Shares of Chinese property companies are coming down to earth a lot faster than the prices of the apartments they are selling. Somewhere in there may be a buying opportunity.

The Chinese government's measures to rein in the overheating sector are starting to work. Big cities across China have begun to see declines in sales volumes and even prices for residential properties, after a four-year run of steady, mostly uniform price increases. Many Chinese property developers have seen their Hong Kong-listed shares fall more than 40% since the start of November, outstripping declines of 26% on the broader Hang Seng Index.

Analysts say the sharp declines have brought these companies' valuations back down to reasonable levels, making the sector ripe for cautious bargain-hunting. Brokers and analysts in the physical-property market remain optimistic about the overall China property story, pointing to rising wages and waves of mass migration to the country's booming cities, trends unlikely to abate for years.

Those who watch these stocks, like Clifford Lam at Credit Suisse in Hong Kong, are also keeping a positive "overweight" rating on the sector — though he bluntly titled a recent report "Don't Get Too Excited."

One reason for the cautious optimism: The recent success of Beijing's aggressive tightening measures may mean central authorities will hold off on initiatives to curb lending or hold back developers. "We see a very small probability of overtightening in 2008," Tony Tsang, an analyst at Citi Investment Research in Hong Kong, wrote on Jan. 31.

Another positive may be rising inflation, a major concern of authorities and consumers. Current levels could drive more people to buy property as a hedge.

Developers active in the Shanghai area are particularly attractive to analysts, given the robust demand fundamentals there. So are developers with strong balance sheets and access to alternative sources of financing, as equity markets are likely to keep facing head winds this year. Many developers issued shares and debt in recent years to fund aggressive land acquisition, which in turn propped up share prices.

"Much of the rise has been fueled by a virtuous circle of rising residential prices, land prices and equity prices," Robert Fong, an analyst with Merrill Lynch in Hong Kong, wrote late last month. "For a while, it seemed all that developers needed to do was to keep buying more land to fuel a seemingly endless surge in equity prices."

Now, it is a question of which developers will be able to sell their flats and keep cash flowing in. Those with fat wallets will gain even more of an edge in a year that many expect will see a wave of mergers and acquisitions. Conversely, weaker developers could become takeover targets as big players scour for sources of land to develop at low costs.

Two Hong Kong-listed developers that are well capitalized are China Overseas Land & Investment and China Resources Land. Analysts say both are light on debt and should have good sales in 2008. And Shanghai Forte Land is seen as well positioned in its home city. For the three developers, share prices dropped about 40% or more between Nov. 1 and Jan. 22, though all the stocks except Shanghai Forte have since regained some ground.

Analysts say it is generally best to avoid problem areas in southern China, where the Shenzhen and Guangzhou property markets have shown the most serious signs of cooling, even as nearby Hong Kong enjoys high growth. In recent years, prices rose dramatically in the two mainland cities, which depend on retaining big industrial bases.

"The growth there is not very sustainable, and going forward, demand growth for property won't be as aggressive," says Yi Chen, a property analyst for ABN Amro in Hong Kong, who notes that new-home sales in Shenzhen have slowed to fewer than 20 units a day from 200 units not long ago. Home prices dropped about 8% in Shenzhen between September and the end of 2007, while prices in Guangzhou in November fell 9.9% from a month earlier, government figures show.

That is one reason Mr. Chen, who lists China Overseas Land and Shanghai Forte as his strongest recommendations, has a "sell" rating on Guangzhou R&F Properties, a developer with a big presence in both cities. From a Nov. 1 peak of HK$43.40 (US$5.56), its stock tumbled 55% by Jan. 22, to HK$19.22, before recovering a bit. Yesterday, it closed at HK$22.80.

Mr. Tsang of Citi doesn't share the pessimism, arguing that Guangzhou R&F could soon reach its goal of listing on Shanghai's exchange, a move that should boost investor interest in the company.

Still, in general, southern China's weakness reinforces the appeal of the Yangtze River delta, home to Shanghai and second-tier cities Nanjing, Hangzhou and Suzhou. Demand and price growth have been relatively restrained there for several years and only started to take off last year. Property broker Jones Lang LaSalle, suggesting fundamentals in Nanjing are still healthy, notes that land auctions in the provincial capital set records four times in 2007.

Joe Zhang, chief operating officer of Shenzhen Investment, a Hong Kong-listed developer with a major presence in Shenzhen, said recently he remains bullish on that city despite what he estimates is a 20% correction there since September.

Still, his company is hedging its bets, receiving HK$1.2 billion from sales of land and property in Shenzhen and adding exposure in the eastern Yangtze River delta provinces of Jiangsu and Anhui. That could help Shenzhen Investment shore up its battered shares, which fell 55% between Nov. 1 and Jan. 22. The stock closed yesterday at HK$4.19, or 45% below its Nov. 1 level of HK$7.66.

It hasn't, but the 25-year-old marketing assistant recently bought the place anyway. That's because two weeks ago and half a world away, the U.S. Federal Reserve cut interest rates again, hoping to stimulate an economy dragged down by a housing sector in disarray. Since Hong Kong pegs its dollar to the U.S. currency, it followed the Fed's lead, knocking the city's base rate down twice in less than two weeks for a total of 1.25 percentage points.

A picture taken from the roof of Two International Finance Centre, Hong Kong's tallest building, shows the city's Central district.

The unintended result: home-loan rates so cheap that they are throwing more fuel on an already scalding property market.

A typical mortgage here — which is pegged to the prime rate which, in turn, is tied to the base rate — now carries interest of about 3.1%. But compared with Hong Kong's inflation rate of about 3.8%, which is hovering at a more-than-nine-year high, that looks especially inviting, creating a so-called negative real interest rate.

For many potential home buyers in Hong Kong, mortgage payments are now effectively cheaper than rents, which are slower to adjust to rate changes. Indeed, within hours of the Fed's latest rate cut, Ms. Lau was on the phone with the owner of the apartment in the Kowloon district of Hong Kong and signed the contract to buy it that night. She says she plans to rent the flat out to tenants for two years to make money on the mortgage/rent spread and then may move in herself.

Real interest rates have been in negative territory before here in China's international-finance hub. During the early 1990s, cheap home loans helped inflate a property bubble that hit records before bursting, with devastating effect, during the Asian financial crisis of 1997-1998. Prices have only now begun to touch those levels again, and further gains could be in the cards.

Andrew Fung, head of investment and insurance for Hang Seng Bank in Hong Kong, calls the property market here one of two "certain investments" — along with the appreciation of China's currency, the yuan — in an uncertain economic environment. Underlying the property-buying enthusiasm: fast-rising wage increases, unemployment near its record low and bank deposits growing at about 20% a year.

Then there's the weakness of Hong Kong's dollar, which is tracking the U.S. dollar's decline. Mr. Fung credits the cheap currency with making properties even more attractive to foreign private-equity funds.

"A couple of years ago, lots of funds were pouring their money into Singapore's residential market, and now we're seeing them buying in Hong Kong," says Keith Yeung, a senior director and head of greater China property for Merrill Lynch in Hong Kong. Also pushing up the market, Mr. Yeung says, are speculators from mainland China looking for new places to put their money.

Finally, new supply is tighter than ever before. According to property broker CB Richard Ellis, home prices in 2008 will rise another 20% or so in both the luxury and mass markets. The number of new units in the luxury residential market fell to 70 in 2007 from 1,055 units in 2005. In the mass residential market, new supply fell 44% in 2007 from the year before to more than 8,700 units.

That tight supply has helped push prices for luxury properties up 38% in the past year alone, with fresh reports of eye-popping transactions grabbing headlines every few months last year. In November, one 7,000-square-foot penthouse apartment fetched $36 million, or about $5,140 a square foot. A few months earlier, a luxury house on Hong Kong's Victoria Peak sold for $27 million, or about $5,270 a square foot. Prices in the mass market, which is comprised of the nonluxury properties, grew quickly as well in 2007, though at a more modest rate of 14% — a sign, analysts say, that even more growth lies ahead.

Now, with inflation eating away at bank-deposit returns and volatility hitting the stock market, interest rates are giving Hong Kong residents another incentive for putting their cash into real estate, a classic hedge against inflation.

"With so many favorable factors in place, the housing sector is likely to heat up further," says Gordon Tse, corporate-development director at Midland Realty in Hong Kong, a big local brokerage firm. But, he adds, "exactly how hot it will get is difficult to predict."

Does that mean a bubble is in the offing?

Analysts are urging home buyers to be cautious since interest rates could continue to fall. A bubble is "absolutely possible," says Nicholas Kwan, regional head of research for Standard Chartered Bank here. If rates drop even more sharply in 2008, which Mr. Kwan says is possible, the market could at some point begin to overheat. "But it's so hard to say where that point is," he says.

The average price of mass-residential apartments in Hong Kong rose 10.3% to roughly $593 a square foot in December from about $537 a square foot in June, according to CBRE Research in Hong Kong.

Much also will depend on where inflation and interest rates are in relation to each other. While most analysts see inflation staying high in China for some time, pushed up by more expensive commodities, interest-rate movements are going to be decided, for the most part, in the U.S. That, in turn, will depend on the condition of the U.S. economy, a broader and more important variable than interest rates alone.

"Negative real interest rates is a plus, but it's not everything," says Steve Chow, a corporate credit analyst at ING Wholesale Banking who covers the property sector. The "economic outlook is equally important for potential buyers, since buying an apartment is a major decision in many people's lives." And lately, the global economic outlook is looking wobbly, he adds.

Some Hong Kong market watchers point out that interest-rate cuts had long been expected here and that the lessons of the 1990s bubble are still seared in the city's collective memory, serving to temper further excesses.

Also, property owners are generally far less leveraged than they were a decade ago, with mortgage payments currently accounting for an average of 35% of disposable income, compared with an average of 92% in the 1990s, according to Oscar Leung, a senior investment manager at ING Investment Management in Hong Kong. Back then, cheap home loans were also accompanied by ample new supply in the market, a far cry from today's slow trickle of newly constructed apartments.

"This is a healthier market," Mr. Leung says.

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Paul D. Deng
Department of Economics
Brandeis University
IBS, MS 032
Waltham, MA 02454
http://www.pauldeng.com

Slower Hiring, Not Layoffs,
Hurts Labor Market

The current weakening of the labor market reflects a slowdown in hiring — not the mass layoffs that have characterized past economic downturns.

The Labor Department said there were 1.8 million layoffs in December, about the same number as in December 2006 — despite the mounting turmoil in the meantime in the housing, mortgage and finance markets.

Andrew Tilton, senior economist at Goldman Sachs Group, said the absence of large-scale layoffs partly reflects companies' uncertainty about the economic environment and their determination, at least for now, to hang on to their skilled workers.

"It's really in finance and housing — and to some extent retail — where the pain is being felt most clearly," he said. "Many other sectors aren't feeling pressure [yet] to lay off workers [and] are hesitant to let them go if they'll need them back soon," should the economy recover, Mr. Tilton said.

Still, job creation is lagging. Most economists say 100,000 to 150,000 jobs need to be created each month to sustain economic growth. Since July, just 68,000 jobs on average have been created each month. In January, the economy lost 18,000 jobs, the first employment drop in 4½ years.

Still, that didn't come close to the job losses of past recessions — which typically have run 100,000 to 200,000 a month. And that has some economists scratching their heads.

"It would be odd to have a recession in an environment where there's not a lot of layoffs," said J.P. Morgan Chase economist Michael Feroli. "We're hanging in this no-man's land between recession and growth."

In the meantime, companies have hit the brakes on hiring new workers. The new government figures show there were 4.6 million new non-farm hires in December, after seasonal adjustment, down from a recent peak of 5.1 million in July 2006. There were just over four million job openings in December, down from 4.4 million the year before.

Goldman's Mr. Tilton said "underemployment" may be part of the puzzle. Workers like contractors and real-estate agents may still be employed but earning much less money now than they were at the height of the housing boom. That dynamic isn't captured in the statistics, but could help explain why consumer confidence is sinking and spending is slowing.

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**************************************
Paul D. Deng
Department of Economics
Brandeis University
IBS, MS 032
Waltham, MA 02454
http://www.pauldeng.com

China May Invest in J.C. Flowers Fund

China's state-owned investment fund is in advanced discussions to invest $3 billion to $4 billion in a new fund being started by J.C. Flowers & Co., the private-equity firm that has made a name for itself investing in distressed financial institutions, according to a person familiar with the matter.

A potential investment by China Investment Corp., which has $200 billion in assets, would be the latest sign that the newly formed government investment fund hasn't been deterred by the criticism it faced from investing in another buyout firm, Blackstone Group LP. CIC took a $3 billion stake in Blackstone last year right before the U.S. company's initial public offering, only to see its investment decline sharply in value when Blackstone's stock dropped as the buyout business fizzled. Then in December, CIC invested $5 billion in Morgan Stanley for a nearly 10% stake in the New York investment bank.

In an interview with The Wall Street Journal last week, Lou Jiwei, chairman of CIC and former vice minister of finance for China, said the state investment fund was looking to invest in "portfolios" of companies, rather than individual firms.

An investment in a fund managed by J.C. Flowers would fit that criteria. The U.S. firm, run by former Goldman Sachs banker J. Christopher Flowers, specializes in buying financial companies. His firm made headlines recently for backing out of buying student-loan provider SLM Corp., better known as Sallie Mae, for $25 billion. By investing in a new fund being formed by Flowers, CIC would be able to indirectly invest in different companies and also inoculate itself from any political backlash that could arise from investing directly in iconic American companies.

A spokeswoman for CIC said she was unaware of any discussions. J.C. Flowers couldn't be reached for comment.

The discussions between J.C. Flowers and CIC were earlier reported by the Financial Times on its Web site.

CIC was formally established in September to earn better returns on China's huge pile of foreign exchange reserves, which now total more than $1.5 trillion. That money had traditionally been invested in low-yield investments like U.S. Treasurys. Two thirds of CIC's initial $200 billion in capital has already been committed to investments in China's own financial sector.

Although the fund made waves with its investments in Blackstone and Morgan Stanley, its managers have said that they intend to allot the bulk of the money it has for international investments to professional fund managers. CIC said last month it had received more than 130 applications from money managers to help it with equity investors. It has set a deadline of next week for applications from managers to handle international fixed-income investments.

Japan Gets Shelter via China Trade

TOKYO — Japan's economy is so dependent on exports that the whole nation traditionally frets when anything threatens its overseas markets. Now, though, with the world economy under threat from a U.S. slowdown, Japan is less worried. That is because of the exceptional speed with which Japanese manufacturers have tapped into China.

If Japan does go into recession soon, many economists say, it will be because of serious domestic weaknesses rather than export dependency.

For a long time, the U.S. was Japan's biggest export market, and Japanese businesses are concerned about the possibility of a recession in the U.S. A one-percentage-point decline in U.S. personal consumption would, according to Goldman Sachs, lower Japan's GDP growth by 0.27 percentage point.

But the share of Japan's exports going to the U.S. fell to 20% in 2007, from 30% in 2001. Last year, China (including Hong Kong) overtook the U.S. as Japan's biggest export market.

Japan is the only G-7 nation to run a trade surplus with China, as it supplies industrial equipment and parts. China imports more from Japan than anywhere else, more than from the European Union and nearly twice as much as from the U.S. That means if China and other major export markets for Japan can avoid a major impact from a possible U.S. recession, Japan would be less vulnerable to a U.S. slowdown than would be the EU and developing economies, which tend to be far more exposed to the U.S.

"Japan's economy has developed some resistance to weaker economic conditions in the U.S.," Merrill Lynch economist Takuji Okubo said.

Japan still has big economic problems of its own making, from an uncompetitive service sector to a declining work force. Wages are stagnant because of long-term job shedding by major corporations and a shift toward lower-cost, part-time workers. Last year, after the government suddenly tightened regulations on buildings' earthquake resistance, house building declined sharply.

That cut into growth in the July-September quarter, when annualized growth was 1.5%, and it could have done so again last quarter, which economists expect to have been not much better. Goldman Sachs, in one of the more pessimistic assessments so far, has said that Japan might already have entered a recession.

However, it was referring to the Japanese government definition, which is based merely on a downturn in certain indicators, and does not require two quarters of contraction, the most commonly used definition in the U.S. The consensus view is for meager growth of some 1.5% in 2008.

The question now is just how vulnerable Japan's exports are to a U.S. slowdown.

Some of the components and materials Japan sends to the rest of Asia go into products that are later exported to the U.S., and some Japanese machinery and building equipment goes into factories that make these products. Manufacturers' output is expected to fall 0.4% in January and 2.2% in February, the government announced last week. Partly because of such "triangular trade," exporters have been hit particularly hard on the Tokyo stock market, whose key index is down 9% this year.

"A lot of Japanese exports to Asia are indirect exports to America," said Takashi Omori, economist at UBS Securities Japan. "The impact of the U.S. economy hasn't declined….Recession in the U.S. would lead to a lower forecast in Japan." Mr. Omori doesn't think Japan will go into recession.

But many of Japan's exports stay in China to be used in products such as auto parts and building materials, where the final demand is from the Chinese consumer or government infrastructure projects. Such exports, however, could be ultimately dependent on Chinese exports to the U.S. Even though most Japanese auto parts that go to China tend to stay there, some of the people who buy cars in China might be able to afford them just because they are earning money from exports to the U.S.

This kind of effect means economists find it impossible to figure out exactly how much of Japan's exports rely indirectly on American consumers.

Some economists point to evidence that such impact is far less than in the past. Macquarie Securities economist Richard Jerram says U.S. world-wide import growth has slowed sharply over the past half year but Japan's total exports still have been growing strongly. Exports to China and other destinations will likely continue to contribute to Japanese growth, Mr. Jerram said, "giving hope that the slowdown over the next six months might not be too severe."

China's economy has expanded by more than 11% for the past two years. Any hiccup in Chinese growth would affect Japan. So, too, could exchange rates. The Chinese yuan is pegged to the dollar, and the Japanese yen's recent rise (to 14.86 yen to the yuan from last year's low of 16.28 on June 23) makes Japanese products less competitive and diminishes the value of Japanese export revenue when it is repatriated to Japan. However, if China lets the yuan rise, that would make Japanese exports more competitive and lucrative.

We finally began to see inflation passthru showing up in prices and American consumers starting to feel the hit. However, in contrary to what’s suggested in the article, that China’s rising inflation is a result of rising domestic wages and policy shift that reppealed export tax rabates, I think there are some deeper reasons.