Kiss of Debt. And Regional Impacts of the Great 2009 Carry Trade
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Frequently one muses how excesses in real estate and real estate lending are at the core of economic meltdowns, recessions, bank implosions. It still amazes me how governments, banks, central banks and consumers don’t seem to learn from these cycles of excess. What is also unclear is whether real estate is the cause of these economic disasters, or an effect. Whatever the pattern of cause and effect, lending is very much at the core of these meltdowns. Real estate is a highly capital intensive activity, which naturally draws a need for debt financing. A key difference in the current cycle has been the use of derivatives that package up parcels of loans which were sold to investors as a form of receivable, thereby allowing the banks to go out and lend again, and again, and again….Secondly, the markets have experienced huge flows of capital across borders, in an industry that traditionally drew on purely domestic capital for its growth and development.
Also it is quite incredible that scions of banking such as Alan Greenspan claim to have not seen the bubble forming in the US property markets, claiming that bubbles are only evident after the fact. Sorry. That stretches credibility too far, and smacks of excuse–making for sinking the ship while on watch. Similarly, in the UK, the current Prime Minister, Gordon Brown as Chancellor of the Exchequer, oversaw the development of the UK’s housing bubble, and did precious little to stop it. He had the ability to do so if he had been in the least bit disposed to do so. No one likes to take the punch bowl away from the party, but binge credit is perhaps to be likened to the binge drinking that seems to pervade the UK these days.
New York’s Professor Nouriel Roubini is often attributed as the economic super hero who singlehandedly forecast the demise of the US property bubble and the banking system. While we admire Roubini’s work and prescience, he is far from being the only one who foresaw the impending problems brewing in the housing/banking sector. Many people had warned of the problems of Fannie Mae and Freddie Mac. My wife found a book in a second hand shop written by a former Goldman Sachs banker, John R. Talbott, entitled “The Coming Crash in the Housing Market”. This very readable tome was written in 2003 well before the sub–prime problems surfaced in 2007. Our own work and observations (as very much outsiders looking on from afar in Asia) on the US, UK Spanish, Irish property markets highlighted conditions that were plainly unsustainable. Simple metrics such as affordability had got to as much as 2 and 3 standard deviations out of “normal” ranges in many western countries.
Then, there are always the “new paradigmists” who continue to spout the most dangerous words in investment – “It is different this time”. These attitudes characterised the tech bubble in the late 1990’s. A great many investors, analysts and intellectuals saw the unsustainability of that bubble also, but such manias can run on way longer than rationality would suggest that they should.
Many analysts and observers may spot the formation of bubbles, and may forewarn of the potential downside risks to that particular asset class, but very few people predict the second and third order effects that usually come from such bubble bursts. The Asian financial crisis was a classic case in point. In late 1996, early 1997 many of us came to the belief that Thailand would inevitably have to devalue its currency at some point, and that this would lead to a bursting of the stock market and property bubble in that country. That bubble had been fueled by Yen/Swiss Franc/Dollar carry trades (sound familiar?).
The mantra in the region at the time was “this is the Asian way” – implying that “we know how to do these things better than you do in the west”. Malaysia’s xenophobic, strident then Prime Minister Mahathir was the leading proponent of the “Asian values” paradigm.
Many analysts forewarned of a potential Thai devaluation in 1996/97, but no one predicted the nature, scale and geographical reach of financial and economic mayhem that would be unleashed around the region from Southeast Asia to Korea, Taiwan and China – the second, third and fourth order effects. Carry trade based lending was at the core of that financial disaster. Today’s global financial markets are characterized by a carry trade of a scale that is many multiples of that which drove Asia into its worst ever economic tailspin. A repeat performance in prospect?
Most Asian countries, particularly in Southeast Asia were involved in a similar set of carry trades, explosive growth in real estate development, way in excess of what genuine end–user demand could justify, huge credit growth at the corporate and consumer levels. While Thailand was up–front and centre on analyst screens, most other parts of the region were embroiled in similar economic processes – rigged currencies, growing current account deficits, growing corporate debt fueled by the various carry trades, rampant building booms, rapid consumer credit growth. Thailand’s capital had more than 300,000 empty homes at this point, and a level of commercial property building running at 4 times annual demand levels.
When Thailand was forced to let its currency float on July 2nd 2007, no one imagined the forces of economic destruction that would be unleashed around the region, touching all parts of Southeast Asia, and reaching way north to China, Taiwan and Korea. A great many analysts correctly saw the Thai devaluation as likely to prompt similar actions by neighbours such as Malaysia and Indonesia, but few predicted the scale of the devaluations and the scope and direction of the subsequent fallout. Asia remained in recession for a considerable time, with deflation and collapsing asset prices for years.
For example prior to Thailand’s devaluation Indonesia’s currency had traded at around R2,300 to the US$. This quickly surged to around R12,000 to the US$ after the Thailand currency devaluation. Large numbers of Indonesian companies had borrowed in a range of foreign currencies, enjoying substantially lower interest rates than the prevailing local rates. A slightly more than back of the envelope calculation I did at the time estimated that the average debt equity ratio of the Indonesian stock market, excluding banks, was around 1,100%. A staggering amount that implied a massive part of corporate Indonesia was basically bust.
In the late 1990’s, Asian borrowers of US$ suddenly found themselves having to pay two to four times as much local currency to repay each dollar of debt. No one foresaw that scale of devaluation. A rise in the US$, for whatever reason, may let loose a crash in Asian asset prices this time around.
Thai and Philippines currencies had both been trading around 20 – 23 to the US$, and suddenly rushed to trade around 50 to the dollar. Imagine the impacts for say a property company that was geared say 80% debt to equity, largely in US$ (because interest rates were cheaper than Thai Baht), now having to pay back dollar debt, and now requiring twice as many Baht to do so. And, Oh, by the way, no one is now buying all those houses that the debt was used to build.
Markets like Hong Kong and Singapore, where debt levels were modest by comparison with many other Asian countries, and economic management generally more sound, were nevertheless knocked flat on their backs as well. China’s economy also went into a funk, with government moving swiftly to pump up domestic consumption to compensate from a sharp slowdown in inter–regional trade – again, sounds very familiar to the present. Contagion became the watchword for the region.
China’s response to the Asian Crisis was Similar to its Response to the Current Global Financial Crisis. Pump up Domestic Demand.
China, then, as now, sought to sharply increase the domestic economy in the face of sharply slower regional export markets. Intra–regional trade was the order of the day back then. Capital was being exported from high production cost locations such as Japan, Taiwan and Korea to lower cost nations such as southeast Asia and China. The high–tech components for TV’s phones, electrical gadgets still made in the “old” countries, were being exported to lower labour cost markets for assembly and distribution. As China saw that trade falling, policy quickly shifted gears to grow domestic development in housing (there was a huge need for housing anyway) and infrastructure.
Most of China’s now very substantial property companies were effectively spawned in that time. Encouraging property ownership was not only a great fiscal thing to do, jumpstarting a sagging economy, but also filled a huge social need for improved accommodation.
It also allowed companies, and particularly State Owned Enterprises (SOEs) to offload one of the key responsibilities of the iron rice–bowl economy. Housing had traditionally been provided for all workers by the commune, or work unit. Not only was the quality of housing often poor, but it also imposed significant costs on to the business unit. Encouraging workers to buy their own homes by way of one off ex– gratia cash payments killed several birds with one stone:
- It removed the on–going housing cost provision from the balance sheet.
- It provided a huge fillip to the domestic economy through igniting a massive building boom.
- It provided impetus for households to take responsibility for their own lives and also create a store of value through property ownership. China’s households have not been slow to grasp this particular aspect of housing markets.
The current global financial crisis has elicited a similar response in China at least, though less so elsewhere in the region.
China has faced cries from outside the country that it needs to bail the world out of its self induced mess through pumping up domestic consumption. China has its own reason for pumping up domestic consumption, but it is convenient to have the world believe it is doing so in the interests of “international economic harmony”. China’s body politic harbours great fears of the political and social impacts of an economic slowdown where GDP slows much below 8% or so. Hence China’s policy initiatives to pour massive lending into the economy in the first half of this year, to the tune of more than US$1.1 trillion of new bank lending in the first 6 months of the year.
And where did this lending go? Well of course, real estate took a goodly share, both at the consumer level and at the corporate level.
China is one of the few countries in the region where we have seen this explosion of lending into the real estate sector, particularly on the supply side. Other markets have seen a big pick up in lending to homeowners in the form of mortgages, but lending to the development community has been modest.
Consistent with our notion of attempting to identify potential second and third order effects of extraordinary economic events, we should be now exploring the potential and likely second and third order effects of China’s recent massive lending packages. China today is running a similar risk that the US Fed ran in its own easy money policies that led to the sub–prime crisis and its subsequent impacts.
Has the Asian Developer Community Learned From its Past Mistakes, or Simply Not Had Enough Time to Get into Trouble From the Last Crisis?
It maybe fair to say that Asian companies have learned from the debt mistakes of their past – pain that is still very much in the memory banks from the late 1990’s. A more cynical observer might say that the real estate community simply has not had enough time to get themselves into trouble having just crawled out of some very deep debt holes that were legacies of 1990’s excesses.
We here take a look at the property industry debt levels within the listed property companies in key markets in our region. We also distinguish between listed REITs and traditional property companies. The structure of the listed property sector in Asia is rather different from what many investors in North America might be used to. We identify three main types of companies:
Property developers – business model is to build and sell, usually residential, companies have high asset turnover, generally higher ROE, volatile earnings, can have high earnings growth. These companies make up about 65% of the listed property sector universe.
Property investment companies – business model is to build/buy and hold for rental purposes, mainly commercial property, lower asset turnover, lower ROE, more stable, predictable earnings. These make up about 20% of the universe.
REITs – these are relatively new on the Asian property scene but have been around in Australia for many years. REITs in Asia are simple creatures, with little development property, mainly rental properties, quite tightly regulated. They make up about 15% of the universe.
Our simple analysis of broad debt levels in the industry distinguishes between traditional property companies and listed REITs. In Australia most of the companies in the listed property universe included are Listed Property Trusts (LPT’s) of one form or other.
Despite debt levels looking pretty well contained in Asian property companies in this cycle, a welcome change I have to admit, the sector is not entirely immune from debt and credit related problems. The existence of relatively low levels of debt relative to assets does not in itself suggest no problems are going to exist on the credit side.
- Outright Credit Withdrawal: The meltdown of the global banking system, and the subsequent withdrawal of credit lines to just about all kinds of businesses has had significant impacts on property related business in the region, despite the industry being relatively lowly leveraged for the most part. But the impacts have been very different across different markets. By country we can summarise simply the situation and likely forward looking conditions.
- Japan: This market has probably endured tougher credit withdrawal conditions than most other Asian nations this time around, but impacts have been very different according to size and perceived company credentials. If your property company carries a name of the like of “Mitsubishi Estates”, “Mitsui Fudosan”, “Sumitomo Realty”, “Mori” etc credit withdrawal has not really been a problem though negotiations for loan rollovers might be a little tougher and costs may have risen a few basis points.
Many smaller companies with perhaps less than “household” name status have endured a very tough time. Even companies and REITs that have not sported excessive leverage, with modest debt/equity ratios of say less than 45%– 50%, have sometimes found it impossible to rollover existing loans, forcing them into bankruptcy. Servicing interest payments has not been an issue for most of these companies, but the simple availability of credit lines to roll over existing loans has not been there.
The Japanese property sector, in aggregate, appears quite vulnerable. Not only do companies generally have relatively high absolute total debt much more of it is short term debt than is often the case elsewhere. For example, the property developers as a group have an aggregate SHORT TERM debt/equity ratio of around 65%. The J–REITs are better positioned, with about 24% short term debt, but still much higher ratios than is the case for most other major markets in the region.
This year government has pressured banks to be a little more accommodating in such funding, and has established some government backed funding lines for use particularly in the REIT sector.
A key issue in the Japan property sector is that loans are often of short tenure, even for companies that are funding longer term investment properties as opposed to development properties for sale.
- Australia: Property companies in Australia in recent years went down a path of increasing complexity, mixing REIT businesses with development businesses, embarking on expensive foreign adventures, establishing property “wholesale” funds, and taking on loads of debt, often in a non–transparent way. We have been underweight the Australian property sector for a long time because of these factors, and also what we perceived to be a misalignment of property yields/cap rates and cost of capital. This financial adventurism has come back to bite some very high profile companies in the sector that have fallen foul of much tougher credit conditions. Forced sales of assets, bankruptcies and extensive restructuring are a feature of the Australian property sector.
While reported debt levels do not look too excessive, (short term debt/ equity ratio of less than 5% for last financial year, and total debt equity ratio of more than 65%) they often do not state the whole picture. Australian Listed Property Trusts (LPTs) often have significant debt obligations in associated and affiliated companies, that often do not appear in company accounts. Hence the recent focus on “look through” gearing. We also have to bear in mind that the “equity” side of the equation may be vulnerable to downward revaluations of property assets.
- China: Property companies in China – both local companies and those listed in Hong Kong – our comments refer to HK Listed China property companies– have gorged on debt in recent months as banks have turned on a veritable waterfall of lending to the economy generally, and to property specifically. Company data for the last financial year do not reflect this, but it will show up in the 2009 accounts. So from a dearth of credit availability in the second half of 2008, property companies have almost been swimming in credit availability in the first half of 2009.
Consumers have also drunk deeply at the debt well.
Credit expansion has slowed sharply in the past few months as banks are being reigned in. The issue for China developers is to what extent the strong pace of residential property sales will continue over the coming year to permit repayment in a year or two’s time of the loans taken on in the past year.
While this is not upfront and centre in investor thinking, recent murmurings of “bubble” concerns, slowing credit growth have reduced investor risk appetite in the sector.
- Singapore: Both the developers and the S–REITs look reasonably comfortable on the gearing front, with low near term debt/equity ratios of around 11% – 13% on average. It is also worth noting that most of the property developers have substantial investment property holdings that provide solid cash flow, and decent cash balances at an overall industry level.
The withdrawal of foreign banks from the lending scene in Singapore in 2008 did provide some anxious moments for the property industry, but local banks have plugged gaps that might have existed to a very large extent. Singapore REITs and property companies have also not been shy about tapping markets in various ways to boost cash to grow businesses and/or pay down debt. The S–REITs have been particularly active in this regard.
It is also noteworthy that many of the larger property companies have some government backed ownership. In the scheme of Singapore’s cosy financial system, it is highly unlikely that companies with solid government “sponsorship” would be allowed to get themselves in to life–threatening financial straights. While shareholders may face some dilution or other discomfort, outright collapse is probably very unlikely for many of the major property names in Singapore.
- Hong Kong: Of all the major markets in the region, Hong Kong property companies are probably the least vulnerable, as a group, to debt concerns. Nine of the 15 largest property companies by market capitalization are Hong Kong companies (we exclude the China property companies listed in Hong Kong in this count). The Hong Kong property companies have very little short term debt, in absolute terms, and short term debt/equity ratio for the industry is a meager 4.6%. Cash on balance sheets is more than twice the level of short term debt. Total debt is also very modest at around 35%, the lowest in the region, and this drops to around 23% on a net debt/equity basis.
Hong Kong’s REITs are rather more highly geared at around 54%, but with low short term debt. This higher debt level has given rise to some concerns about the possibility of companies breaching loan covenants in the face of downward adjustments to property values in the second half of 2008. Those concerns have dissipated recently as property values have bounced back.
Japanese property developers are vulnerable to credit withdrawal given the high proportion of short term debt carried. J–REITs have lower levels of short term debt. Credit outlook, however, is easing for companies in this sector, and should be less of a drag on share price performance than has been the case in the past year, particularly for smaller property developers and smaller J–REITs. Many smaller companies in the sector have underperformed their bigger cousins, particularly in the developer space.
I expect Australian property companies are going to continue to raise capital in the coming months, and expect further asset sales to reduce debt. Stocks have rallied sharply this year, but retreated in October. The sector is trading at a premium to asset value and a narrower spread to local bonds than the long term average. Rising local interest rates may also prove a negative for the sector short term. Growth is anemic at best.
At present, debt repayment does not look to be a major risk for the sector generally given recent sales levels, but a sharp slowdown in sales in the coming year could re–kindle the debt repayment/cash flow fears that crushed the sector in 2008.
China property stocks are in Goldilocks territory right now, neither too hot nor too cold. Valuations are a little on the high side of long term levels but not hugely so. A slightly cooler reception for a slew of property IPO’s demonstrates some withdrawal of investor enthusiasm for the sector. However, China property companies as a group will enjoy stronger growth in the coming year or so than any other property sector in the region. A pullback now will provide a better entry point I believe in a few months.
Given the capital raising that has taken place, S–REITs generally are in good shape from a debt perspective, are showing decent yields, even given share price increases this year, and have some shot at modest growth.
Hong Kong developer share prices reflect the low vulnerability to debt related concerns, and are trading at present at mid–cycle valuations. Near term earnings growth is modest for the most part. Recent government instigated policies may dull the near term performance of developer stocks, providing a cheaper entry point. Office based stocks are likely to outperform residentially focused property companies near term.
Aggregate Debt is One Thing, but Falls in Values Bring Risks of Loan Covenant Breaches.
Although total debt levels in many instances may look manageable, and in the vast majority of cases debt continues to be serviced by property companies quite comfortably, the issue of loan covenants has reared its head in parts of the region. The global financial crisis brought with it significant falls in property values in most markets around the region, which in turn has brought companies close to or in breach of loan covenants. This has very much been the case in Australia and also Japan. But even in Singapore and Hong Kong this has been of concern to certain REITs. In the case of Singapore many have gone out to the market this year and raised capital that has pulled them back into the safety zone again. In Hong Kong the spike in property values that has kicked in since Q1 has given reduced the threat of loan covenant breaches, that were quite negligible anyway.
While aggregate debt levels look manageable in most markets, falling values have raised the threat of breaches to loan covenants, particularly in Japan and Australia. Singapore REITs have raised capital throughout the year, and Hong Kong companies have benefited from a sharp surge in property values this year.
Talk, Policy Turns to Bubble–Beating – Product of the Global Carry Trade.
Asian markets are willing recipients of the massive global carry trade that is rumbling round the world. The Fed’s near zero rate policy has pushed most other major developed nations into the same policy jacket. Recent dollar weakness is also exacerbating the problems of carry trade flows – investors at the margin are betting that currencies in areas such as Asia will outperform the dollar, making the holding of non–dollar assets even more attractive. Asian governments are concerned about too much appreciation of their domestic currencies against the dollar, and therefore are edged towards keeping local interest rates at the low end of the scale to avoid excessive upward pressures on local currencies.
Investors are also betting that Asian economies are likely to enjoy faster economic recovery and higher economic growth in the coming couple of years. Probably not too far wrong.
So far, governments and central banks have not been focused on sterilising such flows, certainly at least in Asia.
These flows into Asian markets, as well as low domestic interest rates, are producing rapid surges in asset prices – stocks, bonds, real estate – in many markets around Asia. Japan is the main exception. Central banks and governments are leery of the potential of surging asset prices morphing into unsustainable bubbles, and rightly so. It was easy credit and property bubbles in the west that got the world into the mess it is in today.
One can argue the finer points of whether asset prices are truly at “bubble” levels in Asia, but the fact is that they have rallied very strongly from their Q1 lows in the face of huge flows of capital, low interest rates and floods of lending, particularly in markets such as China. This is feeding concerns in policy circles.
Record low interest rates, massive liquidity injections, the carry trade are all raising the prospect of asset bubbles in Asian markets. Asian markets have recent experience of reversals of such conditions and the impacts of this on asset prices and the real economy. Governments and central banks are understandably leery about the potential impacts of an unwinding of the current easy monetary conditions. This has proven devastating in the past for the real estate sector. Policy makers are edging towards heading off potential problems further down the track by tightening conditions in real estate markets.
While the dollar remains weak, this carry trade will probably continue. But the moment the dollar settles, or begins to firm, this carry trade will likely reverse, with potentially very negative implications for Asian asset prices, and banks both local and international. This time, a collapse in Asian assets and the potential for systemic problems in Asian banks may well derail the recovery of the western banking system also.
Asia’s last financial crisis had little impact on the global banking system. This time around might be a different story, particularly if a collapse in Asian asset prices is also accompanied by collapses in other emerging markets that have been beneficiaries of this global carry trade – Brazil and Lain America generally stand out. There are many factors that could lead to a reversal of recent interest rate and currency trends, factors that could lead to investors scrambling to cover short US dollar positions.
It has happened before. The Asian Yen carry trade of the late 1990’s is a relevant case in point. The moment the Thai Baht devalued in mid 1997, that carry trade was swiftly unwound, bringing devastating collapses in stock, bond and property markets around the region.
Hence the understandable nervousness of Asian central banks and governments. The memories of the crippling effects of the last carry trade induced bubble in Asia are still fresh in policy maker’s minds.
So What are the Policy Responses So Far?
While there are no real signs of any reversal of interest rate trends in the US or Europe, the carry trade could well continue to inflate asset prices in our markets. The longer this goes on, the bigger the asset price inflation, and the bigger the potential crash when it all turns the other way. Countries in Asia are quite used to asset prices crashes of 50% or more, but it is hard to think this is right way for economic affairs to be run.
However some policy makers are signaling a need to sterilize capital flows and debt creation in an effort to forestall the growth of asset bubbles.
China probably stands at the forefront of this. When senior academics, bank managers, politburo members and central bank functionaries are all heard to be sending warnings signals to the community via multiple media outlets, we can be pretty much assured that this is with official Party sanction. And there has been no shortage of such rumblings in the China media. The official Party line is that easy monetary policy will continue, but bank lending has been constrained in recent months, dropping to about half or less of the monthly volumes of lending seen in the first half of the year.
However recent volumes of property sales show that end users are still extremely active in the housing markets. Latest surveys show the pace of residential price increases has accelerated to levels not seen for more than a couple of years.
China will likely introduce more incremental administrative and financial measures to curb the growth in real estate prices. It has a history of doing so incrementally – introducing a few measures, watch the reaction, and adjust policy further in response. This will likely temper property stock performance near term.
The market is aware of policy concerns about property bubbles, and is taking a slightly more cautious view of the fortunes of property stocks recently. China’s property stock index (Shanghai market) is off about 15% since the recent peak in July. The threat of further measures to cool the property market is likely to cap upside for the China property stock sector in the coming months.
High earnings growth though for 2009 is pretty much assured, and quite a significant portion of 2010 property sales earnings are already locked in.
In Hong Kong the press is full of property bubble stories. Record prices of high end residential apartments have generated a media frenzy, not to mention a political uproar. This episode was sparked by the sale of an apartment in the Mid Levels district of Hong Kong Island for a world record per square foot price of approximately US$11,350/sq ft of saleable area. The lucky(?) punter supposedly paid approximately US$56.6 million for the privilege – bragging rights!
This and other recent high prices paid for luxury apartments has unleashed a torrent of political mileage seekers calling for government action to curb price appreciation. In Hong Kong’s case, prices of mass housing aimed at middle class families have risen, but nowhere near as rapidly as for luxury housing. Affordability for such housing is still good, but there is no doubt that the current trends are pointing up, and look like possibly pushing affordability into the “red zone” at some point in the future.
Hong Kong’s defacto central bank has pushed banks to curb lending to high end properties (I very much doubt that the buyer of the US$56 million property is seeking a mortgage!), and policy talk is focused on means of increasing land and housing supply in an effort to rein in rising prices.
With interest rates tied at the hip to Mr. Bernanke’s Fed policy, and we think with little near term prospect of a significant rise in rates, Hong Kong mortgage rates are likely to remain low, and affordability generally good for the near term at least. Banks and government have other ways to slow the market if they so choose, and the threat of such action may well be sufficient to cap upside for the main residential developer stocks near term. They are off about 10% since the mid–October policy address which ignited policy actions. We prefer office focused companies and REITs near term where news flow is likely to be to the upside.
Singapore has seen a very sharp rise in residential property prices in the past few months, despite there being substantial new supply coming on to the market as a result of en–bloc redevelopments initiated a couple of years ago. The Singapore government recently introduced minor measures that were designed to drain some liquid from the real estate punch bowl. In view of recent sharp upward moves in prices, we would not be surprised to see further measures introduced in an effort to cap upward momentum in residential prices. The office market however is lagging the residential sector with substantial new supply coming on stream acting as a handbrake on this sector.