The China Bubble (4)

Gady Epstein, Forbes Magazine, dated December 28, 2009-

Assuming China’s reckoning does arrive some day, it’s impossible to say whether it might presage Japan-style deflation, Russian-style hyperinflation or American-style stagnation. For now, private, semiprivate and state-owned enterprises are getting creative to keep the boom alive. Some cash-starved local governments are believed to be asking companies to prepay 2010 corporate taxes to meet this year’s budgets. It’s the kind of monkeyshines you might expect in New Jersey or California, not in supposedly cash-rich China.

Related-party transactions are another popular funding source. Hainan Expressway Co. in southern China is a government-owned outfit deep in hock. In the last year it has lent some $40 million to its founding shareholder, the Hainan Department of Transportation, and booked the loan due as an asset on its balance sheet. This classification provides the Hainan Expressway with additional collateral to borrow even more in new construction loans from state-owned financial institutions and increases the risk that it will eventually default, according to Northwestern’s Shih.

Western and Hong Kong investors are in on the frenzy, too. Evergrande Real Estate Group, a Guangzhou developer, recently staved off a default on short-term debt by raising $800 million in a Hong Kong initial offering, which bestowed it with a $14 billion market cap. But whom is it kidding? Sixty percent of its “profit” this year is expected to come from increasing the reported value of its properties, a ploy that is a common source of earnings for Chinese real estate developers.

As is typical in the later stages of property booms, many investors in China appear to have discarded rental yields as a measure of how much a building is worth in favor of greater-fool pricing. In downtown Beijing office towers sold this year for $400 per square foot, despite the fact that many were unleased and many more are under construction. The leading buyers: state-owned enterprises, including banks and insurers.

Warning Signs

Asset flipping can go on only so long. At some point you need paying tenants.

–Developers highly leveraged, dependent on easy credit.

–Government funding via debt and land sales to state-owned corporations, prepayment of corporate taxes.

–Total outstanding debt approaching Japan’s precrash level.

from The Forbes