Peter's Perspective
22nd March 2016 by Peter Churchouse

A Night in Beijing

Four years ago I visited a real estate development site in Beijing as part of a due diligence exercise.

It was then, and is now today, an extraordinary site.

The location, in terms of the Beijing residential stakes, is exceptional. It’s right next to the stunning Summer Palace, a “must visit” attraction for anyone visiting Beijing.

This is as ultra-prime as it gets for location. It’s like being next to Buckingham Palace in London.

And these houses are the very top of the highest end of residential real estate. Size? Anywhere from 11,000 to 35,000 square feet. Each.

When I inspected the site four years ago it was still under development and I visited the show home.

Last Thursday night I was in Beijing as one of China’s wealthiest tycoons invited me for a quiet informal dinner at their home, which happens to be in this development.

Two other guests, friends of mine based in Hong Kong, our host and a family member attended.

A Cantonese chef had been brought in, perhaps in deference to our Hong Kong origins. The first dish to arrive on the table was the almost obligatory plate of steamed chicken feet, quickly followed by fish belly drowned in mild soup with Choy sum – delicious.

We were offered a choice of stunning first growth Bordeaux wines to wash down the delicious fare that was being served up.

I have enjoyed a good number of dinners with our host over a number of years. They have always been relaxed affairs, but this one promised to be even more so given the small number of people at the table.

All the same, I knew that there would be a quiet agenda.

You see our host, although extremely wealthy, is a quiet, incredibly intelligent, low key, below the radar sort of person, who values informed discussion about business, investing, and world affairs.

Given the fragile state of the world economy right now, and considerable disquiet in the world about China’s role in this state of affairs, I knew our evening was going to full of opinions and observations.

China watchers will know that the National Peoples’ Congress (NPC) was completed earlier in the week. The 13th five year plan was the main outcome of the Congress.

This event is a big deal in China. It is where the top levels of the Communist party, government officials and a hard core of top business leaders gather to discuss the “State of the Nation”.

But it’s not a debate. This is a forum where the top Communist Party brass communicate their policies and goals for the coming few years.

This is more ‘preach-and-teach’ rather than discussion. And our host had been amongst the small band of business people invited.

Going into the NPC sessions the mood of the business community was sombre and concerned. And for very good reasons. A slowing economy, rising debt, a heavy anti-corruption pogrom, falling demand, and excess capacity all putting a damper on private sector demand.

By the end of the congress our host confirmed that the mood amongst the corporate attendees was rather better.

Changes and reforms to the complex labyrinth that is China’s tax system were high on the agenda. And what’s more, this seemed believable, doable.

A Value Added Tax is set for implementation in May/June of this year for several major industry sectors. This will replace other taxes, or allow others to be reduced. Most companies are well down the track to implement this in their systems.

And this Congress provided another “first”. It is the first time that anyone can remember when the President has seen fit to pitch up at the business forum sessions of the Congress.

The President usually sticks to hob-nobbing with the party apparatchiks. The talks aimed to reinforce the role of the private sector in the reforms and growth of the economy.

President Xi Jinping’s courting of the private sector evidently went down well.

From the outside this seemed like an attempt to reassure a nervous business community that has pulled back on investment, decision making, and new projects.

The risk of being caught up in any possible “serious disciplinary violations” has taken a toll on private sector investment.

The “reform” word comes up constantly in policy discussions on and in China.

“How seriously should we take senior leadership’s stated commitments to various reform agendas?” I asked.

“Seriously enough” was the response. But we should not expect reforms to be of the “big bang” variety.

They will be slow, studied, and experimental. “Crossing the river by feeling the stones” as Deng Xiaoping would put it.

This will not be a big single sweep. The leadership is rightly concerned about the social and political impact of an immediate policy blast that suddenly put tens of millions of people out of work.

This is not going to be a repeat of Zhu Rongji’s performance in the late 1990’s (massive privatisation of state-owned enterprises which led to roughly 40 million workers being laid off over five years).

Next question: “How realistic is the GDP growth target of 6.5% – 7%? Does anyone believe the published numbers anyway?”

Our host indicated a belief that the published growth number for 2015 of 6.9% is probably not too far off the mark.

Also to be noted is that the leadership is now talking of a growth range for the first time, and has been managing down expectations for several years now.

Someone noted that the 6.5% growth is more an “aspiration” than a cast-in-stone target that is to be reached come hell or high water.

Real estate has been a core driver of the Chinese economy for many years. It has been at the centre of growth and debt concerns in the past couple of years.

“So where are we right now in China real estate?”

Almost everyone in private business in China has some interest in real estate business. And it is rare to find anyone who does not have strong views on the subject. Our host included.

Well, it’s a very tough business right now. But one where the conditions, risks and opportunities have never been so divergent depending on location.

This concurs with our own observations on China real estate.

The simple fact of the matter is that the Tier 3 and Tier 4 (or lower) cities are in a deep hole. Oversupply is everywhere. Sales are slow, inventories are high, and not falling, pricing power is weak, and not recovering.

Real estate-related debt in these cities is certainly a problem for banks and non bank financial institutions (read, shadow banks).

Defaults will rise for sure, and a rise in bank non-performing loans (NPLs) in this sector is assured.

Plans are being mooted for government to acquire swathes of unsold inventory and provide it for rent or subsidised sale to lower income households.

Let’s see if that happens.

The situation in Tier 1 cities (Beijing, Shanghai, Shenzhen and Guangzhou) as well as key Tier 2 cities is very different.

Inventories are much lower, prices are rising, fast in some cases. Policy settings are likely to be exactly the opposite in some of these cities. It will be aimed at cooling overheated markets.

In all my years of following China real estate I have never seen the markets in such divergent states as they are right now.

This means that companies positioned in the “right” markets are doing well, while those concentrated on Tier 3 and lower cities are much more likely to be struggling.

As we come into the 2015 reporting season I expect that we will see a much wider range of earnings performance of China property companies listed in Hong Kong than is typical in this market.

My key “big picture” takeaways from our delightful dinner session:

  • China’s key leaders are keen to reassure the private sector that they have an important role in China’s growth and reform going forward despite its concerns over the current campaign against “serious disciplinary violations”. The NPC seemed to provide a small measure of comfort at least.
  • Reforms in a wide range of areas including tax, urbanisation, labour, excess capacity in SOE’s, social welfare, environmental issues are definitely on the agenda but will be measured and step by step. No big bang approach here.
  • Will this be of sufficient scale and quick enough to prevent major crises in finance, labour, environment? Hard to say for sure, but the tools and it seems the commitment to make the changes do seem to be largely in place.
  • A big concern for many people within China is political insofar as potential unrest caused through job losses, welfare issues, environment can destabilise certain cities or the country as a whole. That in turn raises the potential for possibly dangerous responses.

Ultimately, real estate is now a very two-tiered market.

Stock picking is more important in this sector than ever. And stocks are cheap across the board, to a large extent irrespective of positioning of individual company portfolios.

We’ll be sharing our top pick in this sector in the upcoming edition of The Churchouse Letter.

Good investing,

Peter Churchouse

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