5oceans is China Blowing Bubbles

8/13/2019 5oceans is China Blowing Bubbles

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Is China blowing bubbles? A China thought pieceBoth China and America are addressing bubbles by creating more bubbles and were just taking

advantage of that. So we cant lose We have to be in everything because you never know whats

going to happen in this world1

Lou Jiwei, Chairman and CEO of China Investment Corporation 28/08/09

February 2010

A number of commentators and analysts have

termed Chinas asset markets (primarily its residential

property and the A share market) an asset bubble,

but without fully explaining what an asset bubble is.

While there is no standard definition2, it is generally

accepted that a bubble occurs where the price of a

particular asset has become significantly detached

from its fundamental or intrinsic valuation

(e.g. sub-prime, TMT in the late 1990s, Japan in the

late 1980s). Given the fundamentals and valuations

of an asset can constantly change, bubbles are by no

means easy to identify. In this thought piece, we

determine whether China really is in an asset bubble.

The backgroundFollowing Chinas massive Rmb 4 trillion (US$585 billion)

stimulus package announced last October and near

Rmb 10 trillion (US$1.3 trillion) expansion in credit

during 2009 and Rmb 1.39 trillion in January 2010,

there has been a steady stream of warnings over recent

months of overheating and emerging asset bubbles in

mainland China.

In China, like the US, property and equity markets

are closely intertwined, and have been supported by amoderately loose monetary policy (i.e. low interest rates).

Chinas cheap currency has also encouraged offshore

capital flows at a time when the US Fed has pursued an

even looser monetary policy than China. However, asset

prices in China could inflate to dangerous levels if there

are further delays in monetary tightening and the

continued suppression of its currency.

The market is justifiably concerned about credit growth.

It is generally accepted that this is often a powerful

predictor of bubbles and subsequent financial crises.

In other words, financial crises are often credit booms

gone wrong3. Unfortunately, the banking data in China

provides only limited details on how the massive

expansion in credit has been used during 2009. While

there are few official numbers or estimates anecdotally,

a high proportion of the banking-led stimulus last year

found its way into the local equity and property market4.

Estimates on the bank lending that ended up invested in

asset markets (including commodities as well as equities,

and property) have ranged between 20% and 70%.

Anecdotes suggest that even corporates who did not

want to borrow money from the banks were told to

borrow money, and invested the proceeds.

As a result liquidity in China became and remained abundant during 2009. Measures like M2 money supply

grew 27.7% yoy in 2009, the highest in over a decade.

As one would expect, this has significantly raised inflation

expectations. Inflation risks are now on the rise in China

as the consumer price index (CPI) turned positive to 0.6%

in November 2009 and 1.5% in January 2010. This was

its first increase since January 2009, and is expected to

rise further during 2010. The two places where rising

money supply and inflation will continue to have an

outlet in China will be residential property and A shares.

The potential consequencesThe question of whether China is rushing headlong into

a liquidity-led bubble is one of the most important for

local and global investors alike. It has repercussions across

many markets, not just in China. As highlighted in a

recent speech by Norman Chan, Hong Kong Monetary

Authoritys Chief Executive, asset bubbles are the number

one threat to financial stability in Asia 5. This is perhaps

most obvious in the Hong Kong property market where

mainlanders are an increasing percentage of buyers


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(by recent reports up to 20% of buyers at the high-end

in Hong Kong). However, it will also affect the pricing

of risk and growth expectations across the Asia-Pacificregion, and even globally. Most investors clearly

acknowledge that China now has a pivotal role in global

as well as regional markets. This is a position that did not

exist in previous asset cycles.

A difference of opinionsThe lack of market history and the quality of data in

China leads to a very wide range of opinions as to

whether China is heading into a bubble.

The bulls dismiss the bears as investors who fundamentallyhave a limited understanding of the local market based on

cursory visits to Beijing, Shanghai, Hong Kong, etc.

On the other hand, the bears deride bulls for believing in

the build it and they will come growth model where a

good story leads to strong growth expectations being

extrapolated too far into the future. The bears point out

that business models and management teams are still far

less proven and less tested in China through economic

cycles, and therefore innately more risky.

It all gets very emotional, and turns the debate polemic.

It ends up as a black and white argument, however, as

we hope to show, a lot of what one can analyse in China

tends to come only in shades of grey. We aim to present a

more balanced view, and identify what could be potential

tipping points in the argument for a bubble in China.

Analysing the China property marketChinas housing reform began in 1998 and has been

a one-way bet for the majority of China homeowners.

There are some very powerful positive forces at work

in the China property market. Residential property

investment and growth has been a key driver, and is a

strong part of Chinas GDP growth. As highlighted in

numerous stockbrokers reports these positives include

strong income growth, increasing urbanisation and low

debt all of which have supported strong price growth in

recent years. The strong macro fundamentals (high GDP

growth, large current account surplus, high foreign

exchange reserves, high savings ratio, etc) do not need

to be analysed here given they are well known anddiscussed by the market. Suffice to say, the view from the

likes of Goldman Sachs that China could overtake the US

to become the worlds biggest economy by 2050 is an

increasingly consensus view. As China rapidly urbanises(from a 45% urbanisation rate against 90% in most

developed markets) incomes are forecast to grow strongly,

and there will be growing demand for all types of goods

and services (including residential property) from a

growing wealthier urbanised population.

However, as with technology and the internet in 1999-

2000, there is the risk that a very good story can quickly

turn into unrealistic expectations. As a result, a number of

respected market commentators like the independent

commentator Andy Xie and the hedge fund manager Jim

Chanos have already termed Chinas property market a

giant ponzi scheme6or Dubai times 1,0007. These are

supported by amazing stories of ghost towns like Ordos

in Inner Mongolia8and completely empty shopping malls

in places like Dongguan9.

The thought that this could be akin to a ponzi scheme

comes from the fact that state-owned enterprises (SOEs)

have been one of the biggest buyers and supporters of

the property market since late 2008. Some estimates10

suggest that up to a staggering 60% of the transaction

volume in the initial stage of the market recovery during

the first half of 2009 were from SOEs. This leads to the

interesting situation where SOE developers (like COLI,

Vanke, China Resources Land, etc) funded by SOE banks

(China Construction Bank, Bank of China, ICBC, etc) have

been buying land from local governments (where land

sales represent 40-60% of local government revenue)

to develop and then sell property to other SOEs for

investment purposes.

According to China Business News, a recent survey of

134 SOEs in China highlighted that 70% are involved inreal estate in either direct or indirect ways. However, only

16 of them are developers or real estate companies11.

Companies in industries as diverse as chemicals, steel,

textiles, and shoes have started up property divisions

given the chance of a quick return in the property market

can be much higher than in their primary business

plagued by overcapacity.

As a result, there has been frequent talk that Chinas

situation is now starting to resemble Japans situation in

the late 1980s. Even one of the smartest local property


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developers, Vanke Chairman Wang Shi, recently

compared China to Japan when he mentioned recent

land prices in Beijing and Shanghai are like prices seen inJapan before the Japanese property bubble burst12. This is

worth noting as local property specialists see Vanke as

one of the smarter local developers at calling the

market. Vanke is the market leader in China residential

property market; however its market share is still only

2.3% (of national residential sales by revenue in 2008)

given there are more than 30,000 property developers in

China.

The interesting similarities between China and Japan in

the 1980s include the highly regulated nature of the

economy, a Confucian ideology, a hard working

population with a high propensity to save, robust

domestic investment rates, tension in currency diplomacy,

a shift in the geopolitical balance, etc13. The

demographics of China will also become increasingly

similar to Japan over the next 5-10 years as they turn

less favourable in China as the decade progresses.

Affordability is a grey areaTraditionally, to assess the health of a property market,

most analysts would look at data like affordability.

Normally house prices expressed as a multiple of

household income, or as monthly housing repayments

as a percentage of monthly income, are a standard

measure in helping assess whether there is a property

bubble. In China the data suggests fuel for both bulls

and bears.

On the nationwide numbers, while property is by no

means cheap, it does not look like it is in bubble territory

at under 7x income or 43% of monthly income

(Charts 1, 2). This compares to 10x in Japan in 1989 and

14x for Hong Kong in 1997. However, when we start to

look at specific cities like Beijing and Shanghai,

affordability looks a lot more stretched (over 13x income

or 70%) and far more bubble-like. Again, while the

affordability numbers in the major cities suggest a serious

problem, it is possible that this just represents a mix

problem in the housing stock. This is possible because

developers have tended to focus more on high-end

housing and there is perceived to be a shortage of cheap

housing for the mass market in China. If this can berectified affordability could look significantly better.

Charts 1 and 2 Affordability looking stretched

Property Price/Annual Income: Four Major Cities

0.0x

2.0x

4.0x

6.0x

8.0x

10.0x

12.0x

14.0x

16.0x

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e

0.0x

2.0x

4.0x

6.0x

8.0x

10.0x

12.0x

14.0x

16.0xShanghai

Guangzhou

Shenzhen

Beijing

National

Average: 7x

l

i

i i

i

:

l

Source: CEIC, Morgan Stanley Research

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i

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Mortgage Payment/Annual Income: Four Major

Cities

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%Shanghai

Guangzhou

Shenzhen

Beijing

National

Average: 43%

lSource: CEIC, Morgan Stanley Research

As our discussions with numerous property developers in

China have highlighted to us, no one seems to have a

reliable affordability model in China. However, many havepointed out that affordability does not work the way it

does in the West. The peculiarities of Chinas one child

policy and the living arrangements of families in China

mean that for a young married couple to afford a house

one needs to consider not just the joint income of the

couple but also the income of their four parents.

Therefore, affordability data in China is always likely to

be misleading and the bulls say massively understate

housing affordability. This is quite a tortured argument.


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Rental yields and inventories telltwo sides of a storyAs well as affordability data, the picture on rental yields

and inventories is also extremely grey, and again

highlights fuel for both bulls and bears. In China there

is no real residential rental market to speak of, and

certainly not one that can provide accurate yield or

valuation data. What rental market there is suggests

rental yields of 2% to 3%. Again highlighting the

peculiarities of the China market, few property investors

in China rent out their properties preferring to keep them

as empty shells (to be sold after price appreciation for a

capital return) rather than rent them out for an incomereturn. In China the key driver of property prices going

forward seems to be as much rich peoples desire to

preserve/enhance their wealth (using property as a store

of wealth with the lack of alternative investment

channels) as it is about mass-market affordability. Vankes

Chairman Wang in his recent comments estimated certain

first tier cities have seen over 80% of transactions come

from speculative buyers.

Though the inventory data (in terms of months of unsold

property) is more readily available it also paints a prettymixed picture. Again using Beijing as the example, in the

2008 downturn Beijings inventories were reported to be

over 30 months (close to three years) which in a normal

market would lead to a sharp price correction. However,

in Beijing house prices only fell marginally during 2008

despite the disturbing inventory picture. In commercial

property (Office and Retail) vacancy rates in excess of

20%, and 30% in the case of Beijing premium CBD office

space, do not seem to lead to the normal or expected

market adjustments. Commercial property in China seems

even more dependent on a build it, and they will come

mentality than residential property. Anecdotes14like the

emptiness of the massive Pangu Plaza development, right

beside the Olympic Water Cube tends to confirm these

impressions.

There is even significant debate on the urbanisation

number. An interesting piece of research authored by Pivot

Capital15last August highlighted that Chinas definition of

an urban centre for urbanisation (population density of

above 1,500 people per square kilometre) would exclude

cities the size of Houston (2.2m people with density of

1,375/km2) or Brisbane (1.9m people with density of 918/

km2). This is a confronting statement as Chinas reported

low urbanisation rate around 45% is forecast to movetowards global norms (in excess of 90%) providing

significant demand support to the property market long-

term. If Chinas urbanisation rate is considerably

understated by official figures then it does not just question

the long-term health of the property market but also many

of Chinas other growth industries like automobiles,

technology products, sportswear, etc that are all supported

by Chinas growing urbanisation trends.

The China equity marketWhen looking at the equity markets in China one firstneeds to make a clear distinction between Chinas

onshore market (China companies listed domestically in

Shanghai and Shenzhen) and its offshore market (China

companies listed in Hong Kong, Singapore US, etc).

Chinas closed capital account means the onshore market

is typically invested in by domestic investors, even though

foreigners can invest through the Qualified Foreign

Institutional Investor (QFII) scheme. However, these quotas

are very limited16. The offshore market is mainly invested

in by foreign investors, even though domestic investorscan invest through the Qualified Domestic Institutional

Investor (QDII) scheme, but again quotas are limited.

The focus here is to discuss the onshore A share market

because this is the most likely destination along with the

property market for any excess liquidity in the domestic

economy because of the capital controls.

Onshore valuations seem stretchedOn the surface, valuations in the onshore market look

stretched when comparing the multiples that stocks trade

on globally. Only two sectors, Energy and Financials, trade

below 20x 2010 consensus estimates (Chart 3). These are

traditionally low P/E sectors. The earnings of the Financials

are dependent on the continuation of very low credit

costs, and the earnings of the Energy sector are

dependent on volatile oil prices. The rest of the A share

market trades at between 20x and 32x. This compares

to 13.1x for the offshore China market (using the MSCI

China as the proxy), 13.4x for the MSCI World index,

12.2x for MSCI Emerging Markets, 13.9x for the US,


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and importantly 17.3x and 13.2x for the Indian and

Indonesian markets respectively. Both markets investors

view with similar attractive long-term growth stories toChina (Chart 3).

Chart 3 Local Chinese shares are the most

expensive in the world

CSI 300 (CNY) 2010e P/E

Energy 16.7x

Materials 21.1x

Industrials 21.4x

Consumer Discretionary 23.7x

Consumer Staples 27.6x

Healthcare 26.6x

Financials 14.4x

Information Technology 31.5x

Telecommunications 31.3x

Utilities 21.6x

CSI 300 Market 18.3x

MSCI China 13.1x

MSCI Emerging Markets 12.2x

MSCI India 17.3x

MSCI Indonesia 13.2xMSCI USA 13.9x

MSCI World 13.4x

As at 26 February 2010.Source: CSI, FactSet, I/B/E/S, MSCI, Goldman Sachs Research estimates.

So does the fact that local Chinese shares are the most

expensive in the world mean there is a bubble? History is

inconclusive. For example, the NASDAQ peaked at 100x

earnings in 2000, well above current levels, though the

broader S&P peaked at 25x in 2000 and the Dow Jones

index peaked at 33x in 1929. The A share market itself

peaked at 37x during 2007. So we are now at valuation

levels in some sectors which have, in other markets, been

indicators of significant future declines. On the other

hand these valuation levels may be completely justified by

future growth which would mean there is no bubble,

whether this strong earnings growth occurs is the

fundamental question which we are constantly testing.

Interpreting the valuationsThe differing views of international and domestic

investors are demonstrated by the A share versus H share

premium. Chart 4 shows the P/E premium that local

investors will pay for similar earnings stream relative to

international investors. As with everything in China, this

can be interpreted in a number of ways. One view is that

more experienced international investors are far more

wary of the risks of Chinese growth disappointing than

local investors, which would be an indicator of possible

excessive optimism in the local market. Another

interpretation is that they have similar views of the risks

but also have a far lower cost of funds, and so it makessense that they would pay more for the same earnings

stream. Either way, if the two classes of shares were

fungible it would be rational for a long-term investor to

own H shares in preference to A shares.

As mentioned, Financials as a sector in the A share market

is trading on 14.4x forward earnings. But if credit costs

deteriorate with some of the lending risks in the property

sector, for example, the sector could easily be trading

over 20x like the rest of the A share market.

Chart 4 Valuations favour H shares over A shares

Forward 12-month P/E for MSCI China and CSI300 index,

1998 to 2009

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

MSCI China 12-m forward P/E CSI300 12-m forward P/E

13.1x

4.9x

14.1x

6.4x

18.9x

16.4x

11.1x8.8x

15.1x

25.1x

9.8x

29.1x

36.9x

24.0x

30.6x

15.5x

7.9x

Source: CEIC, CSI, DataStream, FactSet, I/B/E/S, MSCI, Worldscope,GS Global ECS Research estimates.


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Investors are also asking themselves what the appropriate

risk premium is for companies between the two markets

and particularly for companies and industries with lowertransparency and less trading history. Again using the

example of Chinas banking sector, can one be comfortable

that the long-term credit history and credit risks in the

banks will be materially better than previous cycles? In

many cases there is insufficient historical data for long-term

analysis, but the markets future estimates of non-

performing loans are still relatively low.

The current market consensus on credit costs over the

next couple of years is within the range of 50-70 basis

points, similar to the average of the last five years which

might not fully capture the risks created by the 2009

lending growth given the risk that lending standards have

been lowered. The short-term focus of the market means

it is still relatively comfortable believing asset quality will

remain benign over the next 12-24 months as non-

performing loans from last years lending spree might take

a number of years to surface.

In simple terms, many Chinese industries (like sports

retailing, wind power, cement, steel, etc) offer higher

growth, but they are also more fragmented andcompetitive. For example, there are close to a dozen listed

sportswear retailers in China. Numerous industries are so

new in China and have grown so quickly they are yet to

be tested by a downturn. In looking at risk premiums, its

also important to remember that most companies

sustainable earnings streams are heavily influenced by

government policy not just in the Banks and Property

sectors, but in all four corners of the economy. If we look

at the largest companies in China listed offshore (again

as defined by the MSCI China index) then policy-driven

priorities often have to sit alongside shareholdersinterests, and from time-to-time depending on the policy

priorities and settings of Beijing this can conflict with the

profit seeking motives of minority shareholder interests

(Chart 5).

Chart 5 Potential National Service requirements of Chinas largest listed companiesMSCIChina

Ownership The grand plan requirement of China's largest listedcompanies

1. China Mobile (HK) 10.9% Govt Develop TD-SCDMA as China's technology platform

2. China Construction Bank 6.2% Govt Lend to promote China's economic growth

3. China Life Insurance 6.1% Govt To develop a welfare system (and debt capital markets)in China

4. ICBC 5.9% Govt Lend to promote China's economic growth

5. CNOOC 5.2% Govt Help China become more self-sufficient in the supplyof oil and gas

6. Bank of China 5.2% Govt Lend to promote China's economic growth7. PetroChina 4.3% Govt To develop natural gas for China

8. Tencent Holdings 3.2% Mangt To maintain political stability/control through the internet

9. China Shenhua Energy 2.5% Govt Affordable coal for power users (given inflationary risksthru power tariffs)

10. Sinopec 2.2% Govt To provide refining capacity for China

11. Ping An Insurance 1.8% Govt To develop a welfare system (and debt capital markets)in China

12. China Overseas Landand Investment

1.5% Govt To develop affordable housing in China(a cap and floor approach)

Source: MSCI, Five Oceans Asset Management. Weightings as at 26 February 2010.


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ConclusionChinas property and equity markets often do not conform to the normal operating model that many investors in the

West expect. For example, affordability, rental and inventory metrics in the property market do not seem to work in

quite the same way as other property markets. Therefore, the evidence of a full scale asset bubble in either property or

equities in China is far from conclusive despite the empty apartments, office blocks, shopping malls and hotels, and the

strong recovery in the A share market.

Though it is possible to identify areas of misallocation of resources in Chinas asset markets it is far harder to determine

whether this is all pervasive. On a simple checklist, not all conditions for a bubble seem fulfilled (Chart 6).

Chart 6 Not all typical bubble conditions are fulfilled

Typical bubble conditions China

A compelling and exciting story that all investorscan easily understand

4 High GDP Growth, growing among 1.3 billionpeople, increasing urbanisation

Cheap and easy credit with a high credit multiplierand loose monetary policy

4 Bank lending of Rmb 9.59 trillion in 2009 at lowinterest rates, Rmb 1.39 trillion in January 2010

Friendly Government or regulatory policy 4 Government policies to support property market aswell as subsidise a number of industries

Abundant market liquidity, and very high tradingvolumes

4 Turnover in the A share market now the largest inAsia (including Japan)

High levels of investor confidence (that eventuallyturns into hubris)

7 Number of A share account openings still relativelylow versus 2007

High levels of leverage 7 Low loan-to-deposit/loan-to-value ratios, highsavings rate, low household debt, debt to GDP

Extended levels of valuation often well abovehistoric norms/averages

7 Current valuations (PE, PB) close to historicaverages (both onshore/offshore)

Source: Five Oceans Asset Management.

There has actually been a relatively low credit multiplier (loan growth/nominal GDP growth) in China over recent years

below one times during 2004-08 (Chart 7). This suggests that China is not yet a full-scale bubble. It was only from

2009 that loan growth in China has aggressively expanded into the two to three times nominal GDP level, which

normally acts as a warning sign for non-performing loans, credit quality, and the formation of bubbles. As with the

Asian Crisis and more recently with sub-prime in the US, the credit multiplier normally needs to stay at an elevated level

for a number of years before problems start to emerge, and to give time for a bubble to inflate.


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Chart 7 A relatively low credit multiplier

(%) Nominal

GDPgrowth

Real

GDPgrowth

Export

growth

CPI

inflation

Loan

growth

Deposit

growth

Credit

multiplier*

Loans /

GDP

1990 11.8 3.8 18.2 3.1 23.1 29.9 1.96 94.7

1991 16.7 9.2 15.8 3.4 20.7 29.0 1.24 98.0

1992 22.1 14.2 18.1 6.4 23.4 29.8 1.06 97.8

1993 34.0 14.0 8.0 14.7 25.1 26.2 0.74 93.2

1994 36.0 13.1 31.9 24.1 23.9 36.6 0.66 84.7

1995 25.9 10.9 23.0 17.1 23.8 33.1 0.92 83.1

1996 17.3 10.0 1.5 8.3 21.0 27.3 1.21 85.9

1997 10.1 9.3 21.0 2.8 22.5 20.2 2.23 94.9

1998 6.0 7.8 0.5 -0.8 15.5 16.2 2.58 102.5

1999 5.3 7.6 6.1 -1.4 12.5 13.7 2.36 104.5

2000 8.4 8.4 27.8 0.4 13.4 13.8 1.60 100.2

2001 10.4 8.3 6.8 0.7 11.6 16.0 1.12 102.4

2002 10.4 9.1 22.4 -0.8 15.8 19.0 1.52 109.1

2003 13.3 10.0 34.6 1.2 21.1 21.7 1.59 116.6

2004 17.5 10.1 35.4 3.9 14.5 16.0 0.83 111.2

2005 17.7 10.4 28.4 1.8 13.0 18.9 0.73 103.2

2006 17.5 11.6 27.2 1.5 15.1 16.8 0.86 101.7

2007 18.7 13.0 25.7 4.8 16.1 16.1 0.86 99.52008 16.6 9.0 17.2 5.9 18.8 19.7 1.13 98.9

2009e 8.0 8.7 -18.6 -0.6 30.0 N/A 3.75 119.0

2010e 13.0 9.8 13.4 3.2 20.0 N/A 1.54 126.3

Source: Citi Investment Research and Analysis estimates

*Credit multiplier = Loan growth/Nominal GDP growth.

Bulls would say we would probably need to see the credit

multiplier in China stay at the current level for a longer

period of time to become really concerned about a full-

scale problem.

This seems a reasonable assumption however there is a

strong need to continue testing this. While the credit

multiplier has been low, this is mainly because of

exceptionally strong nominal GDP growth. Credit has still

been expanding at 15% to 20% for the past 10 years.

We can also not be sure that we have full disclosure on

total debt outstanding. The massive spike in bank lending

during 2009 also coincided with a large increase in

corporate debt issuance, which is not commonly

discussed. There have also been a number of anecdotes

about Chinese banks moving loans off their balance

sheets into wealth management products. There could

also be significant debt hidden in local government

financing vehicles. These are investment companies set upin local governments whose debt is not reported in official

figures.

Credit growth was probably therefore much stronger than

has been reported. For 2010 a slowdown is planned to

20% bank credit growth (the PBOCs target is Rmb 7.5

trillion), still a large number in absolute terms. The key

unknown is in the timing of any problem with China

having pulled years of cheap credit into just one year.

The old IMF rule of thumb is it takes three years of

20-30% loan growth for NPL problems to surface.


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The key question in China is what 10 years at 15%-20%

and one year at 30% followed by another 20% means.

Another condition of a typical asset bubble is whenmarket participants assume significant amounts of

leverage. While the numbers are naturally much harder to

obtain in China there does not seem a large build-up in

leverage on the numbers that are available (e.g. loan-to

deposit ratios in the high 60s, loan-to-value ratios below

70%, high % of cash buyers, high savings ratio, low

consumer debt, etc). China still has a very high percentage

of property sales financed by cash (around 20-25%), or at

least financed by relatively low loan-to-value ratios which

are rarely above 65%. Again the risk is much of the

leverage is off balance sheet in China. For example, local

Government debt (which is highly dependent on land

sales) is not reported in Chinas debt to GDP numbers, and

property developers relatively high gearing ratios look even

higher when one adjust for unpaid land premiums.

But, the authorities in China have been very proactive in

managing leverage as well as trying to contain asset prices,

when compared to the likes of the Fed. They are quite

bubble wary. For example, the increase in bank reserve

requirements over 2004-07, and a variety of policies

towards the property market during 2004-07 were

introduced to combat what the authorities justifiably

perceived to be an overheating market at that time.

Investors can take a degree of comfort from the fact that

the Chinese authorities have in the past shown a greater

willingness to use monetary policy to target asset prices

than most other central banks. In such a command-driven

economy the authorities in China has a wide range of tools

to cool asset markets. The Government has in recent

months already flagged their intention to stabilise prices

through taxes, interest rates, land policies, etc. A cap andfloor approach seems likely to be pursued given the risks

to social stability from rapid rises or falls in property prices.

We also have not yet seen the Chinese version of the

fabled indicator that a bubble has to burst. In Japans case

this was famously when the value of the Imperial Palace

grounds in Tokyo in 1988 were worth more than all of the

real estate in the state of California. In late December

though we saw Chinas largest ever land transaction at a

price of Rmb 25.5 billion (US$3.7 billion). However, given

the size of the plot (4.38m sqm) in Panyu, Guangdong

this worked at a price of Rmb 5,822 per sqm (US$852 per

sqm). The record for a residential per sqm purchasehappened in Shanghai the same week when China State

Construction paid Rmb 32,500 per sqm (US$4,758 sqm).

Still well below the level of high-end (rather than average)

prices in Hong Kong or London, even if this is a very

stretched point of comparison. For example, Hendersons

Land sale of an apartment at 39 Conduit Road in Hong

Kong last October at a reported price of HK$439 million

(US$57m) equates to a price of US$9,200 per square

foot, or close to US$100,000 sqm17. This beat the

previous world record set in London, where a flat in One

Hyde Park was sold for over US$90,000 per sqm. Recenthigh-end prices in Shanghai have been more like

US$30,000 sqm.

As with property, while A shares can hardly be termed

cheap, and we would not recommend owning them (on

an absolute basis, or relative to H shares) they also do not

seem to be in full bubble territory. Bubbles also tend to

inflate over the course of around three years and can

have a parabolic explosion in prices towards the peak of

the bubble. The A share market remains some 40%

below its October 2007 high. However, we believeinvestors have to invest in China acknowledging the risk

of asset bubbles, and have a strategy to manage bubble

risk. This should ideally include high cash discretion, and

the ability to short to manage portfolio risk. A number of

H shares in Hong Kong are shortable, and there are an

increasing number of exchange traded funds available. In

the final stages of a market blow-off risk (when the share

price ascent is near vertical) the ability to hedge and have

high discretion on cash levels is highly desirable.

We will be looking out for a range of top of the marketindicators, including taxi driver anecdotes, Chinese

corporates undertaking expensive M&A transactions on

the global stage, etc. The problem is that identifying asset

bubbles is a lot easier than identifying them in a timely

manner. History has shown it is often as just as dangerous

to call a bubble too early as not to call it at all. We will

continue to look for tipping points, and maintain a

dialogue with both bulls and bears to help our clients

manage this risk.


10/10

10

1 Zhou Xin and Alan Wheatley, Reuters, Chinas CIC wealth fund muscles up as markets recover dated 28th August 2009 (http://www.reuters.com/article/idUSTRE57S0D420090829)

2 http://en.wikipedia.org/wiki/Economic_bubble3 Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 18702008 Moritz Schularick and Alan M. Taylor NBER Working

Paper No. 15512 November 2009.4 One estimate from Mr Wei Jianing, a deputy director at the Development and Research Center under the State Council on June 27, 2009, as

reported by Chinese Business News (via Bloomberg) suggested that 20% of bank lending ended up in the A share market. This represented anestimated Rmb 1.16 trillion of loans invested in stocks in the first five months of 2009.

5 A speech given by Mr Norman T.L. Chan, Chief Executive of the Hong Kong Monetary Authority, at the Hong Kong Economic Summit on 14thDecember 2009 (http://www.info.gov.hk/hkma/eng/speeches/speechs/norman/20091214e1_index.htm

6 Andy Xie, Caijing Magazine, China Counts Down to the Next Bubble Burst dated 5th August 2009 http://english.caijing.com.cn/2009-08-05/110220584.html

7 In a CNBC interview on 15 December 2009, Jim Chanos, President of Kynikos Associates said that China could be Dubai times 1000, or worse.http://www.cnbc.com/id/34433626

8

Chinas empty city Al-Jazeera News dated 10th November 2009: http://www.youtube.com/watch?v=0h7V3Twb-Qk#t=01m20s9 Utopia, Part 3: The Worlds Largest Shopping Mall dated 18th August 2009 (http://www.pbs.org/pov/utopia/). New South China Mall (formerly

South China Mall) in Dongguan, China is the second largest mall in the world after Dubai Mall. It has the most gross leasable area of any mall inthe world; room for over 1,500 stores in approximately 7.1m square feet (659,612 square metres) of leasable space and 890.000 square metres oftotal area. Despite opening in 2005 much of the retail space remained empty in 2008 with 99.2 % of the stores vacant. http://www.thenational.ae/article/20080612/REVIEW/206990272/1042

10 Koyo Ozeki, PIMCO, The Chinese Real Estate Market: A Comparison with Japans Bubble dated December 2009.11 http://www.china-cbn.com/s/n/000004/20100108/000000144489.shtml12 Vanke Prepared for Bursting of China Property Bubble, Post Says Jian Guo Jiang, Bloomberg News, Published December 22 2009 (http://www.

bloomberg.com/apps/news?pid=20601089&sid=ae8DfuMnzi.0)13Dylan Grice, SG Research, The lesson from Japan? China will be the biggest bubble the world has seen dated 15 September 2009.14 Pivot Capital Management Chinas Investment Boom: the Great Leap into the Unknown dated 21 August 2009.http://www.pivotcapital.com/

research.html. Chinas definition of an urban centre includes, among other things, population density of above 1,500 people per square kilometre.By that definition Western cities like Houston (2.2m people with density of 1,375/km2) or Brisbane (1.9 m people with density of 918/km2) couldtechnically not be counted as cities. Back in China, a lot of the so-called villages and townships are in fact highly industrialised. Qiaotou, home

to 64,000 people, produces 60% of the worlds buttons and 70% of its zippers. Songxia with 110,000 people is the umbrella capital of the world:it produces 500mn umbrellas per year.

15 http://chovanec.wordpress.com/2010/01/03/beijing-tenants-fight-eviction and http://articles.latimes.com/2009/feb/22/world/fg-luxury2216 http://en.wikipedia.org/wiki/Qualified_Foreign_Institutional_Investor17 http://en.wikipedia.org/wiki/39_Conduit_Road

Information in this document is current as at 22 February 2010 and is provided by Five Oceans Asset Management Pty Limited ABN 90 113 453 160AFSL 290540 (Five Oceans). The document is intended solely for licensed financial advisers or other wholesale clients. This document should beregarded as general information only rather than advice. It has been prepared without taking account of any persons objectives, financial situationor needs. The information must not be copied or disclosed in whole or in part without the prior written consent of Five Oceans, and Five Oceansaccept no liability whatsoever for the actions of third parties in this respect. It is presented for informational purposes only and is not to be construedas a solicitation or an offer or recommendation to buy or sell any securities. While due care and attention has been exercised in the preparationof the information, Five Oceans gives no representation or warranty, either express or implied, as to the accuracy, completeness or reliability ofthat information. Any opinions expressed in this document may be subject to change. Five Oceans is not obliged to update the information. Theinformation must not be used by recipients as a substitute for the exercise of their own judgment and investigation. Neither Five Oceans nor any of

their directors, employees or agents accept any liability for any loss or damage arising out of the use of all or part of, or any omission, inadequacy orinaccuracy in, this document.

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5oceans is China Blowing Bubbles

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