Monday, September 26, 2011

The Reasons Behind the Overbuilding of Luxury Retail Malls in China


Some readers may have mistakenly ascribed a political agenda to my postings about Chinese real estate. My views on commercial real estate are nonpartisan and non-ideological.

To those who think that I have been poking fun at “The Communists” or the Chinese government, I point out that the fiascos I've reported have been capitalistic decisions of private owners and investors which happen to have occurred on Chinese soil. (Only one, New South China Mall, had some government involvement, as it was financed by the Agricultural Bank of China, which was State-owned at the time of funding nine years ago.)

I even disagree with the notion that the People’s Republic of China is a communist society. During my trips to the PRC I’ve met many Chinese people, none who have ever expressed the sentiment that he or she wanted to create a classless, utopian society that benefited “The People” rather than themselves. Most just tell me “I want to be rich”. If I ask for an opinion of Chairman Mao, I generally get a strange look which implicitly asks “What century are you living in?

As part of enforced “general education” requirements as an undergraduate at the University of Chicago, I was required to read The Communist Manifesto and The Russian Revolution (strictly in the context of critical inquiry), and neither Karl Marx nor Lenin ever stated that “The People shall have an Omega watch store every four blocks.” or "From each, according to his abilities; to each, a Gucci handbag." Overbuilding is not a Marxist concept, but Marx did explain in Das Kapital that overproduction is part of the natural outcome of a capitalistic society.

Karl Marx has probably caused more human suffering than any other philosopher who ever lived, but his criticism of capitalism was often insightful. He explained that technological advances increase labor productivity, which increases material wealth in the ruling classes while diminishing wages of workers, creating “poverty in the midst of plenty” manifested by overproduction and underconsumption. That may just be what is ailing China at the moment, as Chinese consumer spending as a proportion of GDP has been declining for the last half century in China.

Article in October issue of Shopping Centers Today

Next month’s issue of Shopping Centers Today (the house publication of the International Council of Shopping Centers) quotes me among other analysts in an article entitled “Many shiny new malls in Asia are devoid of tenants and shoppers”. Curt Hazlett reports many new but empty luxury malls in both China and India. There are various reasons cited, chiefly lack of experience and market analysis by the actual developers, who are private entrepreneurs.

This misallocation of resources is now being discouraged by the Chinese government. Recently, the Chinese Banking Regulatory Commission has been trying to proactively engineer a soft landing to a real estate bubble through stricter bank regulations. Reckless Chinese developers now find themselves unable to get Chinese bank loans for ill-conceived projects. The People’s Bank of China reports, for instance, that new lending to property developers declined to 42 billion yuan ($6.56 billion USD) in the second quarter of 2011, down 75% from 168 billion yuan in the first quarter. I have also seen similar policies put in place by the elected governments of Singapore and Hong Kong.

Real estate developers the world over are like heroin addicts, constantly seeking financing, and Chinese developers are no exception. If you give enough money to a developer, he will develop, because that is his raison d’etre. Chinese developers have found two alternate sources of funding after the shutting off of the Chinese banking spigot: private trust companies within China, which funnel investments from wealthy individuals and companies, and REITs created on foreign stock exchanges. The Chinese government is now cracking down on trust company lending, too.

So what is currently causing the continued overbuilding of luxury malls in China? In short, it is foreign investment. The “Chinese economic miracle” has been oversold to naïve foreign investors by self-serving capitalists. If the focus is on wealthy Chinese, most of their shopping is done outside the country, particularly in Hong Kong, in order to escape the VAT, the customs duty tax and the consumption tax, together adding up to as high as 60% on imported goods. That is why all the Hong Kong malls are full.

This last year has shown that it is easier to finance grandiose Chinese commercial real estate development schemes with equity offerings on foreign exchanges than with Chinese lenders. These equity investors (shareholders) have often been suckered because the "Chinese economic miracle" story has been so compelling and the IPO sponsors have been less than forthright. The logic that Chinese GDP growth is causing equivalent growth in consumer demand is contradicted by actual statistics: Per ISI Emerging Markets Inc., who maintains the CEIC China Premium Database, Chinese consumer spending as a proportion of GDP has now hit an all-time low of 34% and predicted to decline for two more years after being about 45% one decade ago and about 50% two decades ago, not quite the "consumption revolution" crowed about on empty New South China Mall's web site.

Walking through empty retail malls in Dongguan, Beijing and Shenyang, I was struck by the high prices on the merchandise offered. The median household income for Class-1 and Class-2 cities is estimated to be about $5700 per year, about 12% of the U.S. median, which is not conducive to a Gucci lifestyle. (The Chinese national average is about $3300 per year.) Wealthy Chinese, however, have the ability to travel and shop outside the country, where they find lower prices on luxury items, whether in Hong Kong, Singapore, Beverly Hills, or Vancouver. (Hong Kong attracts many Chinese shoppers due to the lack of a sales or value-added tax.) That narrows down the universe who have the resources and desire to buy their luxury goods domestically.

Recruiting foreign investors

Foreign investors may have misconceptions about Chinese shoppers based on the Chinese shoppers who travel to their own countries. These shoppers represent the affluent class of China, which is small in proportion to the total population. Mall investment sponsors have been capitalizing on this misconception.

Foreign investors are easier to take advantage of than Chinese investors due to their lack of legal recourse when they are cheated. Law enforcement can be heavy-handed within China. For instance, while I was staying in Shenzhen, the former mayor had just been convicted of corruption and sentenced to death. Executives of a company committing fraud on the Shenzhen or Shanghai stock exchanges are subject to severe criminal penalties, particularly if they cheat the government. Not so if the company is listed on a foreign exchange, such as Hong Kong, Singapore, New York or Toronto.

From GAAP to CRAAP

Just as U.S. securities laws are not extra-territorial, neither are Chinese securities laws. China does not have GAAP (Generally Accepted Accounting Principles), so the rules governing accounting are different; Chinese accounting policy has been nicknamed CRAAP (Chinese Regularly Accepted Accounting Policy) by hedge fund manager Jim Chanos.

The Chinese economic miracle has been a 30-year growth trajectory that has averaged annual GDP growth of 10% per year (according to the government) and created 115 billionaires as of the last Forbes count. Just remember, though, that the building of empty malls and office buildings is part of that GDP growth.

Chinese consumer spending has failed to keep pace, too, as Chinese household income, is less than 10% of U.S. household income. This is what Marx predicted would happen to capitalist societies, that workers would end up being financially unable to buy the very products they were producing. The empty luxury malls are evidence of that.

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