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Monday, September 22, 2003

The Shankhai Dream Factory

Well, for my content starved readers, here's a piece from Andy Xie that should give plenty of food for thought.

Shanghai is China’s dream factory. Everyday, one can observe some progress in its march towards becoming a modern metropolis. Like Chicago in the 1920s or Hong Kong in the 1990s, its skyline is constantly changing. The Shanghai government recently announced that the city’s GDP grew by 10% in the first half of 2003 from last year, despite SARS, and that its per capita income (US$4,020 last year) has just surpassed Shenzhen’s, making it the richest city in China.

The throughput at its ports reached 5.2 million 20-foot equivalent units (TEU) in 1H03, almost surpassing the third-busiest port in the world, Busan, Korea. Over the weekend, the city commenced the construction of the world’s largest deepwater port at Little Yangshan Islands, which could reach capacity of 20 million TEU by 2020. The first phase of construction is scheduled to cost Rmb 14.3 billion (or US$1.73 billion), which involves the construction of a 31-km long bridge.

On the other hand, there are signs of rampant speculation and over-speculation. The city will likely complete over 20 million square meters of property development this year. The increase in property sales was equal to 34% of the increase in GDP between 1999 and 2002. The price for mass residential property has about doubled during the same period. I calculate that rental yields have declined from 8% to 4% in the past three years, due to a combination of price increases and rent declines.

I was wandering around Shanghai over the weekend, pondering the ‘bubble or miracle’ question. The former is a leverage-cum-capital inflow story. The latter is about productivity. There is clearly a huge leverage story in Shanghai. Loans extended by financial institutions grew by Rmb 355.3 billion or 2.6 times the GDP increase between 1999 and 2002. The same for China as a whole was 1.6 times. If we apply domestic credit as a better indicator of national leverage, the ratio was 2.7 times. Thus, Shanghai is at least as debt-driven as the country as a whole.

There is, however, an even greater capital inflow story. Deposits at Shanghai’s financial institutions increased by Rmb 555.6 billion or 1.5 times the loan increase during the same period. A dramatic decline in the loan/deposit ratio would cause sharp economic deterioration, unless the rise in deposits is due to capital inflows. This has been clearly the case. Shanghai’s surplus liquidity has been an important source of investment funds for the rest of the country. This is why Shanghai’s attractiveness to the international community is vital to China as a whole.

Foreign direct investment (FDI) into the Shanghai area has been impressive, increasing from US$3 billion in 1999 to US$5 billion in 2002. However, the increase cannot explain the extremely strong liquidity in Shanghai. Its surplus liquidity totaled US$25 billion during this period. Other types of capital must have been bigger than FDI. Property purchases by non-residents have been the main source of liquidity inflow, in my view.

Property sales in Shanghai reached Rmb 81 billion last year (or US$9.8 billion), equivalent to 15% of GDP, and could reach 16% of GDP this year. As land or resettlement costs exceed construction costs, property sales enrich both the Shanghai government and its residents. Non-resident buyers have been the dominant force in the luxury segment. I would not be surprised if one-third of the property sales are to non-residents. The property sector is, therefore, vital to Shanghai’s finances and its growth.

Thus, Shanghai’s liquidity boom depends on capital inflow. It looks quite similar to Hong Kong’s macro picture ten years ago. The obvious questions are: Who is pouring money into Shanghai? Do they have the capacity to sustain this investment? When will their objectives be met? And would this lead to declining capital inflows?

Purchases by non-residents are mostly for speculation, in my view. Taiwanese investors form the biggest group. We often observe that Taiwanese property investors in Shanghai flip flats to each other at rising prices. There are several reasons for the influx of Taiwanese money into Shanghai. The most important is the political instability in Taiwan -- it is no coincidence that Taiwanese money has poured into Shanghai since 2000.

The emergence of the Yangtze River Delta as a cheaper export base than the Pearl River Delta is the second reason. Taiwan’s electronics manufacturing services (EMS) companies have moved into the region on a massive scale in the last three years. Their staffs have settled in the region and found Shanghai a potential home. According to reports, half a million Taiwanese have settled in Shanghai.

Entrepreneurs from Zhejiang province have been the second source of demand for Shanghai’s properties. Many are speculators, in my view. They have also made their money from exports. Indeed, they have been targeting their Taiwanese competitors for market share. A Taiwanese businessman in the region complained to me over the weekend: “Zhejiang people cut prices like mad”. The Yangtze River Delta’s exports doubled to US$102 billion between 1999 and 2002 and increased by 45% YoY in the first five months of this year. The fruits of this export success have flowed into Shanghai’s property market, enriching its government and people beyond what they could earn in terms of productivity gains.
As capital inflows drive the city’s property market, property prices have become disconnected to income levels among the local population. I did a survey of eight taxi drivers in the city over the weekend and found their income was one dollar per hour with virtually no variance. A taxi driver usually works 60 hours per week, and his income is considered above average. A university graduate can expect 50-100% more per hour. A senior executive may make US$500 per month. The average selling price for mass market property is between US$500-600 per square meter. Thus, it appears that an overwhelming majority of people in Shanghai cannot afford property at today’s prices.

Shanghai’s per capita income numbers, however, suggest a higher income. Yet per capita income is misleading. Government revenue was 40.7% of GDP, of which about 70% went to the central government. Foreign businesses are probably taking a bite out of the city through income remittance. The money left for the local population is probably less than half of GDP. Shanghai thus is likely much poorer than what its GDP figures suggest.

The huge demand from local residents currently comes from people who have received resettlement payments that become their equity in purchasing a new property. A resettlement payment comes from a Taiwanese investor or Zhejiang entrepreneur who pays three times the mass market rate. The property game in Shanghai thus depends on other people’s money.

I am not suggesting that Shanghai is just a property bubble. There is clearly a productivity story. The urban design and management are among the best in the world, reflecting the high quality of local talent. An increasing number of multinational companies are choosing Shanghai as their headquarters in China. Shanghai’s physical infrastructure is playing the same role for the Yangtze River Delta as Hong Kong did for the Pearl River Delta a decade ago.

However, productivity gains in China do not necessarily translate into financial gains. Excessive competition always transforms productivity gains into lower prices that benefit consumers. Investment, hence, depends on borrowing money from savers who can cut their consumption cost and save more. The alternative is to attract capital inflows.

I heard Shanghai taxi drivers complaining that their competitors from Chongming -- an island at the mouth of the Yangtze River -- were accepting lower wages. We are not even talking about the hundreds of millions of people in Hunan, Sichuan or other poor provinces who have very little. Why shouldn’t they compete for the jobs in Shanghai, either through migration or the hollowing out of Shanghai’s manufacturing activity?

The absence of quantity constraints is another reason why GDP growth has not translated into property price rises. It seems difficult to believe, but Shanghai’s property prices today are at the same levels they were ten years ago. Of course, there was a substantial fall somewhere along the way. In Hong Kong, property prices rose faster than per capita income, because the government did not make land supply sensitive to price. Local government officials in China are judged by the physical progress in the areas under their control. When property prices rise, I believe it is a safe bet that they would increase land supply to mark out their accomplishments.

The logic for buying Shanghai property is that it is much cheaper than in other major metropolitan cities like London or New York. Property prices ultimately depend on the purchasing power of local people. As China’s wages tend to rise at a slower pace than GDP, it would be a long wait to achieve price convergence. The only way out in the meantime is to flip to another foreign investor.

For example, Hong Kong financial sector employees have bought up old houses that were built by western communities in the 1920-30s. They have managed to create a bubble entirely independent of others by flipping these properties to each other. “The same stuff costs four times as much in Chelsea” is the rallying cry for the charge into Shanghai’s rundown old houses.

I walked by just such a property over the weekend. It was under massive renovation. I estimated that someone had paid more than US$1 million for the place and was putting another half million dollars into renovating it. Right next door, a middle-aged man was selling watermelon out of a similar house. He probably makes one dollar per hour. Yes, I believe eventually there will be price convergence between London and Shanghai, but only after the original occupants of these houses have moved on.

I believe that Shanghai’s relative property value is less attractive now. It is always dangerous to compare properties in different cities, although as a native of Shanghai and a long-time resident of Hong Kong, I will make an attempt. Ceteris paribus, Hong Kong property was 20 times Shanghai’s in terms of price in the summer of 1997, but is now three times. But Hong Kong’s per capita wealth is more than ten times Shanghai’s. Yes, Shanghai is growing faster -- but how long will it take for Shanghai to close this wealth gap?
Source: Morgan Stanley Global Economic Forum

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