Jonathan Anderson

jonathan@emadvisorsgroup.com
December 2, 2012

How To Think About China

(Part 3)

Introduction and Summary

Part 1 Lies, Damn Lies and Statistics
Part 2 State, Market ... or What?

Part 3 The Most Important Sector in the Universe

Part 4 Banks, Shadow Banks, Debt and Delevering
Part 5 Yesterdays Big Obsession: Rebalancing
Part 6 Todays Big Obsession: Financial Repression
Part 7 Back to Obscurity for the Renminbi
Part 8 The Aging of China
Part 9 Commodities, Food and the Next Decade
Part 10 How To Understand Macro Policy

Jonathan Anderson
December 2, 2012

Introduction and summary

We open this third installment of the How to Think About China series with a provocative question: What is
the single most important sector in the entire global economy, in terms of its impact on the rest of the
world?
There are plenty of candidates, of course. In years past the proper response would almost certainly have
been US financials and/or US housing. At the moment theres a very good case for European sovereign debt,
and perhaps even such out-of-the-box choices as shale gas or new agricultural technologies.
However, when all is said and done we believe there is one sector that has overwhelming credentials for
laying claim to the title: Chinese property.
Why Chinese property? Why? Because this is much more than just an argument over high-end prices in
Shanghai, new policies on social housing, amusing internet pictures of ghost cities or even a view on listed
developers.
Rather, as we will show, real estate and housing construction pervade the entire mainland growth model.
They are by far the most important determinant of commodity demand, a very big marginal driver of Chinas
external surpluses, and indeed a crucial key to real understanding of household balance sheets, saving and
investment behavior and the debate around Chinese rebalancing.
In other words (and without any exaggeration, really), if you dont understand Chinese property you dont
understand China.
The purpose of this report is to address four issues:
Just how big is it? In the first section we go through all the key numbers. Between 2000 and 2011 the size of
housing, property and overall construction skyrocketed by nearly 10 percentage points as a share of GDP,
emerging as the key factor behind Chinas sustained double-digit growth. Despite the common belief that
China is about infrastructure and exports, property alone accounts for an overwhelming share of the rising
mainland investment share over the past decade. It also accounts for nearly the entire decline in household
consumption (i.e., rather than any supposed increase in desired monetary saving).
Property trends single-handedly drive demand for autos, home appliances and construction materials.
Directly and indirectly, the sector consumes almost two-thirds of all the steel used in the economy, a
significant portion of electricity production and a decent chunk of heavy machinery. In this light, it also helps
explain to a surprising degree the swings in Chinas trade balance since the early 2000s.
How did this happen? How did property suddenly become the biggest sector in China? In the second section
we outline the following conclusions:
First, when we talk about property in China were really talking about residential housing, which comprises
the vast bulk of property and building activity.
Second, the fundamental catalyst for the residential boom was the sudden creation of the housing market
itself, through the mass privatization of urban housing in the late 1990s and the inception of mortgage
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December 2, 2012

finance and real estate developers as an active class. This coincided with a period of strong upswing in
corporate profits and household incomes at the beginning of the last decade.
Third, the need for modernization and re-zoning of traditional socialist cities played a huge role, as growth
demanded clearance of old dilapidated flats and factories on prime central urban land in order to create
modern commercial, financial, hotel and luxury districts.
Fourth, its highly unlikely that the boom would have been possible without Chinas unique blend of
authoritarian disregard for farmers land rights and urban residents wishes to remain in existing housing, on
the one hand, and the ability to appeal strongly to commercial profit motives as well.
And we cant conclude without mentioning the desire of the new middle and upper classes to hold their
wealth in something other than fixed-interest banking deposits, which has had a particular impact in the
most liquid first-tier investment markets.
Is it a bubble? Section three addresses the all-important question of a Chinese property bubble. And despite
recurring cyclical concerns about overheating in the luxury sector over the past years, our answer is that the
nationwide market is clearly not a bubble, in the sense of facing a serious risk of near-term collapse.
Why? Because nationwide prices have not risen relative to urban incomes since the inception of the boom
nearly 12 years ago. And while top-end investment-grade prices clearly have indeed, very significantly
they are still a small part of the overall Chinese market (and equally important, even those prices have not
risen significantly relative to urban wealth).
Of course absolute price/income ratios look high relative to developed-country norms, but those norms are
not very useful in analyzing emerging property markets. And Chinas indicators do not look wildly unusual by
low-income EM standards.
Next, household leverage ratios are low regardless of how you define them, which helps explain why the
residential market has been so quick to recover over the past two quarters even with mild policy easing.
And finally, while there has clearly been very significant excess leverage taken up by local government
development and construction vehicles (the biggest borrowers in the 2009 stimulus boom), those excesses
have not translated into massive oversupply in the physical market. Instead, they have simply translated
directly back to non-performing assets in the banking system as projects were cut off or delayed in mid-cycle.
And as we will show in Part 4, banks have a surprisingly easy time dealing with the resulting bad debt.
Where to from here? So no collapse ahead. But does that mean another decade of exuberant double-digit
construction and steel demand growth?
Clearly not, in our view. Even without things falling apart in a heap, there are plenty of reasons to look for
much slower property growth or even perhaps flat indicators outright over the coming 3-5 years.
To begin with, that unique Chinese model we mentioned earlier, the one that contributed so much to the
secular boom, has already undergone deep changes. In todays environment it is far more difficult to extract
agricultural land, provide huge implied subsidies to developers and blithely clear square kilometers of urban
space.

Jonathan Anderson
December 2, 2012

Policy priorities are also changing, towards (i) slower growth at the macro level, (ii) prudential back-stopping
of bank balance sheets in the aftermath of the post-crisis binge and (ii) a firmer anti-speculative stance in
housing markets,; as a result, we dont expect significant further easing of monetary or regulatory restrictions
from here.
And the big shift to lower-end social housing, which more than anything embodies the hopes of those
looking for another fantastic property decade, is still an untested theme with plenty of room for mistakes and
missteps along the way; we would have serious reservations about taking a strong bullish view on
construction, materials and overall growth base on this issue alone.

Jonathan Anderson
December 2, 2012

1. The most important sector in the universe

Investment-led ... or housing-led?
If you want to see the importance of property to Chinas overall growth model, theres no better place to
start than the most well-known macro statistic of all.
As nearly every investor knows, the gross investment share of the mainland economy has risen dramatically
over the past decade, to a stunning 48% of GDP as of last year. This is an absolute record for any economy of
significant size in the post-war era, and almost single-handedly explains Chinas explosive real growth over
the same period.
Where did all the spending go? More often than not, broker reports will focus on huge capacity investments
in heavy industry, in infrastructure projects such as roads and bridges or in export manufacturing.
To some extent this is true, of course but looking at Chart 1 below it is not the main story. Not even close.
In fact, the overwhelmingly largest contributor to the trend increase in the investment ratio has been
property construction, which rose from 6% of GDP on average during the 1990s to nearly 14% of GDP last
year. 1
Chart 1. Where the investment went
Share of GDP (%)
60%

Overall investment
Excluding residential construction
Excluding all property construction

50%

40%

30%

20%

10%
1990

1995

2000

2005

2010

By contrast, while capital investment ex-property (the blue line in the chart) has seen a gradual upturn from
the early 2000s trough, it is no higher today than the 1990s average.
And when we talk about property construction in China, what we really mean is residential housing
construction; as shown in the chart, housing has accounted for more than 75% of total real estate investment
and building completions by value over the past few years.

We measure the property share of investment using the average of (i) directly reported real estate investment and (i) the value of
annual completions.

Jonathan Anderson
December 2, 2012

So while its not a mistake to say that China is an investment-led economy, it doesnt really capture whats
going on. Rather, China is a housing-led economy.
I.e., forget about all those mental snapshots of export factories, high-speed rail lines or shipping yards. For a
true conceptualization of what drives the mainland, the picture you want is one giant construction site.
Where the commodities go. And nowhere is this more important than for Chinese heavy industrial and
commodity demand, as you can see immediately from the relationship between real estate construction,
auto sales and domestic steel consumption in Chart 2. The lines in the chart are not just close they are
virtually identical, following each other on a one-to-one basis through the construction recession in 2004-05,
the tightening and easing cycles of 2005-07, the housing collapse of 2008, the stimulus-led recovery of 200910 and the renewed slump of the past two years.
Chart 2. Property, autos and steel
Growth rate (% y/y 3mma)
100%
80%

Steel product consumption

Auto sales
Property activity

60%

Chart 3. Steel production and electricity

Growth rate (% y/y 3mma)
Growth rate (% y/y 3mma)
50%
35%
Steel product production
30%
Electricity production (RH scale)
40%
25%
30%

20%
15%

20%

10%

40%
10%
20%

5%
0%

0%

0%

-10%

-20%

-20%
01 02 03 04 05 06 07 08 09 10 11 12

-5%
-10%
-15%
01 02 03 04 05 06 07 08 09 10 11 12

Steel and other basic materials, in turn, are the largest industrial users of electricity ... which leads to another
nearly identical relationship in Chart 3.
Why so close? Heres one more chart to consider (Chart 4 below).
As you can see, housing construction alone accounts for nearly 40% of overall Chinese steel usage, and other
property construction demand brings the figure close to 50%. Add in autos (which, again, directly follow new
housing purchases in China) and home appliances and the share rises to 60% ... and thats before we consider
the portion of other infrastructure construction related to property development, or investment in new steel
capacity itself to support this demand. All told, we estimate that two-thirds of total steel usage in the
mainland is driven in one way or another by property demand.

Jonathan Anderson
December 2, 2012

Chart 4. Steel consumption by sector

China annual domestic steel usage, 2011
Housing
39%

Other
14%

Other
constructio
n
9%

Machinery
17%
Infrastructu
re
13%

Auto
6%
Home
appliance
2%

Taking this line of argument through the upstream supply chain, we end up with a long list of goods steel
and other metals, cement, iron ore, thermal and metallurgical coal, auto parts, construction equipment,
power-generation machinery, etc. that depend very heavily indeed on property and housing. So again, if
you get the Chinese real estate call right, you automatically get the commodity and industrial view as well.
Whatever happened to infrastructure? Now, if you look back at the above charts you may notice that theres
something, well, missing from the picture. To whit, what happened to all the fiscal infrastructure spending we
keep hearing about?
Mind you, total infrastructure construction is not exactly tiny; it accounts for 13% of Chinese steel
consumption in Chart 4 above. But if you strip out the property-related stuff, i.e., building of suburban roads,
sewage, subways and urban transport, and just focus on big-ticket areas like rail, highways, waterways,
airports, etc., suddenly were talking about well under 10% of total usage. Which is, quite frankly, small
enough not to matter.
You can see the same point in Chart 2. When China announced big stimulus packages in 2008-09, the
financial headlines focused almost exclusively on the national infrastructure build but if you look at the
relationship between steel and property activity in the chart, the message is very clear: the overwhelming
driver of commodity and industrial recovery in the stimulus era was the massive resurgence in property
markets. With almost no evidence of a strong independent role for unrelated infrastructure spending.
But what about all those local government window financing vehicles that were created to finance quasifiscal projects. Didnt they account for the lions share of new credit given out during the 2009-10 lending
binge?
Yes but when we look at what those local financing vehicles actually do on the ground, the inevitable
answer is a lot of property development This comes in the form of social policy housing, commercial and
administrative building construction, clearance and resettlement for urban renewal and transport and a
number of other areas.
In short, however you want to look at it we still come back to property.
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December 2, 2012

The real consumer boom

This is just as glaringly true when we turn to Chinese households and consumer spending patterns.
Investors everywhere are intimately familiar with the yellow line in Chart 5, the one that shows the collapse
of household consumption as a share of GDP, from 46% in 1995 to only 35% today. And needless to say, this
picture has single-handedly generated an entire cottage industry of breathless warnings and policy proposals
on how to get consumers spending again.
Chart 5. Where household spending goes
Share of GDP (%)
75%

65%

Disposable household income

Household consumption
Total spending including housing purchases

55%

45%

35%

25%
1990

1995

2000

2005

2010

The trouble is, everyone is looking at the wrong line. The yellow line shows what households are spending on
non-durable goods ... but it has nothing to do with total household expenditure. For the latter concept, we
need to add in what Chinese residents are spending on housing. Which is what we have done in the red line
above. 2
What does the red line tell us? It tells us that total household outlays, including consumption as well as
purchases of residential property, has not fallen at all over the past two decades. It was 47% of GDP in 1995
and is 47% of GDP today.
Let us repeat this phrase for emphasis: total household spending has not fallen at all as a share of GDP. As it
turns out, Chinese consumers are spending at a rapid clip theyre just spending less of their incomes on
non-durable goods and more of their incomes on property, full stop. And this is a completely different
phenomenon than the one you normally read about.
(The astute reader will protest that this chart is a bit misleading, since it covers household income and
spending for the entire population whereas the market housing statistics we are using are really just for the
2

The first reaction from readers when they look at Chart 5 is to accuse us of trying to redefine consumption to include housing, an
item that very clearly belongs in the investment accounts. Nothing could be further from the truth; we understand very well the
difference between consumption and housing investment.
Rather, our point is different. You can only make sense of the claim that Chinese consumers are not spending if you look at, duh,
total household spending, which includes not only household consumption outlays but also household investment outlays on
residential property. And when we do, again, we find that Chinese households are already spending at a full tilt.

Jonathan Anderson
December 2, 2012

urban economy, and the buyers are almost exclusively middle- and upper-income urbanites. This point is
absolutely correct, and we will address it further below.)

Property and external surpluses

As a final note, we also want to stress the role that construction and property has played in the biggest
historical source of friction between China and its trading partners, i.e., its frustratingly high trade surpluses
over the past decade.
Well discuss external issues in greater detail in Part 5 of this series, but the main point is that almost the
entire epoch-making increase in Chinas trade balance between 2004-07 came from heavy industrial sectors
like metals, transport equipment and general machinery, which saw a wrenching shift from net imports to
net exports on the order of 6% of GDP despite the fact that these categories account for less than a quarter
of total mainland merchandise trade value. By contrast, the remaining portions of Chinese external trade
were far more stable over the same period.
And perhaps the single best poster child for rising imbalances was steel itself; ferrous metal and metal
products alone accounted for one-quarter of the total trade swing, and for most of the past decade monthly
swings in mainland net steel exports have nonetheless tracked the overall movement in the current account
balance very closely indeed.
So where does housing and property come in? Once again, the one thing that ties steel, other metals and
materials, autos and vehicle parts and a decent swathe of basic machinery together is their heavy
dependence on property construction and home purchases. The first wave of Chinas property boom in 200203 kicked off a well-documented frenzy of productive capacity creation in cement, steel, autos, related parts
and other heavy industries, capacity that began to come on line just in time for Chinas first painful domestic
construction downturn in 2004-05, which was exactly when the mainland became a net exporter in almost all
of these sectors.
As a result, there is a very strong inverse correlation between the ups and downs of Chinas construction
cycle and those of the external balance and one of the key conclusions of Part 5 is that Chinese external
rebalancing is in large part a tug-of-war between (i) capacity creation in sectors that supply into housing and
real estate construction, and (ii) the pace of housing and real estate construction demand.
Once again, its about property.

Jonathan Anderson
December 2, 2012

2. How did this happen?

By now you should have a very good sense of why we call Chinese property the most important sector in the
universe.
But how did it get this way? How did the construction and real estate appear out of nowhere to become the
overwhelming driver of mainland growth in the 2000s and early 2010s?

How to generate a housing boom

To begin with, we need to reiterate a point we made earlier on: when we talk about the property sector in
China, were really talking about residential property.
Housing accounts for more than 75% of total real estate investment and building completions by value over
the past few years, and that share sits at around 80% today. In terms of physical area, residential is 65% of
total building construction floorspace (a category that includes factory, warehouse and administrative
construction), more than 85% of floorspace area if we restrict ourselves to traditional real estate categories
(residential, office, and commercial) and more than 85% of overall so-called commodity floorspace (i.e.,
construction sold in the market as opposed to being built for internal administrative or corporate purposes)
as well.
So in order to make sense of the property story, we need to focus on the key historical elements influencing
housing supply and demand.
And here there are five factors that stand out:
1. Title reforms. Easily the most important, in terms of kicking the whole process off, was Chinas mass
privatization of urban housing during the late 1990s and early 2000s, a program that took home ownership
ratios from effectively zero to more than 80% in the space of a half-decade or so.
And as we stressed in How to Think About Emerging Markets, Part 2 (5 September 2012), the reforms were
far more than just titles changing hands. Rather, they were the wholesale, blank-slate creation of a title
society, with land, commercial and residential structures captured in unified registers and a single legal claim
on each parcel, apartment or house.
This in turn allowed for the rapid rise of a nationwide credit market based on title claims, whether in the form
of mortgages to households or loans to developers and it should come as no surprise that property-related
lending has absolutely dominated the financial cycles of the past decade, be it the developer credit bubble of
2001-03, the inexorable rise of consumer mortgages as a share of bank balance sheets or the explosive
stimulus lending in 2009-10 (which, again, went predominantly to local government development and
property projects).
In Peruvian economist Hernando de Sotos terminology, the Chinese reforms converted dead to live
capital, in strong contrast to the situation in many other low- to middle-income emerging economies where a
sizeable share of residential and small-scale commercial assets may have no documentation or registration at
all, existing in limbo outside of the legal system (or, alternatively, subject to a multitude of competing claims

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December 2, 2012

that effectively nullify their status). As a result, these assets cannot act as a significant catalyst for new
investment or economic growth due to the lack of claims that allow for their use as collateral for new lending
or for the creation of incorporated commercial ventures. And, of course, it is precisely the use of credit and
limited-liability corporate forms that define modern capitalism.
2. Rising incomes. The next key factor was simply growth, in the sense that the tail end of mass privatization
reforms came at a time when the economy was recovering from the post-bubble malaise of the late 1990s.
As we outlined in Part 2, the government had spent the previous five years shutting down unprofitable state
enterprises and laying off excess workers, and the economy had been extremely weak. But as corporate
profitability recovered, as Chinese exports continued to gain global market share and the opening of the
economy brought new foreign investment opportunities, aggregate income growth picked up again rapidly as
well. And this was crucial to supporting both consumer appetite for better housing as well as corporate
demand for new commercial development.
3. Modernization of cities. Which brings us to element number three, in the form of a gaping need for
rezoning and redevelopment across the nation.
Those who visited China in the 1980s and 1990s will vividly remember the original socialist version of
Chinese cities: urban centers were crowded with factories and low-quality mass housing; there were
administrative clusters but no financial districts, only a few hotels, a severe shortage of shopping and
recreation and obviously no higher-end residential areas in short, the exact opposite of modern first-world
cities world, where urban centers are zoned for financial, business, hotels, conventions and high-end
commercial, while factories and residential areas are found in the periphery.
As a result, privatization and rising incomes coincided with a truly massive pent-up demand for putting things
in their proper place. Land prices in prime central locations boomed as companies, local governments and
developers all jumped to clear low-end housing, factories and warehouses to make way for central business
and hotel districts, while urban households were steadily and inexorably removed to new residential belts
(residential belts that, vitally, included parking for the first time about which more below).
The rezoning aspect of mainland housing and property demand is extraordinarily significant, and generally
unappreciated by investors and analysts; well have more to say on the topic in just a moment.
4. Property rights Chinese style. This brings us to the next crucial aspect of the Chinese property story, and
one that should be very familiar indeed to most readers, i.e., the role of policy and administrative distortions
in getting things done.
The great irony in China is that while privatization and title reforms cleared the way for the housing
development boom to come, it was essentially the blatant disregard for hard property rights that fueled
the process throughout the past decade. Rural land was expropriated from tenant farmers with little
attention to legal nicety or market-oriented compensation; urban land was routinely allocated to localaffiliated developers at minimal cost in sweetheart deals, usually in return for resettling original
inhabitants.
And as for those inhabitants, well, local city authorities would authorize urban plot clearance of as much as
dozens of hectares without any advance notification or consultation a stroke of the pen, and hundreds or
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thousands of people could be removed from their homes under arbitrary fixed resettlement or compensation
terms.
As with the fundamental privatization reforms themselves, this also sets China firmly apart from most of its
emerging market peers. And not only is it hard to overstate the importance of this facet of the China model
as a facilitator for property-led growth, as we will show further on this is also the part of the story that is now
fading most rapidly at the margin.
5. Repressed asset demand. The final element, which has played a large role in the investment-grade
segment of the housing market, is the fact that Chinese households (and, for that matter, corporates) dont
have a wide choice of assets for their savings. The external capital account is closed, commercial bank deposit
rates are fixed at very low levels, the equity market is relative opaque and volatile and non-bank fixed income
markets dont really exist as such.
In this environment, its no surprise that there has been a steady bid for second and third homes as an asset,
and no surprise that liquid first-tier high-end housing markets are priced at a considerable multiple of the
nationwide average.

The myth of urbanization

Before we conclude this section, we need to address one of the biggest and most telling misconceptions
about Chinese property: what we might call the myth of urbanization.
Heres what we mean. In the ten-year period from 2001 to 2010, the total number of urban residential
housing units completed (including both administrative and market-oriented commodity development) was
roughly 60 million flats. If we use the average urban household size, this is enough to house around 180
million people.
And as it happens, over the same ten-year period Chinas official urban population rose by ... around 180
million people.
Et voila. You can see why observers everywhere automatically assume that the residential boom was caused
by the need to house this large influx of migrants coming from the countryside.
Whereas we didnt even bother to include urbanization in our list of key drivers above.
Why?
Urban re-housing, not urbanization. Well, lets revisit those overall housing numbers. According to the
Ministry of Housing and Urban Development roughly 11 million housing units were demolished from 200610, during the period of the last five-year plan. 3 We dont have official demolition figures for the previous five
years (i.e., 2001-05), but our estimates suggest a similar number. In other words, as best we can measure
nearly 40% of all residential construction in the past decade went to re-house existing urban residents and
if we add in slum abandonment, where residents exit but the structures are not torn down, the share might
be closer to 50% exactly in line with the urban redevelopment theme we outlined earlier.
3

Many thanks to Rosealea Yao of GaveKal/Dragonomics for bringing these figures to our attention.

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Add in another perhaps 10% to 15% for second home/investment purchases, and at very, very least 5%
(many would argue for a significantly higher share) for outright waste in the form of administrative ghost
projects that go unfinished or unoccupied, and we have already accounted for some two-thirds of total
housing construction ... all without talking about a single rural migrant.
Clearly the remaining one-third does include a dollop of urban migration, as well as an element of natural
growth from new household formation, etc. But these are small shares, far less than the apparent one-to-one
correlation in the headline data. The real story, if you will, lies elsewhere.
Where did the migrants go? So what happened to all those rural migrants?
The vast majority of the rural migrant pool (now close to 150 million strong), are living in (i) crowded
dormitory housing at the light industrial factories where they work, (ii) crowded dormitory-style housing on
construction sites, or (iii) shared rooms in slums on the outskirts of the cities not the makeshift structures
you see in Mumbai or Cairo, mind you, but rather older run-down township housing whose residents have
relocated to new urban units. We will return to this point when we talk about the prospects for new lowincome social housing plans below.

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December 2, 2012

3. Is it a bubble?
So far weve tried to explain (i) the extraordinary role the housing and property sector now plays in China,
and (ii) how and why it got there. But now we come to what is arguably the most important call of all for
investors today:
Is it a bubble?
When people ask this question, they can mean one of two very different things. For some, the issue is
whether property and construction can maintain the explosive growth rates of the past and continue to
expand rapidly as a share of the economy. And here the answer is almost certainly no; we expect growth
rates to slow and their relative share to contract over the next five years, and well explain more in the final
section below.
However, what the broad majority want to know is whether there is a risk of disruptive collapse. Are housing
markets massively overpriced, overlevered and oversupplied? And is there a big shake-out coming, one that
will send activity careening downwards and threaten the stability of the economy and the financial system?
Our answer here is also no ... and this is what we want to spend the next few pages on.

All about prices

Lets start with the question of prices. Chart below shows the historical path of housing prices relative to
average urban income since the beginning of the last decade, using (i) the nationwide data on newlyconstructed housing prices and (ii) the NDRC statistics for residential prices in broad first- and second-tier
markets (for a discussion of why we use these series, please see the footnote below). 4
As a check, we also use the historical average sales price data from Vanke, the single largest mainland
developer by volume over the period in question (we have further cross-checked the Vanke numbers against
the average ASP trend for Chinas top ten developers over the last five years, and the figures are very similar).
Flat or falling, not rising. What are the price data telling us? As you can see, regardless of the series chosen,
nationwide housing prices are either flat or falling relative to urban incomes over the last decade.

There are essentially three property price series in China that not only capture a broad market but also provide a sufficient historical
time scope to carry out macro analysis. One is the new building construction and sales figures, reported by all construction and real
estate development companies to MOHURD and the NBS. The second is the NDRC 36-city price series, which covers major developers
in all provincial capitals and also includes a smattering of secondary transactions. And the third is a 70-city price index compiled by
the NBS.
Of these, the construction data are by far the most comprehensive, including essentially the entire nationwide urban market for new
housing and other building. The NDRC series, by contrast, has more limited coverage but is a good gauge of conditions across firstand second-tier markets. And these are the two we tend to follow. We dont normally use the NBS 70-city index since (i) it is compiled
only in y/y index growth form, which makes it difficult to cross-check underlying prices, and (ii) it shows much lower trend price
increases than any of the other series, for reasons that are not readily apparent. (As we discussed in How to Think About China, Part
1, we also dont normally use the available daily series as their coverage is also limited to the higher end of the market but without
the long-dated historical availability series that, say, the NDRC data provide).

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December 2, 2012

Chart 7. Price/income trends in China

Price/urban income ratio (index 2005=100 6mma)
160
Newly constructed housing
NDRC 36-city average
Vanke (12mma)

140
120
100
80
60
40
02

03

04

05

06

07

08

09

10

11

12

Of course nominal prices have gone up, by 150% to 200% between 2003 and 2012. But then so have incomes,
by nearly 200% as well.
These numbers tend to come as a big surprise to most people. Dont we read in the press nearly every day
that Chinese property prices have skyrocketed to levels far beyond ordinary residents capacity to purchase?
This is true ... for the richest first-tier markets, and at the upper 10% to 15% investment-grade end of a
number of second-tier cities. New housing prices in Beijing and Shanghai, for example, have not gone up by
150% over the past ten years; theyve gone up four- to five-fold (Chart 8). And these are average prices; as
we write, the luxury residential end of Beijing sells for RMB60,000 per sqm or more, and in Shanghai from
RMB90,000-100,000, light years away from normal citizens incomes.
Chart 8. Beijing and Shanghai
Newly constructed residential price per sqm (RMB th, 6mma)
20
18

Shanghai
Beijing
Nationwide

16
14
12
10
8
6
4
2
0
02

03

04

05

06

07

08

09

10

11

12

However, the point here is that China is a big economy; Beijing and Shanghai together account for only 2.5%
of overall residential construction by area, and only around 6% by value. And again, they are not very
representative of nationwide trends (well discuss exactly why below).

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December 2, 2012

(This is true, incidentally, for companies as well; Chinas listed developers i.e., the ones followed closely by
most investors taken together account for only 12% to 15% of total real estate construction activity, and
tend to be concentrated at the highest end of the market as well).
What about absolute affordability? So far so good, but Chart 7 above is in index form. What about the
absolute multiple of prices relative to incomes?
The answer is in the next chart below. The blue line is the nationwide price divided by average annual urban
household income, and the yellow line is the 36-city price relative to estimated income across provincial
capitals. And as shown, Chinese housing trades between 9 and 12 times income.
Chart 9. Absolute price/income ratios

Chart 10. EM vs. DM per-capita comparisons

110sm flat in years of household income

20
Newly constructed housing, nationwide
18
NDRC 36-city average
16

Average home price relative to GDP/capita (2003-11 average)

30
25
20

14
12

15

10

05

06

07

08

09

10

11

12

US

Japan

France

Turkey

Malaysia

Poland

Indonesia

04

Singapore

03

Philippines

02

Russia

Thailand

China

Hong Kong

Taiwan

S Africa

10

Which is a lot, right? Isnt a ratio of four or five generally considered to be the prudential norm in the
developed world?
Sure but thats not the relevant metric for China or other parts of the emerging universe. And we say this
for two reasons.
First, think back to the numbers we went through in the previous section above. Right off the top, a goodsized chunk of new housing built in China over the past decade was not actually paid for out of household
incomes; this is either outright resettlement or full or partial compensation for demolition. And then we have
to account for various administrative projects, waste, etc.
So of the 60 million units built during the 2000s, perhaps 25 million were actually transacted in the market
fully out of buyers own resources. If we further account for second and third home purchases, were talking
about a buying population of 15-20 million households ... or less than 10% of the urban population.
Stop comparing with DM. In other words, when we look at price/income ratios in China it doesnt make
much sense to measure against average incomes as we would in developed economies. Instead, we need to
measure against, say, the highest quartile of urban income earners, a group that makes at least twice the
base average. And if we do, suddenly the numbers dont look at all out of whack.

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December 2, 2012

Exactly the same logic applies to the rest of the emerging world as well, where property markets are
underdeveloped relative to advanced economies. If we take a slightly different metric for ease of
comparison, the average home price relative to per-capita GDP, we get a number of 19 times for China. This
is far higher than the ratio of 6 to 8 that applies in US, Japan or Europe ... but very similar to the reading for
other emerging markets such as South Africa, Thailand or Russia, and only moderately higher than the
Philippines or even Poland (Chart 10 above).
Which helps explain why, looking back at Charts 7 or 9 those affordability ratios have been absolutely stable
since the beginning of the housing boom. This is not what you would normally associate with a price bubble.
Prices and financial wealth. Before we finish with prices we want to look at one further metric, which is the
ratio of home prices to financial wealth. In Chart 11 we show an index of the nationwide average price
relative to per-capita urban saving deposits. The blue line is the trend in the headline ratio over time, and the
yellow line is the mortgage-adjusted ratio, measuring the effective cash portion of the price in a given year
divided by deposits. 5
Chart 11. Price/wealth ratios
Price/urban per-capita deposits (index period avg=100 12mma)
140
130
120
110
100
90
80

Headline

70

Mortgage-adjusted

60
50
40
02

03

04

05

06

07

08

09

10

11

12

What are these lines telling us? The answer is that while price/income affordability may have been stable
over the last decade, prices relative to wealth holdings have fallen dramatically. On this basis, Chinese
housing is roughly twice as affordable today than it was before 2008. Once again, this is essentially the polar
opposite of a classical price bubble.

Households and leverage

How about leverage? After all, even more than prices its usually a sharp run-up in debt financing that usually
defines an unsustainable market.
And on the household side of the equation in China, there answer is that there simply isnt much leverage to
be found.

Many thanks to Logan Wright of Medley Advisors, who called our attention to this concept.

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December 2, 2012

Chart 12 shows the effective mortgage loan-to-value in the mainland property market, defined as the net
increase in mortgage debt outstanding divided by total commodity housing sales by value (i.e., all new
housing sold for cash in the market); the blue line is the current flow ratio and the yellow bars indicate the
cumulative position since 2002. The quarterly ratio can bounce around considerably but the cumulative
exposure is a paltry 25% of sales, and the figure for the past two years has been well below that mark.
Turning to Chart 13, we show mortgage debt as a share of urban disposable income and household financial
assets (measured by urban savings deposits). As you can see, mortgage/income ratios have never exceeded
40% and have been falling gradually outright since 2010. And as for mortgage debt relative to assets, well,
the ratio never even bothered to rise and sits at a paltry 10% today.
Chart 12. Mortgage loan-to-value

Chart 13. Mortgage to income and assets

Net new mortgages relative to residential sales

100%
90%

Mortgages outstanding as a share of urban indicators

100%
90%

Cumulative ratio

80%

80%

Relative to household deposits

70%

70%

Relative to disposable income

60%

60%

50%

50%

40%

40%

30%

30%

20%

20%

10%

10%

Current quarter

0%

0%
02

03

04

05

06

07

08

09

10

11

12

02

03

04

05

06

07

08

09

10

11

12

Why has there been so little household leverage, given the explosive growth of the housing market in China?
As we discussed earlier, the logic here is simple: consumers paid for housing by cutting back dramatically on
purchases of non-durable goods and services, and thus have maintained high net saving ratios through the
property boom.
Chart 14 below once again shows how commodity residential sales fit within aggregate household income
and consumption, and Chart 15 shows a more accurate snapshot of the urban household flows (since the
commodity residential figures are almost exclusively for the urban market). In either case, the picture is very
similar (i) non-durable consumption has fallen sharply relative to income since 2000, and (ii) even when we
add in the total value of housing purchases, net saving ratios (the gap between the blue and red lines) are
have remained strongly positive.

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December 2, 2012

Chart 14. Nationwide household indicators

Share of GDP (%)
75%

65%

Disposable household income

Household consumption
Total spending including housing purchases

Chart 15. Urban household indicators

Urban households, share of GDP (%)
50%
45%
40%

Disposable household income

Household consumption
Total spending including housing purchases

35%

55%

30%
45%

25%
20%

35%

15%
25%
1990

1995

2000

2005

2010

10%
1990

1995

2000

2005

2010

We also need to say a word about the informal credit market. Many investors have read reports of increasing
household debt exposure in the non-bank sidewalk market, i.e., borrowing from local pawnshops, industry
associations, loan sharks, etc. Are we missing a quasi-mortgage bubble outside the formal banking system?
No. We will talk about the non-bank lending market in more detail in Part 4 of this series, but one of the main
findings is that the estimated size of the entire informal credit system and one that exists predominantly
and almost exclusively to provide credit to the small business sector rather than households is only around
25% to 30% of GDP, a mere tenth of the commercial banking system. Which means that even if you wanted
to make very aggressive assumptions about household property-related exposures, its virtually impossible to
generate the kind of numbers that would have any meaningful impact on the debt ratios in Chart 13 above.

The proof of the pudding

For the proof of the pudding of everything weve said so far, just turn to the recent behavior of the Chinese
residential market compared to what happened in the US.
When the US housing cycle peaked in 2005, it peaked for good. The extreme amounts of consumer mortgage
leverage that had pushed up prices and volumes for so long led to a vicious cycle of retrenchment and
liquidation. Two years later well before the onset of the financial crisis the total value of US home sales
had already fallen by 40% (Chart 16), and in the aftermath of the 2008 shocks it took another big leg down,
one that the market has yet to recover from as we write despite a massive, unprecedented policy easing
effort.
Now look at the Chinese line in the chart. When the government tightened policy in late 2010 by slashing
credit liquidity and imposing new regulatory restrictions on the property sector, housing sales also fell by
nearly 20% in value over the ensuing 18 months.
However, when the authorities began to ease in the spring of 2012, providing more liquidity and easing credit
controls an easing, by the way, that was very moderate and not remotely comparable to the 2009
emergency stimulus package residential demand immediately rebounded in volume and value terms, taking
overall turnover back up to previous highs by the third quarter. And if you refer back to Chart 12, you will
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December 2, 2012

note that this recovery occurred with virtually no support from mortgage lending, i.e., this is not just
leveraged speculators jumping back in for short-term gains.
Chart 16. The proof of the pudding
Total value of housing sold (previous peak =100)
140
US (Jun 2005 peak)
120
China (Oct 2010 peak)
100
80
60
40
20
0
-60 -48 -36 -24 -12

12 24 36 48 60
Months from peak

Demand has since stabilized, of course, and in the next section we will argue that sales and construction are
very unlikely to go roaring up in a straight line from here. But the point is that had this been a true bubble,
with prices and volumes sustained only by unsustainable credit extension, the 2011 market downturn would
have been a permanent one and modest policy changes would have had no impact.
Why doesnt China get into bigger trouble? And this brings up another absolutely essential aspect of the
mainland property cycle. Looking back at Chart 16, 2011 was not the first time the market had swooned. In
fact, in the short six-year period covered by the chart alone, there were three major downturns. The first, and
largest, was in late 2007 and early 2008 when sales crashed by nearly 50% from peak to trough, and the next
came in early 2010 when the authorities undertook their first abortive policy squeeze.
If you go back further, there was another lengthy construction and property recession in 2004 after the
government popped the 2001-03 credit bubble. Which makes four sharp drops in the last ten years.
So in thinking about why hasnt China generated a more classic demand bubble?, a big part of the answer
has to be that the authorities keep interrupting the cycle. Since the very inception of the housing boom at the
beginning of the 2000s the pattern has been almost exactly the same: you get a couple of years of sharp
credit and price increases, followed by a significant tightening and a year of retrenchment. Then the
authorities ease up again and the market takes off once more, followed by another round of tightening and
property declines, etc.
Once again, this is a good bit different from the standard Western model, where everything simply goes up
linearly for seven or eight years before falling apart under its own weight.
Back to Beijing and Shanghai. This may all sound reasonable so far but then how can we explain the
patently insane pricing at the highest-tier markets in the mainland?

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December 2, 2012

Once again, the Beijing luxury price per square meter starts at 12 times the official nationwide urban level,
and for Shanghai the figure is more like 20. In fact, as we write a new residential development in the Pudong
region of Shanghai just set a China-wide sales record of RMB220,000 per sqm; this is still only a fraction of
the Hong Kong luxury price, but is so far above average Shanghai income levels that it made headlines
everywhere.
The answer is that this is not just a China phenomenon. In fact, it is more the norm than the exception in the
emerging world. Residents of Moscow and St. Petersburg are very used to living with (although hardly happy
with) housing prices that are 10 to 20 times those in the rest of the country and those prices fall off very
quickly once you get out of those two cities. The same is true for Rio de Janeiro and Sao Paulo in Brazil, for
Mumbai, Delhi and Bangalore in India ... and indeed, turning to the developed world, for London in the UK.
In every case, prices the cities we mentioned are not determined by local income conditions, or for that
matter income and wage conditions anywhere. Rather, Moscow housing is a wealth-driven asset, driven in
particular by the oil, gas and commodity wealth being generated across all of Russia; regardless of where the
money is earned, Moscow is a preferred store of value. So of course is London, and not just for Russians but
for the wealthiest classes across Asia, Africa and the Middle East.
Shanghai and Beijing are no different; they serve as the preferred liquid asset for rich Shanxi coal barons,
Zhejiang manufacturers and Sichuan farming magnates. And just as in Russia or Brazil, prices are far lower
once you leave the very top tier. Luxury costs in Guangzhou and Shenzhen can be relatively close to Beijing
levels, but go to, say, Chengdu, widely regarded as number five on the list, and its more difficult to find highend prices that exceed RMB20,000 per sqm not to mention the next 40 or 50 major cities down the line.
In a country where wealth is being created at a rapid clip, this explains why Beijing and Shanghai continue to
support prices that are wildly above the norm regardless of where we are in the property cycle. And, we
should add, regardless of official policy attempts to bring prices down.

Speculative demand and ghost cities

The next topics wed like to address are (i) the constant claim that its all speculation, i.e., that only a small
fraction of home sales over the past decade are for actual occupancy, and (ii) the famous Chinese ghost city
phenomenon.
Buy a flat, buy a car. On the first point, its simply not true. In two senses.
To begin with, as we noted earlier, a very significant share of total of total residential construction is for
replacement. If you tear down someones existing flat, or move them out of a derelict one, theres simply no
question of whos going to live in the new flat you subsequently build for them. And again, this accounts for
up to 25-30 million of the 60 million urban units constructed over the past decade.
What about the other half? Many analysts attempt to count empty flats around the country, but in a country
of more than 100 cities with a core urban population above one million people this is a hopeless task (and of
course if you just focus on the asset cities of Beijing, Shanghai and Shenzhen youll find far more vacancies
than you would elsewhere).

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December 2, 2012

Instead, investors are far better advised to follow the single best correlated indicator with residential
occupancy, i.e., auto sales.
Why? Because the entire logic of the Chinese housing boom is to take people out of old state-owned units in
city centers or out of traditional rural housing in surrounding villages (both with no parking and relatively
close to residents workplaces) and move them to developments in new suburban belts now generally with
parking access but little in the way of public transport. I.e., as long as new flats are being physically occupied,
you automatically create demand for autos in the process.
Sure enough, the lines for auto sales growth and property sales growth in Chart 2 above are virtually
identical. And this is not just in growth rate terms; Chart 17 shows the absolute seasonally-adjusted path of
monthly sales over the last five years again the same line, with no divergence.
Chart 17. Buy a flat, buy a car
Index 2010=100 sa
140
120
100
80
60

Property sales
Auto sales

40
20
0
2008

2009

2010

2011

2012

Indeed, if you take the physical number of new flats sold in 2011-12 it is almost exactly the same as the
number of passenger sedans sold in the same period (you can look up the data). All of which is an indirect but
very powerful refutation of the view that no one is living in new Chinese housing.
How to think about ghost cities. Finally we come to the famous Chinese ghost cities. And yes, there are a
decent number of them about, large-scale projects that will either never be finished at all or, if finished, will
never be occupied. But weve learned two things over the past decade.
First, this is not a standard phenomenon year in and year out. Rather, if you go through the list of cases you
will find that that they were either initiated during the previous big credit blowout in 2002-03, or else in
2009-10 during the most recent one. In other words, ghost projects are not business as usual in China but
rather a result of particularly crazy periods of administrative laxity and excess. So while you might have had,
say, 25% worth of crap projects back then and another 25% during the immediate stimulus boom, we still
end up with more moderate total wastage numbers of 5% or 10% for the decade as a whole.
Second and this is an obvious point that nearly everybody seems to miss a true ghost city is just that: a
ghost, in the sense that it doesnt have any impact on the remaining overall property market. When a local
government goes hog-wild and builds some senseless big new development project out in the countryside or
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December 2, 2012

the desert, or (as weve seen more recently) when localities rush to start social housing projects en masse
through 100% levered corporate vehicles only to lose their financing and leave things unfinished in the
subsequent tightening, this doesnt create excess capacity or depress prices for existing housing.
Rather, it just gets written off for what it was, i.e., an ill-advised undertaking to begin with. And the bad loan
goes back to the banks.
These two points is are worth repeating for emphasis: Ghost projects are a big issue cyclically but a much
smaller one structurally, and the final negative impact at the end of the day goes right back to the banks ....
... who, as we will argue in Part 4, are having a surprisingly easy time dealing with the issue.

Oversupply?
All of this puts the question of property oversupply today in a very different perspective. To see why, lets
walk through the actual charts below.
As everyone knows, banks exploded in a frenzy of lending in 2009 (Chart 18 below), and as everyone knows
the main borrowers were newly-created fly by night local government construction, development and
infrastructure vehicles.
And then by mid-2010 the excess lending essentially stopped, as new flow credit extension slowed sharply.
Chart 18. The big boom (and the big drop)
New lending relative to nominal GDP (index 2005=100, 3mma)
350
New loans
New total "social financing"
300
250
200
150
100
50
0
00 01 02 03 04 05 06 07 08 09 10 11 12

How did this all show up in the property and construction supply data?
Disaster ... or maybe not. Well, if you look at the left-hand chart below things look disastrous. Reported
starts and overall construction skyrocketed from 2009 through 2011, far in excess of underlying demand (the
yellow bars in the chart show final sales) a seemingly sure sign of massive excess supply set to overwhelm
the property market.

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December 2, 2012

Chart 19. This looks onerous

Floorspace index (2005=100 3mma sa)
350
300
250

Sold
Under construction
Started

Chart 20. This doesnt

Index (2005=100 3mma sa)
350
300
250

200

200

150

150

100

100

50

50

Index (2005=100 3mma sa)

Sold
Steel product usage
Cement usage (RH scale)

275
225
175
125

75

0
00 01 02 03 04 05 06 07 08 09 10 11 12

25
00 01 02 03 04 05 06 07 08 09 10 11 12

But then look at Chart 20 on the right. If you follow the actual commodity figures in the form of domestic
steel product and cement usage ... nothing happened. Materials demand didnt skyrocket; in fact it was
actually pretty flat from late 2010 through early 2012. Electricity usage slowed considerably. Imports of coal,
iron ore and other materials slackened or even fell. All of which was very much in line, incidentally, with the
behavior of final sales.
In short, by any physical measure there clearly wasnt an excessive construction boom; not even close. Which
also means no wild increase in finished housing or other property capacity.
What happened? We already answered the question above: by mid-2010 a large swathe of low-end,
undercapitalized local entities had lost their financing and thus their ability to carry on construction, as banks
were instructed to roll over loans outstanding but not to extend new credit. Because many of these were
policy-mandated projects, however, local authorities were under great pressure to show steady progress
and thus the companies continued to report vibrant increases in construction long after the fact. Once again,
however, its the right-hand chart that shows the true supply situation.

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December 2, 2012

4. Where to from here?

So far we have argued that the Chinese property sector is not a looming bubble ready to explode. And, of
course, the market has recovered nicely in recent quarters.
Does this mean that all is well and that China will now resume its double-digit growth path, accompanied by
20% y/y growth in property and construction activity?
No. Housing markets are not collapsing, but the future prospects nonetheless look very different from the
past ten years.

Five big changes going forward

Why? Its difficult to put precise numbers on paper, but here are five key changes we see underway in China
today.
1. Urban re-housing already well advanced. In 1995, around the time the government first began to
articulate housing reform plans, the urban population was 350 million. And as we discussed above, between
2000 and 2010 China has resettled or otherwise re-housed the inhabitants of at least 25 million units, which
translates into somewhere between 20% and 25% of the population originally living in old pre-1995 state
housing.
This still leaves plenty of urban redevelopment potential ahead, of course, but its not as if the economy is
just starting out here.
2. The rules of the game are different. And in our room for acceleration on this front is very limited, as the
old Chinese model of getting property deals done is rapidly changing. Since the mid-2000s there has been a
significant crackdown on agricultural land conversion and stricter controls on rural land sales. Urban land
transactions have also shifted from widespread sweetheart deals with developers in exchange for
resettlement to arms-length sales at auction prices.
Equally important, there are growing impediments to large-scale housing clearance as residents have evergreater access to legal redress; enforced compensation costs are increasing as well.
You can see the result in Chart 21 below: annual land purchases have been broadly flat since 2004.

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December 2, 2012

Chart 21. Land sales

Land sales by area (2005=100 3mma sa)
200
180
160
140
120
100
80
60
40
20
0
00 01 02 03 04 05 06 07 08 09 10 11 12

3. No room for another credit boom. Nor does China have ample room for strong economy-wide relevering
any longer. Household balance sheets may be relatively clean, but the stimulus-related lending boom to local
government vehicles and other parts of the corporate sector has increased the aggregate credit ratio by 30%
to 40% of GDP since the 2008 crisis (Chart 22).
Chart 22. Credit/GDP indicators
Oustanding credit as a share of GDP (%)
200%
180%
160%
140%
120%
100%
80%

Total loans plus "social financing"

Total domestic credit plus "social financing"

60%
00 01 02 03 04 05 06 07 08 09 10 11 12

We will show in Part 4 that this does not put China near crisis risks today but it certainly leaves the
economy with far less dry powder that in the past. And crucially, after a period of stabilization in late 2010
and 2011 the credit/GDP ratio has been rising again over the past few quarters as a result of monetary
easing.
4. Policy priorities have shifted. Which in turn means that talk of new stimulus announcements ahead is
almost certainly misguided. In fact, now that property markets have recovered and industrial indicators have
started to turn up the authorities are more likely to dampen the pace of bank lending growth (including
purchases of bonds and bills) moderately going forward in order to stabilize the aggregate ratio.

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December 2, 2012

Moreover, even in the depths of the 2011 property downturn the government stressed repeatedly that it had
no intention of lifting high-end property restrictions such as the ban on foreign buying, conditional bans on
second/third home purchases and mortgages and city-specific residency requirements. And in our view these
will remain a part of the regulatory landscape for a good while to come, as policymakers work to reorient
supply towards lower-income buyers.
Finally, the dramatic slowdown in effective labor force growth over the past ten years means that central and
local leaders are no longer under the same pressure to create millions of jobs and achieve 8% at all costs.
Over the coming few years, we perceive a much higher level of comfort with real GDP growth numbers in the
7% and eventually the 6% range.
5. The social housing model is untested. Now, in theory all of this could be more than offset in the medium
term by new opportunities in the low-income market. After all, China still has 150-plus million rural migrants
who do not yet have access to modern urban housing and they now the fastest-growing incomes of any
segment of the population. As monthly unskilled earnings go from US$300-350 today to levels of US$500 and
then US$700 over the coming five years, this represents a very interesting and untapped source of residential
demand.
And sure enough, the single biggest policy change of the post-crisis era is the introduction of low-end social
housing, built to order based on government specifications and then either sold at a subsidized price or
rented at low cost to the poorer parts of the urban population. Indeed, according to official statistics over 20
million units have been started and more than 10 million completed since 2010 to date.
However, these numbers are misleading. If you go back and examine Charts 19 and 20, much of the gap
between reported construction and actual activity is due precisely to policy-led housing and other stimulus
projects, as these are carried out predominantly by local government-affiliated developers. And any Chinese
property analyst can regale you with stories of site visits to social housing projects where construction was
suspended after a foundation was dug (although the local authorities inevitably report glowing progress in
meeting official targets).
The bottom line is that the social housing model is still relatively new and untested. Is the government really
building a reasonable number of units in the right locations? Have they gotten the numbers regarding
financing and affordability? Completing the existing pipeline should easily buoy up overall construction
activity for the next couple of years but after that we will have to take a hard look at initial results to gauge
whether this can be a lasting source of large-scale demand in its own right.
Oh, and its just damn big. And can we just reiterate that, as outlined earlier, the total size of property and
construction in China is already at extraordinarily high levels as a share of GDP? Just to take an internationally
comparative figure, the gross output value of the construction sector (which includes not only building
construction but other categories as well) was 23% of GDP last year. The only time in recent memory that we
have seen similar ratios at least in economies of any size was in the Eastern European belt that runs from
the Baltics in the north to the Balkans and former Yugoslav states in south, at the peak of the cycle in 2007.
And in those cases the average ratio had already collapsed back to 15% by 2011 as a result of international
capital pull-out in the aftermath of the 2008-09 financial crisis.

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December 2, 2012

Our best guess

So lets sum up. Between 2002 and 2012 overall construction, property sales and steel demand all rose at a
blistering pace of around 17% per annum in physical terms, which meant an outright doubling of intensity
relative to real GDP as shown in Chart 23 below.
Chart 23. Steel and construction intensity
Intensity index to real GDP (2005=100)
150

125

100

75
Property and construction activity
Steel usage

50

25
00 01 02 03 04 05 06 07 08 09 10 11 12

Where do we go from here? Putting the above arguments together, our best guess is now mildly up for
absolute physical construction and materials usage and gradually but steadily down for materials intensity
over the coming five years both of which are a very significant change from the explosive numbers of the
past.
In 2011 China completed 1.0 billion sqm of overall residential floor space (including both commodity and
other administrative construction), and the expected figure for this year is 1.1 billion sqm; in terms of total
domestic steel usage, the figures are 650 million tons of crude steel in 2011 (845 million tons of steel product
equivalent) and around 675 million tons in expected for 2012 (900 million tons of product equivalent). We
know the numbers wont be falling over the next year or two, given the sharp recovery in end housing
demand over the past six months and the recent uptick in local steel and cement consumption.
But could we wake up in 2013-14 and find that the numbers are stabilizing at 1.1 to 1.2 billion sqm per year
and perhaps even declining in second half of the decade? Or that steel consumption rises to 700-725 million
tons and then flattens out thereafter?
Of course we could, although our base case forecast is for low single-digit (3% to 4%) growth in property,
construction and materials demand on average over the next five years. And either way it means a declining
construction share of GDP, a declining investment share of GDP and declining materials intensity from 2014
onwards.
I.e., however you slice it, we expect the next decade to look a good bit different from the last one.

2012 Emerging Advisors Group Limited

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