Huawei Quarantine Accelerates Tech ‘Balkanization’ Trend

“The three core issues of concern to China are the cancellation of all tariffs, that trade purchases be in line with reality, and that the text of the agreement be revised so as to be more balanced. These issues must be resolved. This trade friction has made us more aware that we have shortcomings in terms of economic structure, quality of development, and core technologies. [We must] enhance the sense of urgency in accelerating indigenous innovation and resolve the bottleneck imposed by insufficient mastery of core technologies. CCP Propaganda Department Commentary on the US confrontation in People’s Daily newspaper last Friday

We have regularly covered the rise of China’s tech sector over the past decade and the complacency in Silicon Valley which has only recently been shattered by Huawei’s threatened dominance of the global 5G rollout. The ‘balkanization’ trend already evident in software ecosystems from messaging to payments will now extend to hardware throughout the supply chain – there will be a China centric physical internet architecture over the next decade centred on Huawei as much as a software one around companies like Alibaba, Tencent and Bytedance with the big ‘neutral’ EM markets like India a key battleground.

In the near term, the notion that China can be quarantined as a technology supplier looks naïve – alternative vendors like Nokia and Ericsson make 5G hardware with Chinese partners in mainland factories for sale globally, leaving their equipment vulnerable to malicious tampering – will they have to relocate production to ‘safe’ locations to sell into the US? If so, the global rollout will be significantly delayed…

Huawei has been rapidly vertically integrating with its own chip making subsidiary, HiSilicon, producing highly advanced 5G designs, albeit fabricated (as for Apple and Google) by TSMC. As a Chinese tech VC contact told me in Shanghai last October, cut China off from TSMC and it would be casus belli like the Japanese oil embargo in 1940. If the US is serious about confronting China’s competitive threat on a sustained basis, it needs to boost government R&D spend on basic science (instead it’s been cut), deepen the capacity of domestic tech supply chains via education investment and targeted tax credits or cutting off broader Chinese access to advanced GPU chips and postgraduate student access to STEM courses at colleges such as MIT and Stanford. Those moves would be expensive and disruptive for the US economy and are still possible future steps if relations become even more antagonistic.

China offers uniquely low (marginal) consumer electronics assembly costs plus high-volume flexibility. You can never replicate the mainland factory dormitory model in the US or even Korea and Taiwan. The increasingly well educated rural migrants filling Foxconn factories are the ultimate ‘on demand’ workforce – manufacturing elsewhere would mean higher assembly costs/decreased flexibility thanks to the constraints of current generation assembly line robotics.

Even with high levels of automation, a fully US assembled iPhone would likely cost about 40% more at the factory gate (with Apple gross margins at ~37%, the current tariffs imply a price rise of about 15% to offset the impact, unless the RMB plunged toward 7.5 versus the USD). For instance, Quanta Computer, the largest laptop maker in the world with clients from Apple to Dell, warned last week that the logistical costs of shifting consumer electronics production out of China could prove as expensive as the tariffs themselves. 

Automation is part of the answer to offshoring from China but changes the business model – assembly by Chinese migrant workers is a marginal cost for a factory owner; robots are a fixed cost, although the assembly of an additional unit has zero marginal costs (excluding overheads like maintenance etc.). New AI software will help but it’s still expensive and time consuming to program factory robots to perform multiple tasks.

The implication of this shift from marginal to fixed costs is that there is a heavy incentive to stick with a specific design: any change requires significant capital investment to update the robotic assembly line – the flexibility of the entire consumer electronics sector will deteriorate, with higher inventories and fixed overheads once it loses China’s unique attributes as a global production base – given wafer thin margins, consumer prices will trend higher even if a face saving deal could avoid further tariffs.

Relocating the supply chain for smartphones or laptops will be hugely disruptive, wherever the destination and it certainly won’t be the US – the much-hyped Foxconn factory to make TV screens in Wisconsin has become a fiasco, despite $4bn in tax breaks and subsidies. The lack of a skilled manufacturing workforce will be a key constraint on US re-shoring, as much as logistics considerations – flying components in from Taiwan/S. Korea to assemble phones in the US makes little sense.

The effort to lobotomise Huawei looks ill thought out and will have generated intense lobbying by the most adversely impacted US suppliers – there will likely be some nuance in the implementation. However, the endgame is now clear and US tech companies will have to mitigate ongoing compliance risks by reducing exposure to Chinese SOEs. We’ve seen a few companies like Go-Pro begin relocation (to Mexico in this case), but this will now accelerate while China will race to become a ‘full stack’ technology power by mastering semiconductor fabrication and an indigenous mobile operating system.

In the case of both Iran and Huawei, the US has unilaterally exercised its global power over international bank payments systems and key technologies like the Android OS to exercise brute force geopolitical leverage – the lesson drawn by many in Europe and Asia is that alternative architectures are now needed. Ultimately, China which remains the only country apart from the US to understand the critical value of ‘platform’ software and is catching up rapidly in AI and quantum computing research, will become an even more formidable competitor to the US tech giants. The Xi 2025 plan, whose ambitions triggered panic in Washington from the Pentagon to Congress, will now be implemented sooner, by any and all means possible.


China Consumption Shifting From Property to Pensions…

One of the biggest issues for global investors over the next 3-5 years is that China may be running out of prospective home buyers as the prime household formation age cohort shrinks, creating a secular slowdown in a sector which directly generates 13-15% of GDP and in its wider spillover impact closer to 22-25%. Consumption in China doesn’t neatly fit the Western ‘life cycle’ model of neoclassical economics (e.g. housing tends to be bought in advance of marriage/household formation and left unfinished and empty until that point) but the structural demographic shift will transform housing demand as much as the shape of monetary and fiscal policy. Beijing’s efforts since 2015 to boost the birth-rate by easing restrictions on family size always looked likely to fail, given the ever-rising costs of child rearing and fertility trends across developed urban Asia.

Japan’s experience in recent decades indicates that when rapid growth begins to slow in an economy with very high corporate and household savings driving fixed investment, demand can prove extremely difficult to manage, particularly when demographic decline sets in simultaneously. This is particularly true if the deliberate promotion of credit growth and asset price bubbles has been part of the mechanism used to sustain demand. The tactical stance has been overweight China and AXJ despite still poor earnings and macro momentum but structural growth constraints are becoming binding as rising debt and declining demographics interact to radically change policy trade-offs, while the US is now intent on blocking or at least slowing significantly the technology upgrade path.

The real story behind China’s well documented economic imbalances is not just about structurally weak consumption versus investment as a share of GDP but also a large-scale net transfer of savings from abroad (and particularly the US) to the mainland corporate sector, a process which the White House, with broad bipartisan political support now seems committed to ending, whether a new trade deal is concluded or not. China’s plan to move up the value chain rapidly by ‘acquiring’ foreign IP to boost productivity as the workforce and investment intensity declines will now be much harder to achieve, even if it doesn’t in the worst case lose access to advanced semiconductor imports.

The country has an ongoing growth tailwind from urbanization (currently at 59% on official data, but by global standards likely 5-6 points higher), a remarkably advanced digital economy and payment systems, first world transport infrastructure in and between the major cities (and soon communication via 5G), and a growing number of globally competitive companies in mid-tech industrial and consumer markets. However, its economic dynamism will face a growing demographic drag as resource are diverted (whether public or private) to fund rising healthcare and pension costs.

Births last year dropped by 2m to 15.2m, and the median age will reach 48 by 2050, or about 10 years older than the US now. The total number of working-age adults (aged 16-59) fell by 0.44 % to just over 897m while the growth in the pool of rural migrant workers fell sharply, rising just 0.6% to 288m, down from 1.7% in 2017. The national old-age dependency ratio is already at 15%, and twice that in some depopulating peripheral provinces. The population on official data grew by 5.3m last year or 0.38% and Beijing has estimated that China’s population won’t peak until 2029 at around 1.44bn, but some demographers believe that tipping point has already arrived.

The ‘extensive’ growth model of adding more workers and capital becomes untenable as demographic decline starts. So too is the highly expansionary monetary policy that saw the PBoC balance sheet and M2/GDP ratio explode. That never generated much consumer inflation, as it was largely sterilised via housing which absorbed excess migrant labour and industrial capacity as a concrete inflation sink isn’t sustainable much longer. At the same time, the sterilisation of exporter dollar earnings and build-up of net foreign assets on the PBoC balance sheet and Treasury buying by SAFE is also winding down, as FX reserve growth peaks peak.

US demands to eliminate the bilateral deficit simply hasten the existing trend toward a current account deficit. Whatever the exact demographic glidepath, China is going to have to employ its human capital much more efficiently over the next couple of decades and refocus on intensive, productivity led growth. Global investors are going to have to adjust to the perpetual motion machine that drove global capital flows from the late 1990s not just stalling but going into reverse i.e. China will likely become a substantial net portfolio capital importer over the next decade, as it needs to fund soaring fiscal deficits, just as aging households begin running down savings…

With 12% more males than females in the 15-29 age cohort, having an apartment boosts prospects for marriage, and that factor as well as migrants buying properties to retire to in their home provinces helps explain much of the 45-50m ‘empty’ apartments that generate scare headlines. In China, housing has taken on the role of a ‘dowry’ for male offspring that gold has traditionally for female ones in India, but the 34m overall male surplus will rise and create a growing pool of involuntarily unmarried men (so-called “bare branches”). The home ownership rate among young Chinese households is consequently very high, thanks to help from parents who in a major city will have built up huge housing equity. Demographics will clearly begin to impact this cultural support for real estate, as the number of 20something males enters steep decline.

The 20-29 age cohort, the main source of new demand for housing, will have declined by about 80m by the mid-2020s from its peak in 2012/13 and the proportionate decline is similar for the teenage cohort behind them, slowing pre-emptive parental demand. A rising divorce rate and proportion of never married (in the case of many males, not by choice but economic circumstance) will offer some support to housing demand, but alongside a dramatic slowdown in migration, the overall fundamental demand picture will deteriorate materially.

Pension coverage is now relatively high for a country at China’s income level but the income generating assets to fund defined benefits are hugely inadequate and this is where boosting private assets and returns becomes critical to maintaining systemic solvency. The pension funding deficit covered by central government is likely to reach over $150bn annually by next year. Deeper capital markets (including ultimately access by foreign mutual funds with local distribution partners) supported by pension savings inflows are a key part of the wider reform agenda. Current contribution rates for state/SOE pensions are far too low; private pensions and employer annuities (i.e. the addressable market for the insurers) are just over a quarter of total assets with the basic pension/national social security fund comprising the balance.

That ratio will gradually shift over the next decade in favour of private assets – the public pension system’s 43% replacement rate (ratio of annual benefits to final salary) implies a significant cash flow deficit will open up that could amount to over $1.5trn within a decade. Insurers will be a key part of the funding solution – weak capital markets and regulatory changes slowing premium growth have been a drag but they remain a key China exposure as inadequate social provision, from healthcare to pensions, is funded directly by individuals.

Total pension assets are just over 10% of GDP compared to 35% in Korea and HK. Assets will have to grow dramatically over the next decade to close the funding gap and the private share of total pension assets (currently sub 30%) will become dominant. Beijing already has the fallout from local government deleveraging and SOE restructuring to absorb which will see central government debt/GDP double to 70-80% over the next 3-5 years from the currently reported 37% – bailing out the pension system as well simply isn’t realistic. Assets managed by Chinese insurers have already reached over $2.6trn, even as new policy premium sales have slowed since 2016.   Solvency rules are now closer to international norms – capital requirements had been based on simple metrics of size but will now vary in line with how quickly policies turn over and how premiums are invested. Firms that rely excessively on short duration policies or invest heavily in equities must hold a much bigger capital cushion.

The slide in bond yields and A-shares has inevitably hit investment returns (as evidenced by the recent China Life profit warning), but offsetting this is an improving competitive landscape. The restrictions on wealth management product issuance (bank WMPs were offering yields of about 5.4% a year ago versus an average guaranteed rate offered by universal insurance products 30-70 bps lower) has seen retail investors return to insurers. Even with foreign firms likely to grow their share from the current low 5% base as the market opens, investors seem too bearish on life insurer growth prospects, with the key stocks on sub 1x price to embedded value multiples. As with education, investors in the asset gathering/private pension theme have to see through regulatory volatility to focus on the secular tailwind for revenue growth.

Cyclical Bet Remains Attractive…

‘I would overweight MSCI China in a GEM portfolio, and particularly H-shares. Deep cyclicals in China remain favoured on growing evidence of a fixed investment recovery. That backdrop would force side-lined investors, as yet unconvinced by the sustainability of the Q1 rally, to reallocate. From a technically driven repositioning rally, the next leg globally would see a shift to a positive net earnings revision trend and multiple expansion.’ Weekly Insight, 12th April

That unfashionable cyclical bet has paid off but while the RMB proxy short via H-shares (particularly banks) has been much reduced over the summer, global funds are still underweight offshore China by almost 300bps, near a decade high. A key theme is that you have to ‘reality check’ economic data points more than ever in the current environment of rapid structural change and low amplitude trend growth that leaves Japan and Europe repeatedly on the cusp of apparent recession.

That’s even truer in a global economy where incremental growth is digitizing and the global economy is becoming ‘lighter’; it is significant that services added more to global trade growth than manufacturing last year for the first time ever. The standard macro data points used by consensus analysis are increasingly misleading and as Silicon Valley giants start employing large teams of PhD economists, it seems clear that the web giants now have a uniquely powerful perspective on economic data flow from ‘live’ consumer prices to merchandise inventory levels. Investors will likely be buying proprietary data packages from Amazon, Google etc. within a few years that are far more powerful than anything Wall Street can offer (the ‘billion prices’ project at MIT is an early view of the potential of big data and real-time online transaction networks).

There are now hundreds of data releases every week that didn’t even exist a decade ago, with dozens of bank economists commenting on almost every one, but little of that activity is of any practical help in generating actionable insight.  Back in Q1, scanning the outlook statements from key global cyclicals would have reassured any investor paralyzed by ‘sell everything’ headlines from excitable IB strategists. The granular corporate evidence has been more reliable than economist extrapolations all year and remains broadly encouraging.

As for China, Komatsu has seen a 10% rise in excavator utilization hours, the seventh consecutive month of growth. I spoke to a client recently who had attended a major tech conference in Taiwan and thought confidence among companies he met was at levels he had rarely seen over the past decade. To do this job, you need to have an analytical telescope and microscope and most importantly know when to switch between them.

Growth, inflation and earnings expectations are all turning modestly but decisively higher. That  more than central bank actions will generate volatility near-term as complacent bond investors front running central bank buying reposition for a less pessimistic economic outlook. It’s also clear that even central bankers are accepting that monetary policy is at the limits of both creativity and effectiveness, and as Harvard’s Larry Summers has recently argued, fiscal policy focused on infrastructure spending now looks a more rational policy response. By boosting the velocity of money in the real economy, that would be inherently more inflationary medium term than endless monetary stimulus that ex asset inflation effects simply gets trapped in bank excess reserves.

While recent US data has been mixed in housing etc., historically low level of combined debt service and energy outlays at just 14% of disposable income are offsetting soft wage growth, while balance sheets and net worth continue to improve. We have seen some slowing in growth in corporate bank borrowing as more companies tap booming credit markets, but the slowing in corporate bank loans has been offset by an acceleration in real estate and consumer lending.

An interesting lead-indicator granular data point is the Chemical Activity Barometer, published monthly by the American Chemistry Council, up 3.9% y/y recently and suggesting that US industrial production will accelerate into early 2017 now that the energy/inventory adjustment drags are abating. The biggest surprise to a consensus still suffering ‘macro hypochondria’ would be a synchronised cyclical growth rebound over the next 3-6mths and our overweight cyclical risk asset strategy since Q1 remains in place.

‘Peak Pessimism’ on China and EM Suggests Q4 Rebound…

The narrative of slowing global growth, rising deflation pressures and monetary impotence to do much about it remains dominant in markets – that’s reflected in very bearish positioning among global asset allocators on most survey evidence and certainly conversations we’ve had. Back in our last blog post on the risks to emerging markets at end July, we concluded that: ‘While the modest recovery in Europe and Japan looks sustainable, a full blown EM crisis would be a global deflationary shock, particularly if associated with an RMB devaluation. The PBoC is now fighting deleveraging risks/propping up asset collateral values on so many fronts, from the ever growing local government debt swap to the attempt to stabilise collapsing A-shares, that something will have to give…’

Our view since last year was that the RMB’s real effective appreciation against EM peers was unsustainable and likely to reverse with a target of 6.8 versus the USD by end 2016. The ‘shock’ RMB depreciation move in August deepened anxiety about the scale of China’s slowdown and the credibility of policy makers to deal with it. The poorly managed and communicated FX shift, like the preceding stock market intervention, indicates that Beijing’s clever and largely US educated technocrats face a steep learning curve in managing capital market expectations.

The subsequent collapse in commodity and resource stock prices looks more reflective of a 20% RMB fall versus the dollar rather than a 2% one. After the worst quarter in several years across global markets from high yield US debt to Japanese equities, will a degree of stability in China boost risk appetite in Q4? Recent measures to restrict capital outflows have seen the CNH/CNY rates converge and volatility subside, while the margin debt deleveraging process for A-shares now looks complete. The slowdown in China led by investment/heavy industrial activity has long looked inevitable and is ultimately healthy; the services sector is likely being systematically underestimated (possibly by upward of $1trn) given the Soviet style ‘count the bricks’ GDP methodology – whatever you believe ‘true’ GDP growth to have been this summer, with a fast improving property market and recent stimulus measures, momentum should be soon improving from that cyclical nadir.

From a  tactical perspective at least, we’re likely approaching ‘peak pessimism’ for both EM and commodities – negative sentiment and flows for both have been driven by deepening China fears. Even slightly better China data through year-end after the concerted fiscal and monetary stimulus of recent months would lead to stabilizing commodity prices and hence EM currencies; that would trigger a resumption of carry trade inflows as well as equity fund net flows turning positive. Turkey and Brazil remain high risk given political uncertainty, high bank sector loan to deposit ratios and weak net international investment positions (-50% of GDP in Turkey’s case). Real rates in Brazil are already touching 5% and further rate hikes to support the real would push the economy into an even deeper recession next year and drive a surge in corporate defaults.

However, EM Asia looks attractive after the summer selloff; the MSCI AXJ is now on just 11x forward earnings, and while net earnings revisions remain net negative, the pace of downgrades is abating – HK listed H-shares, Taiwan and Korea look likely to outperform if broader sentiment rebounds and unusually high levels of institutional cash are deployed. So does Japan, which despite the softening economy raising deflation risks remains attractive on the multi-year bottom up corporate governance/payout ratio theme. The odds on further BOJ intervention are rising, likely focused on equity ETF and REIT buying given liquidity issues in the JGB market. Overall, improved cyclical macro news flow from China remains key to a rally across global markets into year end and should be imminent, even if the huge structural challenge of deleveraging and rationalizing the SOE sector remains…

China’s Deflating Housing Market Inflating Mainland Stocks…

The spectacular A-share rally which has made mainland equities the best performing major global market over the past year and YTD derives not only from historically low starting valuations (the rationale for our overweight stance a year ago and since), but also diverted real estate flows. The ongoing anti-corruption campaign and sustained overbuilding have depressed long booming housing prices (down 5.5% y/y in February, with sales down almost 18%). Most analysis on China focuses erroneously on GDP and earnings momentum as the equity market driver as it would be in a normal economy, when within China’s hybrid structure the allocation of household capital flows is far more important. Indeed, the inverse correlation between Chinese equities and the housing market has long been evident, given the absence of liquid alternative investment opportunities for wealthy Chinese households (the wealthiest 1% of households own at least 30% of all residential property, while there are about 2.5m USD millionaire households in China).

Easing monetary policy, looming SOE reform, the perception that the 1trn RMB debt swap between local government and Beijing is a form of de facto QE and the further deterioration of the housing market in Q1 have all helped drive the CSI 300 above 4,000. The rally has until recently had official media sanction, as it helped offset the tightening of financial conditions via the RMB’s rapid real appreciation (and a trading band widening remains likely this year) and still rising real borrowing costs as producer price deflation intensifies, against the backdrop of vast excess capacity in fixed investment related sectors.  

There are now clear signs of speculative froth as reflected in margin debt surging by over 1.5% of GDP since late summer (and margin trading comprises about 20% of daily volumes regularly exceeding 1trn RMB), record first week rallies for recent IPOs and A-share trading account openings total a remarkable 2.8m for the past couple of weeks – overall valuations have reached about 18x forward earnings for the large cap CSI 300, on a par with the S&P 500 but small cap valuations are have soared to 60-70x.

From a 10% discount last summer, A-shares are now on a near record 35% premium versus HK listed H-shares. Back in December, I suggested another 15-20% rally was feasible in mainland shares this year; H-shares on 8x 2016 consensus EPS and 25% average discounts to dual listed mainland peers are now the preferred China exposure, and the difference between this episode and 2007 is the rise of aggressive domestic hedge funds to both exploit and eventually counter the retail mob. They have already generated volatility in global commodity markets like copper and can now short the A-share market via futures and via the HK connect scheme take advantage of the huge ‘free lunch’ cross border arbitrage opportunity which was clear in the opposite direction last summer. As well as H-shares, the broader MSCI China looks set to play catch up with the huge move in mainland equities, even as the latter enter a more volatile period in Q2…

Tech Driven ‘Creative Destruction’ Remains Key Global Trend…

‘Admittedly, during the First and Second Industrial Revolutions the magnitude of the destructive component of innovation was probably small compared to the net value added to employment, NNP or to welfare. However, we conjecture that recently the new technologies are often creating products which are close substitutes for the ones they replace whose value depreciates substantially in the process of destruction.’ New NBER paper on the latest wave of technology driven ‘creative destruction’

Academic economists are beginning to wake up to the macro implications of the accelerating digitization and dematerialization of the global economy, which has been a key structural theme both in terms of its impact on interest rates, inflation etc. but also portfolio weightings – earnings power across many established sectors will be destroyed by new entrants, who will see earnings explode even as they offer services at a fraction of the cost of incumbents e.g. instant messaging versus SMS revenues. The point the study is making is that unlike previous disruptive cycles (the industrial revolution from the mid-19th century, the first IT revolution from the 1970s) much of this mobile/cloud based service innovation destroys value within the overall economy to the extent that there is a net loss of profits, jobs etc., a topic I’ve covered recently in notes looking at deep automation/robotics and the sharing economy trend. However, one thing I’d note is that nearly every tech innovation of recent years from instant messaging to social media has been initially dismissed as trivial, but that ignores the huge impact of rapidly scaling network effects in creating utility for consumers and market value for investors. The value of LinkedIn or WeChat to users lies in the critical mass of peers they offer access to and the value to investors is the near zero marginal cost of adding new users. There are certainly too many mobile messaging services and the sector in aggregate is overvalued, as highlighted in previous notes, but the opportunity for the winners to take revenue from the established offline media and financial services sectors remains compelling. Against this secular backdrop, the NASDAQ Internet Index hasn’t quite regained its March peak but is 20% above the low set in early May after a brutal selloff as momentum positions unwound; the US Biotech Index, which led the momentum stock selloff in Q2, has broken out to a marginal new high and is up almost 30% from its mid-April low. Analysts have been upgrading their earnings estimates for the Biotech sector, with earnings now expected to rise almost 40% this year.

Meantime, Facebook, Google, and Twitter all reported above consensus results for Q2 and forward earnings for the internet sector have risen to a new record with about 20% compound earnings growth expected across the sector over the next few years. Chinese web stocks have generally continued to beat expectations from Tencent to Alibaba, the former driven by mobile gaming leveraging the 350m WeChat user base and the latter by mobile e-commerce, with active users up to 188m in Q2 and mobile up to almost 33% of gross sales volume. I noted in the 10th September note last year on the sector that: ‘China’s combined dominance as a smartphone market and manufacturing base has very bullish implications for domestic web software and service companies. For software companies from Google to Microsoft, smartphones are simply the platform for profitable content delivery. The value of content consumed on Android devices will explode in the coming years, starting with ‘in -app’ click through purchases in games and ads viewed while browsing, but smartphones will become the terminal of choice for e-commerce and the decision point for offline retail purchases too.’ Alibaba’s float is likely to drive volatility in smaller Asian tech sector names as portfolios reposition to fund their allocation, particularly as the internet sector has regained its Q2 losses, but it’s hard to see Alibaba generating the 13x 10-year returns of Google which was a very misunderstood business model at its $95 IPO price. For non-benchmark huggers, there will be a tactical trading opportunity in the wider Chinese tech ecosystem over the next couple of months – the secular outlook for the digitization of the Chinese and other EM economies remains very bullish. On that note the more modest but still multibillion float of e-commerce start-up incubator Rocket Internet bears watching. It’s an odd company which has been accused of ‘cloning’ established online business models, with its hugely well-funded operations led by former management consultants rather than entrepreneurs and little of the typical Silicon Valley start-up culture. Nonetheless, it has established leading positions in e-commerce markets across ASEAN, which ex Singapore are several years behind China in terms of development but will catch up rapidly as smartphone penetration rates rise and mobile payment systems mature.

Chinese Housing Market Risks Subsiding…

Whenever I walk around a Chinese city, I’m struck by how poor the finish can be on ‘luxury lifestyle’ new developments of bare shell flats which rarely match up to the billboard images of foreign sophistication. A key issue is that with no national building code, the quality of construction is generally very poor and sometimes downright dangerous compared to HK or Singapore (thin floor plates with exposed rebar, disconnected sprinkler systems etc.) and the depreciation rate will be far more rapid. There have been numerous cases of new towers subsiding into the ground soon after construction, and the same is now happening to prices in several markets. Average new home prices in China’s 70 major cities rose 7.7% y/y in March, slowing from 8.7% in February but activity and prices are slumping in some second and third tier regional cities.

For instance, although national home sales declined 7.7% in Q1, in the weaker provincial markets they collapsed e.g. -38% in Hangzhou, -25% in Wuxi, reflected in developers slashing prices to sustain cash flows, a trend I highlighted in a note last month. Indeed local media have reported that the cities of Changsha, Hangzhou and Ningbo have been openly discouraging property developers from cutting prices further. The coastal city of Wenzhou, which saw an SME liquidity crisis, and Ordos in Inner Mongolia where coal mining profits spawned a well-publicised boom of empty towers have seen their property markets hardest hit by the shift in sentiment. In Hangzhou (home city of Alibaba), the average selling price for residential units in the downtown area is down by over 11% y/y while as of March, 76,004 residential housing units were available for sale, an annual increase of 36%.
<New property construction starts fell 25.2% y/y to 291m square meters (the lowest quarterly amount of new floor space started since Q1 2009).

Urban real estate investment accounts for more than 10% of GDP, so ongoing weakness in the property sector would be a drag on H2 GDP growth. Some degree of policy loosening has already begun, with a few of the worst hit cities discussing removing curbs on property purchases but the key remains to boost supply of low-income rental housing (with a 7m unit public housing target this year, and 4.8m completions – the latter is actually over 600,000 fewer than last year) and accelerate the property introduction (being piloted in Shanghai and Chongqing) to curb speculative hoarding and expand the local tax base. Low income housing only accounted for 13% of total real estate investment last year (or 2% of GDP), so it can’t offset weaker trends in the wider market – the focus in any case seems to be on renovating existing 1950s/60s shantytown flats rather than Greenfield new build.

Beijing and other Tier 1 cities remain resilient although momentum is slowing; developers remain aggressive buyers with the total value of YTD land sales in Beijing reaching 102bn RMB as of last week, a level not seen until late September last year and even allowing for a moderation, the total is likely to exceed 200bn RMB this year for the first time. Meantime, commercial property investment also seems to be stalling after a huge rise in values (e.g. prime office space up 65% in Shanghai in the past 4 years, with gross yields sub 6% and flat to falling). I think indoor shopping malls (of which the country has 2,500 and still rising) remain the most egregious example of real estate over-investment and looming write-offs now that the online share of retail sales has reached 10%. At the moment the risks of a property crash look more regional than systemic, but contagion risks to Tier 1 cities bear close watching in coming months. In the meantime, with China’s total foreign debt at only about 9% of GDP and export demand still sluggish, the RMB will continue to take the growth strain.