104 - longitude #26

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longitude #26 - 105

Domestic markets

Walking along the Huangpu riverbank on thePudong side in Shanghai, one has the im-pression that the 22nd century science-fic-

tion stories have all come true. A multitude of high-ris-es clutter the skyline, but, if one looks more closely,most of the apartments in the residential buildings thatare close to the ferry stop which crosses to the Bund –one of the most expensive areas in Shanghai – are darkand seemingly empty. Statistics on vacancy in Chinavary, with surveys from CSLA and the State Grid Cor-poration of China showanywhere from16million to 65million vacant homes in China, while Bloomberg esti-mated that in 2010 at least 50%of apartments in Shang-hai and Beijing were empty, a figure that knows no par-allel in rapidly developing areas around the world.

Even with the marginal slowing of the economy in2012, China’s economic engine is still firing on all cylin-ders. The main fuel for this Chinese engine has beenshifting from external demand to internal consump-tion. Commercial bank lending has been the greasethat keeps the machine well lubricated, but as marketsdevelop, China can tap into different sources to main-tain its momentum. There is a consensus that Chi-nese capital markets are underdeveloped (the newstock index futures market has been launched as re-cently as 2010, with international investors graduallybeing allowed to access it), and one of themain featuresis the unusually high demand for residential propertyin major cities.

Empty homesin China

There is a glut of empty apartments in China. Manyfactors make it preferable not only to invest in realestate, but also to keep the property empty. Thisphenomenon is having a huge impact on the economy,especially on small family-owned businesses.

People re6ected in thewindow of a ferry asthey cross the HuangpuRiver near the 5nancialdistrict of Pudong inShanghai, December12, 2012.

by Rodrigo Zeidan

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longitude #26 - 107

Domestic markets

106 - longitude #26

China

While the real estate bubble was fueled by scarcesupply and low interest rates in Japan in the 1980s,and cheap credit in theUS in the 2000s, inChina the sit-uation is more complex, because of excessive supplycombined with rising prices. One of the major over-looked factors in China’s real estate dynamics is the un-derdevelopment of financial markets.While domesticinvestors in developed countries have access to aplethora of financial products, from complex insuranceto home-trading derivatives, most individual investorsin China have limited options. In fact, more than 60%of domestic assets are in bank deposits, while 30% arein equities, according to theWharton Business School.The bonds market represents less than 10% of domes-tic assets and domestic mutual funds have a negligibleshare of the market.

The recent Chinese economic development hasbeen fueled mainly by bank loans, with commercialbanks growing to become some of the largest in theworld. Banking loans are increasing dramatically – thetarget is 8.5 trillion yuan ($1.36 trillion) in new lendingthis year by commercial banks, according to ChinaDaily. However, domestic investors have a surprising-ly small number of options for channeling their savings.Deposit rates constantly yield negative real rates of re-turn (in February 2013, the average annual depositrate for 1-year time deposits was 3.25%, against a pro-jected 5% inflation rate for the year). The aforemen-

tioned bonds market is inaccessible to most investors,and the stock market has proven to be unreliable as along-term investment due to its excessive volatility.International markets are also mostly inaccessible.There is a lack of mutual funds and complex insurance.In fact, there are few options open to most investorsapart from real estate.

Domestic investors cannot form diversified port-folios, balancing risk and return through a combinationof diverse liquid and illiquid assets. Also, there is astrong preference for tangible assets which is a char-acteristic of emerging countries – the developmentprocess usually raises an economy up from a crisis ordepressed situation, and a crisis period is one in whichfew financial assets hold their value better than tangi-ble assets – that is why countries such as Brazil, SouthAfrica and India, as well as China, hold real state as themiddle class dream. Property, for most families in de-veloping countries, is the ultimate dream and a suresign of prosperity. In the Chinese case, coupled withlimited options, real state comprises the majority offamilies’ portfolios.

One of the main interesting side-effects of the lackof financial alternatives for Chinese domestic investorsis the surge of exotic investment alternatives based ontangible assets – some examples are racing pigeons,aged tea, and wine. An art fund bubble burst in 2011because some investors used the art market almost

like a stock market, with artworks that are split intomultiples of dematerialized shares, according to Art-price and CNN. Even so, China has become a majorplayer in the art auction world – art auction resultsshow a shift of money going east, with China leapfrog-ging the US to become the largest art auction marketin 2011. Even though the market has cooled down a bit, according to the Financial Times, China is now a ma-jor player in the art world, with auction sales topping$10 billion in 2012.

Even more interesting is that most families are notafraid of the concentrated risk brought by investingmainly in real estate and other tangible assets. Talkingto some owners there is a perception that the govern-ment would never allow a housing devaluation thatwould threaten property values. The central govern-ment is walking a thin line between allowing for athriving housing market and curbing excess demand.Regulations include bans on multiple home purchas-es, higher loan rates, and other buyers’ restrictions.Also, there are property-tax trials. One of the most con-founding aspects of the Chinese property market isthat property taxes do not exist in most places. The re-

sult is that there are very few transaction costs in vacantresidential real estate, allowing the purchase of prop-erty as assets that are easy to hold and investors cantake some time to observe attitudes regarding proper-ty value appreciation.

Analysts at times underestimate the importanceof property taxes in giving real estate its special finan-cial asset status in the Chinese market. While in mostcountries building a real estate portfolio brings allsorts of transactional costs that makes managing it ex-pensive and time consuming, in China it is easy tobuy and sell property, and leaving it empty incurs al-most no costs.The result is that real estate is liquid, andgiven the lack of other attractive financial assets, itplays the most important role in the portfolio of Chi-nese families. Data from Global Property Guide indi-cates that only Singapore has comparable low trans-action costs in Asia, while in developed and emergingcountries this is true only of the UK. For other BRICScountries the process of buying and selling a propertyaverages around 11% of the final price in Brazil andSouth Africa, 14.66% in India and a forbidding 25% inRussia, Chinese buyers face a very modest buy/sell ra-

SHARES OF TOTAL DEPOSITSIN COMMERCIAL BANKS CHINA - 2001/12

DEPOSITS IN COMMERCIAL BANKSUS$ TRILLION – CHINA – 2001/12

* Enterprises are institutions af�liatedto central government departmentsand companies solely fundedby the state or state-controlled

Source: CSMAR, GTA

Depositsby enterprises*

Total Deposits

Depositsof governmentdepartmentsand organizations

Urban and ruralhousehold savingsdeposits

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CHINESE SAVINGS AND DISPOSABLE INCOME

Residential high-risesline a deserted street inthe Kangbashi districtof the town of Ordos inChina’s Inner MongoliaAutonomous Region.

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longitude #26 - 109

Domestic markets

108 - longitude #26

China

by michele bagella

The savings glut

“Why is the United States, withthe world’s largest econo-my, borrowing heavily on

international capital markets – rather thanlending, as would seem more natural?”Thisquestion, put by FED Governor BenBernanke to the members of the VirginiaAssociation of Economists on April 14,2005, continues to be valid at the begin-ning of 2013 as the figure below suggests.

The black line on Figure 3 depicts thegovernment budget deficit recorded by ad-vanced countries (US, Canada,Western Eu-rope, Japan, Australia) between 2001 and2011 as a share of GDP. The dark grey lineshows the corresponding private sector fi-nancial surplus. The light grey line addsthe current surplus of China and otherAsian countries (the tigers) to the surplus ofthe advanced countries private sector. Thefact that the grey lines are the mirror imageof the black one is indicative of the imbal-ances that are at the origin of the global fi-nancial crisis that broke out in 2007.

As matter of fact, the crisis continues,badly affecting the European Union Econ-omy, while the US Economy is still strug-gling to get past it. The developments ofthe recent crisis are related to two issuesfiguring high on the agenda of policy mak-ers: 1) the world economic change,marked by the rapid growth of the BRICSeconomies, China and Brazil before allothers; 2) the closer integration among

This is how the US has became a debtorcountry, while on the other side China be-came a creditor country. As long as Chinamaintains its fixed exchange rate regime,US imbalances and corresponding globalimbalances will continue, strengtheningthe new credit/debt countries’ positions inthe international economy.

On the European side, Germany is in acondition similar to that of China in termsof its current account surplus. Germanyhas a positive net export rate and a publicdebt rate close to the 60%of GNP.This is thereason why it has not needed to change itsexport led model. But Germany is not alonein the European scenario, being part of theEuropeanUnion andof the EuropeanMon-etary Union. In other words, Germany ispart of an integrated economic area, whereits economic policy is crucial for the eco-nomic and social stability of both Unions.As is well known, there are also the Mediter-ranean countries – Italy, Portugal, Spain,Greece – with high rates of public debt, thatare pushing Germany to adopt expansion-ary policies; this would imply increasinginternal demand and imports in order to al-leviate the recession in the eurozone, whichis cutting the growth perspectives of therest of the world, including the US.

So if China and Germany do not changetheir economic policy, increasing internaldemand and imports, the saving glut willcontinue, feeding the dangerous interna-tional imbalances, that have come fromunemployment and social disease every-where. The lesson that the crisis is deliver-ing to the world is simple: its end is linkedto the role of Germany and not only to Chi-na. If both countries want to give new fuelto the engine of Atlantic growth, they haveto reduce their saving glut, increase their in-ternal demand and imports, and give toother countries of the eurozone new Euro-pean financial instruments in order to re-duce their public debt more slowly. If theEuropean economy backs such shared de-cisions, the expectations of a positive newcycle of the world economy will start witha major strength, less biased by the imbal-ances that have stopped it in the begin-ning of this new century.

Increasing domestic demandand imports in China is oneway of kick-starting the worldeconomy. But in order to dothat, the conditions for saving,rather than spending, must bein place.

the two sides of the Atlantic Oceaneconomies, US and Europe.

To put the question raised by Bernankeinto perspective, it is important to remem-ber that China’s present rate of saving is es-timated to be at around 50% of its GNP, arate China has maintained since the earlyyears 2000. A large share of these savingshas been channelled to the US in search of“sure” investments in the international fi-nancial market. This happened with par-ticular vigor from the beginning of the2000s, as the Chinese Central Bank andother national authorities chose US Treas-ury bonds as a safe asset.This is how the UStwin deficits (government deficit and cur-rent account deficit) ended up being fi-nanced by Chinese savings. It was the sig-nal that the relationships between ad-vanced countries and emerging countrieswere changing deeply – an effect of rapidgrowth in China. As national Chinese au-thorities prevented the exchange rate ofChina’s national currency, the yuan, fromappreciating in spite of China’s large currentaccount surplus, this was and continues tobe the main source of the imbalances of theeconomic relations among China, US, andthe rest of the world. In terms of macro-economic arithmetic, the excess of Chinesesaving, the savings glut, accompanied bythe Chinese net export rate, guarantee theUS economy the external financial re-sources it needs to keep growing.

Government de!cit

Private sector surplus

Private surplus + China-Tigers* current surplus* Tigers:

Malaysia, Hong Kong, Korea, TaiwanSingapore, Philippines, Indonesia

Advanced countries:US, Canada, Japan, AustraliaWestern Europe

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michele bagella is a professor of economics at theUniversity of Rome Tor Vergata.

ADVANCED COUNTRIES FINANCIAL BALANCES

tio of 5.26%. Liquidity from low transaction costs andthe nonexistence or unattractiveness of other financialassets makes housing an appealing investment forChinese domestic investors. But by itself it does not ex-plain the seemingly irrational behavior of ignoring theopportunity of renting in order to maintain propertiesvacant.

Vacancy is high in China due to three major factors:no property taxes; low rental yields and a strong cul-tural preference to first usage rights. Most buyers con-sider that a used property has no special allure, andplaces that have been previously occupied can besteeply devalued by prospective buyers – there is evi-dence of a 50% premium for never-used properties.Since rental yields are low in China, around 2.66% peryear according to Global Property Guide – India has acomparably low rental yield, while Brazilian propertyowners get more than double the Chinese return onrenting – the rationale amongdomestic investors is thatthe devaluation that a rented property faces makeskeeping it vacant preferable. Given that there are noproperty taxes – in Brazil, for instance, these are paidby tenants – there is almost no incentive for owners toput vacant properties into the rental market.

One of the side effects of the vacant property dilem-ma is the lack of affordable housing in mainland Chi-na – a perennial problem resulting from migrants andlow-salaried workers facing trouble trying to live inexpensive urban areas. The scenario for the Chinesegovernment is a delicate one – toomuch regulation andthe market may collapse, not because of a bubble, butdue to its special place in Chinese families’ portfoliosand the composition of the GDP; too little regulation

A wall 5lled withcardboard notices fromvarious Chinesecompanies looking forworkers in Zhuji, eastChina’s Zhejiangprovince. Rapid wageincreases arethreatening China’scompetitiveness.

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longitude #26 - 111

Domestic markets

110 - longitude #26

China

markets, and the relevance of the real estate market tothe economy. Residential real estate investment ac-counts for roughly 6% of GDP in China, according toGK Dragonomics, while property construction in gen-eral represents 11% of GDP. Any abrupt change in theresidential property market can have far-reaching con-sequences for the Chinese economy as a whole, and itwould have a huge impact on domestic investors. Re-forms are forthcoming though, and the central gov-ernment, according to The Economist, is planning tocontinue boosting minimum wages, loosening con-trols on interest rates and increasing spending on ed-ucation and affordable housing.

Chinese family-owned firms face the same con-straints as other small and medium-sized companiesin developing countries – capital is scarce and there arenot many other sources of funds apart from reinvest-ed profits and the occasional commercial bank loan.

The paradox is that while banking loans are in-creasing dramatically, small companies are still strug-gling to find accessible capital. The link between fi-nancial and economic development is well established,but in the Chinese case economic development is hap-pening despite lagging financial markets.

and an American-style bubble may form that wouldcreate long-term havoc in the economy.The regulato-ry mood of the Chinese government depends on Chi-nese real estate data. As recently as early 2013 datasuggested a buoyant market, and the central govern-ment signaled tighter regulations. If the market coolsit would be expected that authorities would loosenregulations to improve market conditions. Long-termstructural reforms are supposedly coming. Some cities,like Shanghai and Chongqing, have been slowly settingup property taxes. However, as other financial marketsdevelop, demand can shift from property to more so-phisticated assets. This displacement effect would un-lock vast amounts of capital and would ease the longterm pressures on the housing market (responsiblefor 13% of China’s GDP). Also, property taxes would en-sure long term revenues for city government that stillreign in large amounts of revenue from sales of anever diminishing stock of land.

There are signs that financial markets are changingfor domestic and international investors in China. Asis usually the case, the Chinese government moves ata slow pace regarding structural market reforms, es-pecially given the delicate balance of Chinese financial

Commercial banks play such a large role in theeconomy that total deposits reached $12.8 trillion in2012. Even though households’ savings deposits havedeclined as a percentage of total deposits, the totalwas a staggering $5 trillion in 2012.

However, small and medium-sized enterprises(SME) continue to face a dearth of capital. Chineseentrepreneurs face an environment in which incom-plete financial markets allow entrepreneurs only twooptions: funding from their own families and rein-vested profits. The strong ownership culture and legaluncertainties result in companies that simply cannotfunction in the same way as companies in developedmarkets. If there is a bubble in the Chinese economy,it is a bubble of potential entrepreneurs and estab-lished SMEs that cannot find funding for new ven-tures, projects and firms.

The development of financial markets will bringtwo major changes to the Chinese economy: it will al-low domestic investors to diversify their portfolio andtherefore ease the pressure on the residential proper-ty market by stabilizing demand; and it will allow do-mestic entrepreneurs more access to capital. Chineseregulators have been slow in allowing the creation of

more sophisticated financial vehicles, but market pres-sures and the need for financial developmentwill even-tually take place and transform the economic land-scape of China. If the evolution of financial marketshappen more rapidly, the future should see the rise ofmany more small entrepreneurs and new financial ve-hicles that will make the transition to a services econ-omy smooth for China – maybe killing the inflatedmillion-dollar racing pigeons market on the way. Thereare already 43 million companies in China, 93% ofthem private, according The Economist, and mostwould benefit tremendously from cheaper and acces-sible capital.

The new migration in China is going to be a mi-gration of capital, from commercial banks to alterna-tive financial markets and, to some extent, to entre-preneurs and SMEs. One of the major keys to longterm economic prosperity will be the development offinancial markets, and if Chinese regulators allow, it cancome sooner rather than later.

rodrigo zeidan is a professor at Fundação Dom Cabral andNottinghamUniversity Business School, China

A woman outside aPudong real estateof5ce. For the past twoyears, China hassought to controlresidential propertyprices with measuresincluding restrictionson second and thirdhome purchases,higher minimum downpayments, and annualtaxes in some cities onmultiple and non-locally-owned homes.

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A customer browsing ina pawn shop inShanghai. China hassome of the biggestbanks in the world, butthey turned their backon small and mediumenterprises seekingloans.

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