Merrill Lynch: China bust upon us

Zarathustra wrote earlier this week:

Deutsche Bank is expecting a 10% correction in home prices because it would be a disaster if prices are allowed to fall by, say, 30%:

Those who understand China’s political economy should know that a 15% decline in average property prices in 35 cities within a few months must be accompanied by a range of economic and social consequences. These will include a sharp decline in real estate transactions, a visible deceleration in real estate investments, rising unemployment in the property construction and agency sectors, a further decline in construction material prices, demand destruction due to inventory destocking, and finally a worrying decline in GDP growth and the resulting concern of social stability. In other words, the government will most likely not tolerate a 30% drop, and probably not even 15% in our view. We expect real estate policies will likely be relaxed way before a 30% price decline is observed.

I hear that!

The next question is, however, can you be happy to allow some property developers to fail miserably while at the same time limit the fall in home prices to within 10% so that you can avoid “a range of economic and social consequences”, in other words, hard landing?

Or, if Deutsche Bank’s judgment is true that policy will be relaxed well before property prices fall significantly, we can question whether that will be enough to save the market if the downturn has passed the point of no return. We should all understand that once a trend is established, it is not easy to turn around. Property prices in the US have failed to bottom-out even with ultra easy monetary policy, for example.

So, the real question is, how do you engineer this landing, which requires the wheels on one side of the aircraft to fall off and a gentle touch down on the other side.

Well, that question has just been cast into stark relief by the following from a Merrill Lynch note:

Credit to Chinese developers is rapidly drying up which will be the trigger for a construction collapse. The rising cost of funding shows the pressure:

– The yields on existing Chinese developers’ bonds in Hong Kong has exploded to around 30%. This means that this source of funding is now shut, as developers could not issue bonds at a 30-35% rate.

– The rate on bank acceptances, another unconventional source of credit, are also surging. The extension of reserve requirements has had a material effect on the willingness of banks to make loans through unconventional channels.

Remember that the developers have a massive need for credit because construction has substantially exceeded sales over the past 18 months. This was never a sustainable situation, but the collapse in credit availability will be the trigger for a slowdown. Apartment construction is 25% of steel demand, so 180 mt of steel demand are now under threat.

As we approach the construction endgame in China we strongly recommend underweights in resource companies and mining services.

I haven’t got much to add except to note that Greentown and Evergrande are both top ten developers in China.