Budgeting for the China syndrome

Beyond the domestic belt tightening, we must budget for China’s pain.

There are three obvious budgetary implications for investors in Joe Hockey’s 2014 budget – the bruising of lower and higher middle income consumers, the massive infrastructure spending, and the use of retirees’ franking credits to pay for paid parental leave.

But there is also a hidden force which will govern the budget outcomes – the big changes looming in China, which may turn out to be most important of all.

There is no doubt that large numbers of people on social services are going to have less to spend, while middle-class Australia will also feel bruised by the budget. These two events must reduce their retail spending. The top income tax rate is now 49%, cutting at higher middle-class levels of $180,000, which will affect the confidence and spending of people in these brackets.

Retailers at the bottom end will feel the pinch. The squeeze on consumers will hasten the pressure on the values of some shopping centres, because not only is there less money for consumers to spend but the tax measures will increase the attraction of two income families and therefore divert even more shopping online.

The massive infrastructure investment ($125 billion over five years) will boost building suppliers, but there are now few listed Australian companies that have the capacity to carry out the building. Most are overseas owned.

The main Australian builder will be Lend Lease, but to obtain the full benefit Lend Lease will need to reach a new accord with its workforce. Many of its current labour arrangements breach Commonwealth guidelines.

The Government is lowering the corporate tax rate from 30 to 28.5%, but then imposing a 1.5% levy on the top 300 companies. This levy is supposedly not a tax, so it does not count for imputation credits. Accordingly, those who rely on the franking credits from, say, bank shares and hybrids, are the people who will pay the paid parental care bill. On the other hand, as Alan Kohler points out, dividends will rise as companies use up their franking credits.

The China factors

However, the biggest factor determining just how well Australia performs in the next two or three years is what happens in China. We might not like it but Australia, in many ways, is a state of China. Our major export revenues, and therefore our tax revenues, come from exporting iron ore, coal and gas.

Moreover, Chinese buying is the main force driving large areas of the Sydney and Melbourne real estate market as well as parts of Brisbane. Chinese tourists boost widespread areas of the economy, and our education sector is closely related to China.

The general view in Australia is that China is going through a difficult lower growth period, but if there is any significant downturn the Chinese administration will again stimulate the economy and, for Australia, all will be well. I have always had that view – and I still have it – but facts emerging in the last week or so have increased the risk of a Chinese bumpy landing.

The first danger stems from what is taking place in the iron ore market. There is substantial oversupply, and iron ore has been flooding into the Chinese market, which is putting great pressure on prices. In turn, the Chinese are flooding the world steel markets, which again affects the prices. That will be rationalised by the withdrawal of supply or an increase in demand.

Real-estate ripples

On its own, a commodity oversupply does not concern me a great deal because it happens at regular intervals in commodity markets. What is much more concerning is the revelation from inside the Chinese corporate hierarchy that has come to Australia via Business Spectator commentator Peter Cai.

We have never seen material from China with this level of accuracy and depth of revelation. In simple terms, Mao Daqing, the deputy chief executive officer of Vanke, the largest property developer in China, decided to speak candidly at a closed session of property developers. But someone in his audience leaked the Vanke material.

Mao Daqing pointed out that sales of high-priced apartments have been really hit by the anti-corruption campaign by the Chinese government. In addition, I suspect that the jailing of political leader Bo Xilau for alleged bribery, corruption and abuses of power has contributed to the avalanche of Chinese property buying in Australia.

According to Vanke data, as reported by Peter Cai, it will take 12 months to sell apartment inventory in 21 cities and more than 24 months to clear other stock in another nine cities.

And within those scary overall numbers, some Chinese cities have very serious oversupply indeed. The real estate sector makes up 16% of China’s Gross Domestic Product, and 20% of outstanding loans.

Chinese banks like the Bank of China and the Industrial and Commercial Bank of China, which are some of the biggest lenders to the property sector, are setting up specialised departments with experts from the property sector to do analysis project by project. It shows banks are getting more risk averse.

“Banks are using market criteria to judge and assess projects,” Mao said. “If they don’t meet the lending target, they will become picky.”

Vanke say that when Tokyo’s land values went above 60% of US GDP in 1990, and Hong Kong achieved a similar ranking in 1997, it triggered a big fall. Beijing land values have risen well above 60% of US GDP. Such trigger points are, of course, arbitrary but the fact that they are being quoted by the largest developer in China gives them a chilling aspect.

China’s housing projects are running about twice the level of Japan and Korea in the boom on a per population basis. And housing construction represents about a third of China’ massive fixed asset investment. And, of course, that is where a third of Australian iron ore and coal has gone.

Mao Daqing believes that China is facing up to its problem and changing its strategy, so that is good news for the country overall. But it is not good news for the next five years for Australia given our dependence on commodity exports.

Whether these domestic China real estate problems will curb the buying of Australian real estate is impossible to determine, but historically when the home market gets into trouble people look inwards and don’t invest overseas. That is certainly what happened when the Japanese boom collapsed.

Greater dangers

It is a good thing Australia is tightening its belt after the long years of overspending. But we need to be aware there are forces in China, which represent a danger that is far greater than the deficit tax or other changes in the local economy. More importantly, none of us know exactly how these China changes will work out. But it does mean that there is an extra risk to investing.

And so, for those particularly in the higher age groups, conservative investment strategies make sense. For those simply investing in equity, you need to spend a lot more time in specific stocks rather than investing across the board.

Footnote:

The Chinese plan is to boost domestic consumption rather than investing so much in real estate and infrastructure. That will boost demand for copper. Big shortages have been flagged by BHP and the copper price is on the move. That’s why the Chinese are buying into PanAust.

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