FSO Editorials: "The China Syndrome, Part 8: Meltdown in Shanghai" by Dr. Joe Duarte 01/11/2006

FSO Editorials

THE CHINA SYNDROME
Part 8: Meltdown In Shanghai
by Joe Duarte, MD
Joe-Duarte.com & IntelligentForecasts.com
January 11, 2006

Editor�s note:

This is the latest installment of Dr. Duarte�s increasingly intriguing series on the �economic miracle� in China, and what is lurking beneath it.

In this article, Dr. Duarte looks at what the Los Angeles Times describes as a housing market that is imploding in Shanghai, and the potential economic repercussions for the world.

This article originally appeared in Dr. Joe Duarte�s Market IQ on January 9, 2006

For further reference read the following by Dr. Duarte:
Rate Hikes May Create 'Perfect Storm'

Part 1 of The China Syndrome concluded that China is not just a power to be reckoned with in the future, but rather that China is a major player in the world now.
Part 2 of The China Syndrome set forth evidence for irregularities in the way China does business, and how the world is looking the other way.
Part 3 of The China Syndrome explores the implications of China's activities on the Asian region.
Part 4 of The China Syndrome described the key aspects of the relationship between China and the world�s other emerging potential Super Power, India.
Part 5 of The China Syndrome explored the bid by Chinese oil company CNOOC for the U.S.�s Unocal.
Part 6 of The China Syndrome explored the Yuan revaluation that occurred on July 21, 2005, as well as other key developments that made it something that had to be done by the Chinese Government, due to mounting political pressures.
Part 7 of The China Syndrome where Dr. Duarte documented the state of unrest in the highly affluent Chinese province of Guandong.

Today's Analysis: The China Syndrome Part 8: Meltdown In Shanghai

The housing boom in China is imploding, just as major global banks and private equity firms are making huge forays into the Chinese banking system, suggesting that as Wall Street firms trip over one another to buy China, we could be on the verge of yet another Asian contagion.

According to the L.A. Times, China's model city of commerce, Shanghai is now a model for what happens when a housing bubble bursts.

Indeed, the situation, as described by Don Lee, is bordering on hysteria: "Once one of the hottest markets in the world, sales of homes have virtually halted in some areas of Shanghai, prompting developers to slash prices and real estate brokerages to shutter thousands of offices. For the first time, homeowners here are learning what it means to have an upside-down mortgage � when the value of a home falls below the amount of debt on the property. Recent home buyers are suing to get their money back. Banks are fretting about a wave of default loans."

What makes this interesting is that this is not new, as it has been going on for months. According to the Times: "3,000 brokerage offices had closed since spring. Real estate agents, whose phones wouldn't stop ringing a year ago, say their incomes have plunged by two-thirds."

The Achilles' Heel Has Been In The Making For A Long Time

To be sure, at first glance it would seem as if property values in one city do not necessarily lead to the potential for economic collapse, or even economic damage to an entire economy.

But a closer look suggests that this is indeed significant, as "Although the city's 20 million residents represent less than 2% of China's population of 1.3 billion, Xie says, Shanghai accounts for an astounding 20% of the country's property value. About 1 million homes in Shanghai alone � about half the number of housing starts for the entire United States in 2004 � are under construction.

Andy Xie, Morgan Stanley's chief Asia economist in Hong Kong, told a woeful tale to the Times, noting that the homes in question in Shanghai "will remain empty for years," and that the situation in Shanghai is but a prelude of "a jolting comedown," that in store for "other Chinese cities with building booms � including Beijing, Chongqing and Chengdu � though other analysts say the problem is largely confined to Shanghai."

We tend to side with Xie, given our previous reporting, September 25, 2005, of an otherwise little noted situation in China, the pending danger of social disorder, as described by a senior member of China's Politburo:
["A member of China�s Politburo told Hong Kong lawmakers and Chief Executive that the poster child Guandong province in the midst of a multi prong crisis, characterized by the fact that �its residents' living conditions are deteriorating, and law and order are on the verge of breaking down.�]

Indeed, in that article, we provides stark details of the Politburo member's speech, provincial Communist Party secretary Zhang Dejiangand its five key points:

According to the Hong Kong Standard, Zhang�s speech zeroed in on five key points:
1)["Guangdong has been the nation's pioneer for economic reform in China and a miracle in the eyes of the world ... but, in fact, Guangdong is now in crisis management," Zhang said.]
2)["There are various hidden worries and risks. If we took a wrong step, we might be overtaken by Jiangsu, Shandong, Zhejiang and Shanghai.�]
3)["The Pearl River Delta has prospered as the most affluent place in the country, but northern Guangdong is suffering the most severe poverty and underdevelopment.�]
4) ["Guangdong faces [serious] problems arising from our rapid economic growth. The land area is getting smaller. Water and air pollution is serious and getting worse. We are worried about the safety of what we eat and drink."]
5) And sounding rather fatalistic and grim �Zhang said the province's target of becoming a middle-class society may be an impossible dream, and ["in the long run, we may not achieve this."]

A Familiar Story

According to the Times, the housing bubble, like all bubbles began to melt up, creating a feeling amongst the population that if they didn't join in the craze, they would be left out:
1) ["Shanghai's housing bust comes after a doubling of prices in the previous three years, a run-up fueled by massive speculation. With China's economy booming and Shanghai at the center of worldwide attention, investors from Hong Kong, Taiwan and elsewhere were buying as fast as buildings were going up. At least 30% to 40% of homes sold were bought by speculators, says Zhang Zhijie, a real estate analyst at Soufun.com Academy, a research group in Shanghai."]
2) ["Ordinary people had no option but to follow the trend," Zhang said. "Worrying that prices would be even more unaffordable tomorrow, many of them borrowed from relatives and banks to buy as soon as possible."]
3) ["The Shanghai government only pushed the market higher, he added. "Many of the officials said Shanghai's property market was healthy and wouldn't drop before the World Expo" in 2010.]

Water Under The Bridge And Ghosts Of Greenspan's Past

On April 5, 2005, on Marketwatch.com, we wrote:
["As Europe flounders in its self-inflicted bowl of economic soup, and Japan muddles along, China continues to outpace them all, fed by still relatively low interest rates, and international capital searching for growth. But, even that, will come to an end, at some point, especially if the Federal Reserve raises interest rates further. It's difficult to predict when that magic rate will be hit. But, for those who believe that China's economy addicted to cheap money, the withdrawal syndrome will be painful when it happens. According to Intelligence service Stratfor.com: Chinese "debt is extremely vulnerable to interest rate hikes. As rates rise, that debt will become impossible to maintain, and China will face the beginnings of a financial crisis. Given the makeup of the Chinese financial system, such a development is unavoidable. The only questions regarding the crisis to come are time frame and severity."]

Our conclusion in that article was as follows:
["Assuming that the Chinese economy hits what is an inevitable bump in the road, that would mean that somewhere later this year, perhaps in July or August, the traditional time for financial markets to start stumbling and churning, we could be in for another Asian meltdown, as in 1997's Thai Bhat debacle. That could mean that by October, the usual bad month in the markets, things could be fully underway. If U.S. households find themselves in a cash flow crunch, as a result of rising mortgage rates, and the Chinese economy is suddenly drained of foreign cash, being repatriated to the United States due to the lure of rising interest rates, a significant change of scenario in the markets is not just likely, but inevitable. The shift could start suddenly, and progress quickly, fueled by fiber optic communications and the flow of information at the speed of light. A sudden slowing of the global economy would also nearly guarantee lower oil prices, a situation that in and of itself, given the geography of OPEC and Russia, the world's number 1 and 2 oil producers, could lead to geopolitical instability."]

On April 22, 2005, we wrote: ["According to the Wall Street Journal �Greenspan said China will unpeg its currency from the dollar "sooner rather than later" because the policy poses a growing threat to China's own economy. Mr. Greenspan told the Senate Budget Committee that China's peg ["is beginning to significantly work to the detriment of the Chinese economy."]�

In that same article, quoting Reuters, we noted: "Greenspan noted that �the vast currency intervention required to keep the yuan cheap -- with China buying billions of dollars' worth of U.S. government bonds -- risks bloating its money supply. ["That is creating imbalances that suggests that sooner rather than later they are going to have to, for stability purposes, move their currency,"] he said. ["Fixing the renminbi to the dollar is beginning to significantly work to the detriment of Chinese economy."]�

Finally, Greenspan added: �Currency intervention was also distorting the proper functioning of the Chinese economy, favoring labor-intensive industry at the expense of more technology-rich enterprises that would do a better job of ensuring future prosperity. ["If the exchange rate began to rise, they would start to move capital into more efficient types of uses which essentially would mean that output per hour would rise,"] Greenspan said. ["Holding their exchange rate where they are is preventing the growth in the terms that would be most valuable for China in the decades ahead. So as far as I'm concerned, it is very much in their interest to move."]�

Conclusion

There are several major threads converging here.
1) China's government is no longer in control of its economy, the markets are. The government seems to have noticed it lately, although the markets have yet to come to grips with the situation.
2) Wall Street is pouring billions into China, which means that billions will leave in a hurry, when the panic button is hit.
3) Chinese markets do not have the proper checks and balances in place to survive a world class flight of capital. That means that global markets, will take a major hit when illiquidity and confusion hit the fan in China, and positions have to be unwound elsewhere to meet margin calls.
4) Social unrest is an ongoing, albeit still regional phenomenon in China. But, a national crisis is possible if enough people share the same fate.
5) The huge amounts of foreign capital now present in China, combines with the huge amounts of higly leveraged derivative activity in global markets, could make for a very memorable time in the history of the World.

Since April 2005 much has happened, including the continuation of interest rate increases by the Federal Reserve, with one or two more hikes nearly guaranteed by the April 2006, even though Wall Street is starting to factor in the potential for the end of the rate hike cycle.

What makes the timing of those articles interesting is that they written in the spring of 2005, precisely the same time in which the Los Angeles Times reported, above, that the meltdown in the housing market began.

Since that time, we have seen the U.S. dollar climb, which suggests that money was moving out of China, perhaps into the U.S., a fact that may have prompted China's recently reported moves to "diversify," their currency base away from the dollar.

At the same, time, no further progress has been made in liberalizing the Chinese economy, despite a widely publicized White Paper, and a new Five Year Plan of reform, built around a hazily described redistribution of wealth program, which promised pain to the richest in China.

In September 2005, based on the speech from Guandong province's leader quoted above, we concluded: "China�s most prosperous province currently existing on the verge of a social and economic calamity brought on by too rapid growth, and its consequences, meaning, pollution, crime, and above all, the maldistribution of wealth. If the cream of the crop is in this much trouble, what is the rest of the country like? And what will GE, Microsoft, Bank of America, The Royal Bank of Scotland, Goldman Sachs, Merrill Lynch and Dell do, if and when they figure this out?"

As we said in September: "Our view is only strengthened by this new batch of evidence. China�s economic miracle has a date with destiny, just as every other economy in the world has experienced many times in history. The difference is that the Chinese don�t seem to know what they will do when the inevitable happens."

Which brings us to January 2006, and the following notion: If the L.A. Times is correct, China's economic disaster may have been on its way since the spring of 2005, and may be on the verge of gathering steam.

Investors should be paying very close attention to the currency markets, where many significant debacles tend to start.

joe duarte Joe Duarte M.D. is founder and Editor in Chief of Joe-Duarte.com. Dr. Duarte is a board certified anesthesiologist, a registered investment advisor, and President of River Willow Capital Management, where he manages individual client accounts. duarte iq His latest books "Successful Energy Sector Investing" and "Successful Biotech Investing" (Prima/Random House) are available on line at amazon.com, barnesandnoble.com, borders.com, Traders Press, and all major online and brick and mortar bookstores in the U.S., U.K. Europe, and Australia.

Dr. Joe Duarte's Daily Market I.Q. is a subscriber service that provides daily intelligence, trading strategies, and technical analysis at www.joe-duarte.com.