If you’ve invested
in commodity stocks or real estate in Toronto or, most dangerously, Vancouver—beware.
There are two duelling stories about China: a popular one of rapid and prolonged economic ascendancy, and another—seldom heard around office break rooms but strikingly pervasive among top-level investors— that it’s a facade on the verge of collapse. Contradictory as this sounds, both stories are partly true. In many respects, China has assumed the economic leadership of the world—which is why its hard landing in 2012 will be all the more painful, both inside the Middle Kingdom and beyond.
This shuddering correction to a three-decade miracle will come as no surprise to those who have been watching China’s stock markets over the past six months. If you think the S&P/TSX 60’s had it tough, consider Hong Kong’s Hang Seng index or the Shanghai composite, both down 20%-plus in 2011 and nearly 30% off their 2009 highs.
More troubling than the sliding value of equities is what’s happening in the housing market. Reliable official statistics of resale home prices are hard to come by in China. However, a number of private surveys suggest that the 20% annual price increases of the past several years have come to a halt, and the momentum now points in the opposite direction. According to China Index Academy, a property research firm, average prices in Shanghai have already declined 40% from their 2009 peak.
“The housing sector is experiencing a cold winter as sales fall sharply,” the Xinhua news agency reported in December. One analyst quoted by the state-controlled service, Beijing professor Zhao Xiao, predicts that prices nationwide would fall by 15% to 20% in 2012. In the China Economic Weekly, Cao Jinhai, an economist with the Chinese Academy of Social Sciences, forecast an average 40% decline in national housing prices from peak to eventual trough. For the biggest cities, he expects the average drop to top 50%. China’s central government in part orchestrated this deflation of the housing bubble by reining in speculation and financing rules, but it’s a perilous undertaking. In Beijing, Shanghai and other cities, mobs of recent buyers have trashed the offices of developers that offered steep discounts in the same developments for new buyers.
That the home-price bubble should end with a pop is especially worrisome to economic prognosticators. Housing construction in China accounts for an unusually high share of the economy—13% of GDP, according to UBS China economist Jonathan Anderson, compared with 6% or 7% in mature economies. So a potential halving of residential construction would almost wipe out the country’s official 9% growth rate, even without considering the knock-on effect for sectors such as steel, concrete and retail. Then there is the impact on consumer wealth that a decline in home equity would engender. The Credit Suisse Global Wealth Report for 2011 shows Chinese citizens have roughly half their net worth tied up in real assets (mostly property), compared to less than one-third in the U.S. It follows that a drop in home values will have a dramatic effect on consumer and investor behaviour.
And, as happened in the U.S., trouble in the housing market tends to spread. Longtime China skeptic Vitaliy Katsenelson, a strategist for Denver-based Investment Management Associates, expects a cascade of loan defaults throughout the economy, including in the unregulated “grey” or “shadow” banking sector. “Like the movie Speed with Keanu Reeves, China is a bus with 1.3 billion Chinese on board,” he observed in a presentation last fall.
Were it simply a case of overinflated asset values, the coming crash would be short and V-shaped. Unfortunately, the country suffers from the same problem that’s hobbling developed economies, albeit in a different form: the misallocation of capital. In China’s case, the recipients of this capital are real estate developments, public works, and companies promising to build the new China. They include vast and deserted shopping malls, even entire cities, as well as state-owned industrial enterprises, riddled with corruption and inefficiency.
But wait, sinophiles will interject: it’s precisely that central control of the economy that will help the outgoing generation of leaders pilot a soft landing for their successors toward the year’s end, aided by China’s continuing strong fundamentals of trade and current-account surpluses, high savings rates and overall competitiveness. “The public sector is still close to 50% of the economy,” notes Joseph Caron, a strategic adviser to law firm Heenan Blaikie and former Canadian ambassador to China.
Taken to its logical end, though, this reasoning puts China’s policy-makers on a higher pedestal than their counterparts in other countries. If you believe they can make better decisions more consistently over the long term than leaders in the developed world, you must really believe that democracy, transparency and free enterprise are inferior models of governance. We don’t.
China’s suppression of information only increases the risk to investors and slows the response to shocks that arise. In 2012, those shocks will become impossible to hide. As Katsenelson put it bluntly, the crash “will tank the commodity markets, commodity producers and commodity-exporting nations. Demand for industrial goods will fall off a cliff.” When the Chinese economy collapses, Canada will have to brace itself.
Remember the uproar over BHP Billiton’s proposed purchase of Potash Corp. in 2010? That’s nothing compared to what’s to come. This takeover won’t be hostile, but it will go to the heart of resource sovereignty.
There’s a very good chance that in 2012, Canada will face a Unocal moment. That is, a state-controlled Chinese oil company will make a play for one of our big oil-and-gas producers. There will be a clear benefit to Canada: patient capital for a company in need of cash to proceed with a megaproject. But as with PetroChina’s US$16-billion bid for California’s Unocal Corp. in 2005—vetoed by Congress—fears will linger over ulterior motives. Will a sovereign owner, especially one from resource-hungry China, behave differently than a private investor? Might it, for example, divert production to refineries at home or, worse, leave the resource in the ground as a hedge against future energy price inflation?
In fact, China’s sovereign firms have been model investors in the oilpatch. Since the financial crisis, they’ve acquired minority positions in Syncrude Canada and Teck Resources, and launched several joint ventures. Now it appears they’re ready to buy whole companies and projects, starting with Opti Canada and Daylight Energy last year, and the McKay River oilsands project this month.
“Since 2009, the trend has been quite clear,” says Wenran Jiang, a University of Alberta professor and organizer of an annual Canada- China energy forum. He attributes the increased deal flow to the thaw in diplomatic relations, attractive asset valuations, cash requirements of the target companies and the rising appeal of stable jurisdictions like Canada in the wake of the Arab Spring.
How can China’s national oil companies, flush with foreign exchange Beijing wants invested in real assets, top their buy-in to date? They can take out a large-cap player, one over $5 billion. Nexen and Husky Energy, industry laggards already paired with Chinese JV partners, top the list of potential targets. But would the shareholders of Encana or Talisman Energy say no to a 100% premium over market value? We may find out this year.