Prem Watsa, chairman and CEO of Fairfax Financial, is often regarded as the Canadian Warren Buffett. Some extracts from his recent letter to shareholders, courtesy of long time reader Gary W.)
In the last few years we have discussed the huge real estate bubble in China. In case you continue to be a skeptic, here are a few observations from Anne Stevenson Yang, an American who has been in China for over 20 years and is the founder of JCapital Research in Beijing:
1. China added 5.9 billion square metres of commercial buildings between 2008 and 2012 – the equivalent of more than 50 Manhattans – in just five years!
2. In 2012, China completed about 2 billion square metres of residential floor space – approximately 20 million units. For perspective, the U.S. at its peak built 2 million homes in a year.
3. At the end of 2013, China had about 6.6 billion square metres of new residential space under construction, around 60 million units.
4. Yinchuan, a city of 1.2 million people including the suburbs, has 30 million square metres of available apartments – roughly 300,000 units that could house 900,000 people. This is in addition to the delivered but unoccupied units. The city of Guiyang, capital of Guizhou Province, has roughly 5.5 million extra units for a
city of 5 million.
5. In almost every city Anne has visited, pretty much the whole existing housing stock has been replicated and is empty.
6. Home ownership rates in China are estimated to be over 100% versus 65% in the U.S. Many cities report ownership over 200%. Tangshan, near Beijing, is one.
7. This real estate boom could only be financed through unrestrained credit growth. Since 2009, the Chinese banks have grown by the equivalent of the entire U.S. banking system or 15% of world GDP.
8. The real estate bubble has resulted in companies extensively borrowing and investing in real estate or lending on real estate in the shadow banking system. This is exactly what happened in Japan in the late 1980s.
9. And one observation of our own: Since 2009, the easing by the Federal Reserve combined with the explosive growth in China, backed by higher interest rates, has resulted in huge inflows (‘‘hot money’’) into China. The near unanimous view that the renminbi would strengthen has resulted in a massive carry trade where
speculators have borrowed at low rates across the world and invested in China, almost always backed by real estate. The shadow banking system in China – i.e., assets not on the books of the major Chinese banks – is estimated by Bank of America Merrill Lynch to be approximately $4.7 trillion or 51% of Chinese GDP. Oddly
enough, prior to the credit crisis, the U.S. had $4.5 trillion in asset-backed securities outstanding or approximately 31% of U.S. GDP. You know what happened then. When the flows reverse in China, watch out!
These observations remind me again of the following quote from Michael Lewis’ essay in Vanity Fair, ‘‘When Irish Eyes are Crying’’, which I wrote to you about in our 2010 Annual Report: ‘‘Real estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long term investment real estate has become and flee the market, and the market will crash.’’ Amen!
As they say, it is better to be wrong, wrong, wrong and then right than the other way around! For those of you who believe a picture is worth a thousand words, please watch the recent BBC documentary ‘‘How China Fooled the World’’.
Finally, in our 2007 Annual Report, we quoted Hyman Minsky, the father of the Financial Instability Hypothesis, who said that history shows that ‘‘stability causes instability’’. Prolonged periods of prosperity lead to leveraged financial structures that cause instability. This quote was in relation to the U.S. in 2007. It applies in spades to China in 2013!
Any credit event in China will have very significant ramifications for the world economy, as China is the world’s second largest economy and consumes 40% to 50% of most commodities from iron ore to copper. Here’s an update on the commodity price tables I have shared with you before:
While commodity prices have come down, they have yet to collapse. Of course, a collapse would have a very significant impact on the mining industry. World iron ore capacity has increased by more than 100% in the last ten years, mainly because Chinese demand has nearly quadrupled! Of course, any decline in commodity prices will impact Canada, as I mentioned in last year’s Annual Report. Unlike the U.S., Canada has not had a decline in house prices, and as I said last year, we are watching from the sidelines. Caveat emptor, as they say!
In this environment, with zero interest rates and high debt levels prevailing in most developed countries, giving them limited flexibility to react to unintended consequences, we think it is prudent to have a very strong balance sheet with a large cash position and to be protected on the downside. When problems hit, only those with cash and very liquid assets can take advantage of them. While it is very painful and costly waiting, we think your (and our!) patience will be rewarded.
We are reminded again of the warning from the distant past from our mentor, Ben Graham, which I have quoted before: ‘‘Only 1 in 100 survived the 1929-1932 debacle if one was not bearish in 1925.’’ We continue to be early – and bearish!