingness to own and hold vacant properties actually can serve to further increase the level of properties they need to build, as they also need to build properties for people to live in. There is no doubt though, again, that cyclical risks exist.

      On #4, yes I agree infrastructure overbuild, declining marginal productivity of investment, and local government debt are problems. They have been taking some measures to address the problem, but this is going to be headwind to future growth, not doubt. However, at least the debt has gone into productive assets (albeit with declining marginal productivity) rather than merely consumption/welfare.

      The analysis I outlined above also assumed a 33% decline in Chinese construction-related steel demand over the next decades as well (40% per capita). That's a fairly material fall. And that would still likely result in global steel and iron ore demand remaining broadly flat.


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  4. Great post! Would love to hear what stock picks you made in China/HK!

  5. What is your thought on investing in very cheap asset such as the coal companies you mentioned, or other china companies that have also fallen like tencent which are viewed as higher quality businesses. In a recovery, won't these former high fliers recover much faster?

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