Gao Shanwen on the Chinese Economy - Speech at the 2024 Mid-Year Investment Strategy Conference of SDIC Securities

Dear leaders, guests, ladies and gentlemen, friends, good morning. It is a great pleasure to gather with you in Beijing on this bright early summer day to share and discuss our observations and judgments on the current state of China's economy and capital markets.

Today's speech will be divided into three parts.

In the first part, I would like to share some of our observations and thoughts on the most important issues, trends, and changes at the macroeconomic level since the beginning of this year and over the past few years.

Secondly, we know that China's long-term government bond yields have been continuously and significantly declining for some time, attracting the attention of relevant government departments and widespread market discussion. We would also like to offer some of our thoughts on this topic.

Finally, we know that over the past few years, Chinese enterprises have increasingly gone global, establishing production bases and supply chains in countries and regions outside of China. What are the driving factors behind this trend and what are its future implications? We would like to draw on the basic experiences of Japanese companies going global after the 1980s to provide a brief description.

Part One

Now, let's begin with the first part.

On this chart, we have calculated a very important indicator at the macroeconomic level. In the calculation of this indicator, the numerator is China's trade surplus, which is exports minus imports. The denominator is China's total economic output, GDP. We then performed a rolling calculation over four consecutive quarters to smooth the data and account for the impact of price index changes. In other words, we calculated the trade surplus and GDP in constant prices to observe the changes in China's trade account over the years.

Perhaps a significant fact that most people have not noticed before is that in recent years, since 2021, 2022, and 2023, China's trade account has shown a huge surplus relative to GDP again. After excluding price factors, this surplus level is the highest on record.

We know that the last time China's trade account showed a huge surplus was around 2007. At that time, the RMB exchange rate faced immense appreciation pressure, the overall exchange rate level was somewhat undervalued, the exchange rate formation mechanism lacked flexibility, and coupled with other internal and external reasons, the current account showed a huge surplus. The surplus level at that time was at least the highest since the reform and opening up. However, in the past few years, after excluding the impact of price factors, the volume of the trade surplus has exceeded the level of 2007. But if we compare the macroeconomic environment around 2022 with that of 2007, the RMB has generally faced some depreciation pressure, which is the complete opposite of 2007.

Compared to 2007, the RMB exchange rate formation mechanism has good flexibility. In 2007, the economy once faced relatively severe inflation and very high growth levels. In the past few years, the overall price level growth has been unsatisfactory. In contrast, in 2007, the RMB exchange rate formation mechanism generally had good flexibility compared to 2007. In 2007, the economy once faced relatively severe inflation and very high growth levels. In the past few years, the overall price level growth has been unsatisfactory, and economic growth has remained at a relatively low level.

In these important macroeconomic environments, both domestic and international economic conditions, as well as the formation and level of the exchange rate, show significant differences from that time, yet the trade surplus is still higher than the level at that time.

Let's compare. If we do not exclude price factors and only calculate nominal values, calculate the nominal trade surplus and nominal total economic output, we will see that the degree of imbalance in the current trade account is much milder. It is about half lower than the level in 2017, and slightly lower than the level around 2015.

The significant difference in the performance of the data after excluding price factors and the data including price factors indicates that China's terms of trade have deteriorated significantly in recent years. In other words, the price of whatever you sell has fallen sharply, and the price of whatever you buy has risen sharply.

Because the prices of the goods you export in large quantities have fallen sharply, and the prices of the things you are trying to procure and purchase have risen sharply, there is such a significant difference between the data in the first and second charts.

However, from the perspective of analyzing the performance of the real economy, observing the performance after excluding price factors is obviously more reasonable. The question we need to ask is why China has once again experienced such a severe imbalance in its trade account in recent years.

One attractive explanation is that during the pandemic, due to widespread lockdowns globally, supply chains were severely disrupted. China, at least in 2020, 2021, and for a period in 2022, managed its epidemic control very successfully, and its economic activities ran very normally. China's manufacturing processes and supply chains remained at a very normal level. Under these conditions, a large volume of Chinese manufactured goods were exported, compensating for the disruptions to supply chains and suppression of production capacity caused by lockdowns in other regions, thus driving a significant expansion of China's trade surplus. This idea certainly has merit.

However, the issue is that in 2023, including China, global economic activity has returned to normal. In 2024, global supply chains and economic activities largely show no signs of lockdowns or their lingering effects.

If the previous explanation were correct, then with the normalization of global economic activity, the trade surplus should have contracted significantly soon. However, at most, we have seen a slight decrease in the trade surplus in 2023, and in 2024, the trade surplus has risen again. This data performance largely indicates that the explanation based on the impact of the epidemic and lockdowns is at best temporary and has relatively limited explanatory power for the overall performance of the data in recent years.

A second explanation that many people may tend to propose is that China has maintained a relatively high level of manufacturing investment during the epidemic and in recent years. Coupled with the significant technological breakthroughs China has achieved in areas like new energy vehicles, its competitiveness in these fields has significantly improved, thereby driving the expansion of the trade surplus.

We believe this explanation is not entirely without merit, but it is likely unconvincing to attribute the unprecedentedly large trade surplus in history solely to a significant improvement in China's manufacturing capabilities and competitiveness.

The important counter-evidence is that throughout this period, China's average economic growth performance has been sluggish, price performance has been weak, and the exchange rate performance has also been weak. If a significant improvement in China's competitiveness led to a substantial expansion of the trade surplus, then we should not have seen such a weak exchange rate performance, and in terms of growth, the economic growth during this period was significantly lower compared to the historical normal trend.

This brings us to a third explanation. In fact, this third explanation has been proposed by many people in private discussions before, but it has not been processed from this perspective, leading to much confusion.

The third and most important explanation, we believe, is the significant adjustment in China's real estate market.

Since 2021, China's real estate market has undergone a significant adjustment, with continuous and substantial declines in real estate development investment, new construction starts, and sales. Under these conditions, the demand from upstream and downstream industries has decreased significantly. In such circumstances, coupled with the rapid contraction of demand in these sectors, the corresponding production capacity has been forced to turn to the international market, forming and manifesting as a huge expansion of the trade surplus.

In fact, if we observe the magnitude of the decline in real estate investment relative to the overall economic volume and consider its impact on the upstream and downstream industrial chains, and compare the magnitude of the impact with the magnitude of the trade surplus expansion, we will find that they are relatively close in magnitude.

Although we must also emphasize that due to the scarring effects since the end of the epidemic, and the overall weak demand resulting from the damage to the balance sheets of residents, enterprises, and local governments, consumption is weak, consumption is weak consumption,

To an overall low impact, it also generated insufficient demand, and the resulting insufficient demand also manifested itself to some extent in the expansion of trade surplus.

In the chain of logic, the starting point of the problem is the significant adjustment of the real estate market and the contraction of demand caused by the scarring effect. This force has led to weaker economic growth, a lower price level, and weaker exchange rate performance.

Due to weak demand, the economy is sluggish, prices are weak, economic growth is weak, and the exchange rate is weak. Also due to low demand, the corresponding supply capacity is forced to turn to the international market, thus generating and manifesting as a very large expansion of trade surplus.

Also due to weak demand, and because China is such a large economy, it has led to a significant deterioration of China's terms of trade. Because your demand is weak, the prices of industrial products are very weak. With very weak prices of industrial products, you can form competitiveness in the international market when you export.

China's demand is weak, prices are weak, and in the international market, from steel to many other chemical products and manufactured goods, they are more competitive. Then, from the perspective of your trading partners, they feel the strong competition from Chinese products and begin to complain about China's overcapacity. Although this is not the focus of the discussion on China's overcapacity problem, it is one of the important backgrounds that contribute to and stimulate the narrative about China's overcapacity.

From this analysis, of course, we can say that at some point in the future, if China's real estate market experiences a significant recovery, and the scarring effect subsides, leading to a noticeable increase in aggregate demand, then the imbalances we are seeing will be significantly corrected.

Before discussing the real estate issue, I would like to add one less important observation about this data: observing since 2004, overall we have seen a continued expansion of trade surplus. At the same time, let's look at the price level of industrial products, which is the month-on-month change in the price level of industrial products. We see that since the second half of last year, the month-on-month change in the price of industrial products has generally been below 0. In fact, for most of the time since 2022, its month-on-month change has been below 0, and the price level has been generally declining slightly.

However, if we further observe commodity prices in this context, we see that commodity prices have risen significantly in the past few months, reaching new highs since the pandemic. In other words, in the past few months, on the one hand, we have seen China's trade surplus continue to rise, and on the other hand, we have seen the overall price of industrial products remain below zero, appearing relatively stable, but the prices of basic commodities have risen sharply.

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In other words, if the impact of basic commodity prices is excluded, the prices of industrial manufactured goods have actually been accelerating their decline in the past few months. This is because we have seen the prices of basic commodities strengthen.

These pieces of evidence, when combined, cannot be explained by the contraction of the real estate market, i.e., the data from the past few months, because the contraction of the real estate market can explain the trade surplus and the decline in the prices of industrial products, but it cannot explain the significant rise and new highs in the prices of basic commodities.

In the data from the past few months, although we believe that the adjustment of the real estate market and the scarring effect explain the main trends and characteristics of macroeconomic data since 2021, there have been some new additional changes in the data changes in the past few months on this background and basis.

We believe that the most important background for the new and additional changes is that China's production capacity in some emerging fields is forming new competitive capabilities. The generation and formation of these competitive capabilities have promoted the expansion of China's trade surplus, driven economic growth to perform more strongly than previously expected by the market, and at the same time pushed up the prices of upstream basic commodities. However, the formation of these supply capacities has further put downward pressure on the prices of manufactured goods.

In other words, although we believe that in the past few years, for example, the significant adjustment of the real estate market and the continuous impact of the scarring effect have been the most important characteristics at the macroeconomic level. However, in the past few months, rapid technological progress and the formation of new production capacity in China's manufacturing sector have marginally driven the performance of many new data, thereby driving up upstream commodity prices, driving down midstream and downstream prices, and leading to better-than-expected economic growth performance. To some extent, it may also have some marginal support for the exchange rate. This force seems likely to continue for some time.

However, looking at the overall data performance in the past few years, the impact of this factor is new and marginal, and most of the impact of the data still needs to be attributed to real estate-related influences, making it necessary for us to proceed to the discussion of the real estate market.

To discuss the real estate market, we will report two pieces of data here. This data comes from the tracking of some market research institutions, and from some grassroots evidence, it is relatively close to your micro-level perception.

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There are two important data points in this data. One is the housing price index for 25 cities. These 25 cities include some first- and second-tier cities, as well as some smaller cities. We tend to believe that they have reasonable representativeness for the overall real estate market in China.

The blue line is the absolute housing price index, with the end of 2018 as 100. The red line is the rental price index for housing in these areas, also with the end of 2018 as 100.

First, let's look at the performance of the housing price index. With the end of 2018 as 100, the housing price index rose to above 105 at some point in 2021, and then began to fall sharply, currently falling to the early 80s. In other words, the adjustment of the housing price index may be close to 30% on this data, exceeding 20% and approaching 30%.

Such a large adjustment may be close to your micro-level perception. Some housing projects in some cities may have smaller adjustments, while others have much larger adjustments. However, the combined national data in terms of magnitude and perception may be similar. Moreover, it is particularly important that in the past few months, housing prices have generally been accelerating their decline.

Second, let's look at the rental index. It is very noteworthy that after the outbreak of the epidemic, the rental index began to fluctuate downwards. By April or May of this year, the rental index had fallen by nearly 15% compared to the end of 2018, exceeding 10%, possibly between 10% and 15%. This may be close to your micro-level perception, and the price should be the rental price index for residential housing. If it is the rental price index for office buildings, the adjustment may be significantly larger. The housing prices here are also the housing price index for residential housing. Our micro-level grassroots perception also generally points to a significant decline in residential rents in recent years.

Combining these two charts, I believe it contains a wealth of information and is of great value for us to understand the current situation and future trends of the real estate market.

The first important piece of information is that the rental price level has fallen significantly over a continuous period of several years. If we observed before 2018, for example, from 2010 to 2018, or even excluding the impact of the financial crisis, from the turn of the century to 2018, we believe that almost all data would point to the fact that housing rental indices have generally been rising.

With the rapid expansion of the economy, continuous urbanization, and rising income levels, the absolute level of urban housing rents has been rising. However, in the past few years up to now, for about 4 years, the absolute level of rents has been falling.

If we consider real estate as a very heavy

The capital goods required are a very important asset, and the cornerstone of its pricing is undoubtedly the long-term rental cash flow generated. The basis for predicting long-term rental cash flow is undoubtedly the performance of current or past rents.

The substantial decline in housing rents for four or five consecutive years indicates, for whatever reason, that from a valuation perspective, the real estate market has experienced a significant deterioration in fundamentals from the perspective of future expected rental cash flows. This is because rents were rising before, and it was easy to expect rents to rise, or at least remain stable. Now rents have fallen so much, and for such a long time, and the rebound in rents after the epidemic was short-lived, quickly hitting new lows.

From a valuation perspective, it is easy to believe that the fundamentals of this capital good, this asset, have significantly deteriorated, and its long-term expected rental cash flow has significantly deteriorated. Therefore, a significant deterioration in fundamentals will inevitably lead to a significant adjustment in the prices of capital goods or assets. We believe this is one of the most important backgrounds for the significant adjustment of asset prices or real estate prices.

Next, let's look at the rental yield. Since the fundamentals are deteriorating, let's look at the rental yield. The reciprocal of the rental yield is the price-to-earnings ratio, which should be a concept that defines the price-to-earnings ratio, the ratio of price to rent.

We see that before the end of 2021, on the one hand, housing rents were falling, and on the other hand, housing prices were rising. The trend of prices was contrary to the trend indicated by the fundamentals of rents. Therefore, the valuation of real estate as a capital good rose significantly at that time. Your earnings were getting lower and lower, your stock price was getting higher and higher, and your valuation was rising significantly. The significant rise in valuation indicated that the market at that time believed that the decline in rents was temporary, and everyone still had strong confidence in future urbanization, future economic growth, and future rent increases. So, on the one hand, rents were falling, and on the other hand, valuations and stock prices were rising.

However, in the second half of 2021, or perhaps after 2022, people's understanding of rent increases began to be revised. The market began to realize that rents were not always rising, and rents were not going up. Under these conditions, people's understanding of fundamentals began to align with reality. The result of fundamentals aligning with reality was a significant correction in valuation and a substantial decline in housing prices.

By the second half of last year, valuations had basically returned to the level at the end of 2018. Currently, with the continued rapid decline in housing price indices, the valuation level represented by rental yields is likely to have returned to the level between 2017 and 2018.

In the second half of last year, it returned to the level of the second half of 2018. Now it is likely to have returned to the level of 2017 or between 2017 and 2018. From a longer-term perspective, from the position of the past 10 years or so, these levels cannot be considered to be at a significantly high level. This is our comment on the data.

Next, let's look at further data, comparing the changes in second-hand housing prices and rents. We know that the real estate market has undergone a valuation correction, with a certain bubble originally. Then, when people's perceptions return to fundamentals, there is a valuation correction. The valuation correction led to a substantial adjustment in housing prices. However, against the backdrop of a substantial adjustment in housing prices, we believe that from an overall valuation perspective, it has returned to the level between 2017 and 2018.

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However, against this backdrop, let's look at the differences in housing price performance between different cities. This is a scatter plot. One axis of this scatter plot is the change in city rent prices, and the other axis is the change in housing prices. The horizontal axis is the change in rents in a city over a period of time, and the vertical axis is the change in housing prices over a period of time. We see that overall, there is a very strong correlation between the change in rents and the change in housing prices. That is, the less rents fall, the less housing prices fall, and the more rents fall, the more housing prices fall.

In other words, from a cross-sectional perspective, the correction of market prices is very closely tracking fundamentals. If rents fall less, housing prices fall less, and if rents fall more, housing prices fall more. However, overall housing prices are falling because overall valuations were at a relatively high bubble level in 2021, at least relative to the changes in fundamentals, and the changes in valuation went too far.

However, if we extract a period of time during this period for observation, the adjustment of the entire market is not a disorderly adjustment. It is based on the overall price level returning to reasonable valuations, and it is closely tracking fundamentals. If rents fall less, housing prices fall less, and if rents fall more, housing prices fall more. This pattern cannot be seen in a bubble burst.

We have studied the performance of housing price fluctuations after the US bubble burst, and this pattern cannot be seen in areas where the bubble burst. In areas where the bubble burst, the pattern is that you fall more if you rose more, and you fall less if you rose less. It has no relationship with the difference in rents. Because there is a close relationship between the difference in rents, it indicates that it is an adjustment that follows fundamentals, and further indicates that the adjustment of the entire market is driven by fundamentals, and is unlikely to be driven by an irrational bubble and the bursting of the bubble.

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Against this background, let's further observe the performance of the real estate market adjustment so far. The red line in this chart is based on some survey data and is used to estimate the growth rate of per capita income and the expected growth rate of per capita income. This is because, for housing prices, future rents are the most important fundamentals. However, some related fundamentals must include people's expectations of future income. If you expect strong growth in income every year in the future, then it doesn't matter if housing prices are high now. However, if future income stagnates for a long time like in Japan, then the price-to-income ratio becomes a very convincing indicator.

Undoubtedly, a very important fact is that the long-term income growth rate and its expectations are declining, and during the epidemic, income expectations may have accelerated their decline at least for a period of time. The decline in long-term income growth has undoubtedly put pressure on real estate valuations. However, we observe that the long-term mortgage interest rate has also fallen significantly during the same period. Since the outbreak of the epidemic to the present, the decline in long-term mortgage interest rates has been more than 200 basis points. The decline in income growth may be around 300 basis points.

In some simple valuation models, for long-term growth valuation, it is of course growth minus interest rate, plus some control for risk premium. Against the backdrop of declining growth, interest rates have also fallen significantly. Although we also believe that further declines in interest rates will help support the market and there is room for it, relative to the decline in expected income growth, the adjustment of interest rates has already been quite significant.

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Next, let's look at another important valuation indicator for the real estate market, the price-to-income ratio.

The price-to-income ratio indicator is actually easy for people to estimate intuitively. As we have just said, the current absolute level of housing prices may have returned to the level around 2017, or even to the level of 2016, it should be around 2017, perhaps earlier, that is, the level between 2016 and 2017. However, compared to 2016-2017, if we believe the statistics bureau's data, the absolute income level has undoubtedly risen significantly. However, the absolute level of housing prices has returned to 2016-2017, which must mean that the price-to-income ratio

There have been significant improvements.

The calculation results are presented in this table. From these results, the current housing price-to-income ratio may be even better than the 2014 indicator. This is possibly because the early housing price data we used might have had flaws and underestimations. However, even considering grassroots observations, if the absolute housing price level returned to 2017, it is entirely possible for the housing price-to-income ratio to return to 2015 or earlier, considering income growth.

If the housing price-to-income ratio returns to the level between 2014 and 2015, for most cities, from a long-term perspective, the housing price-to-income ratio would not appear so high.

Therefore, based on all the data presented, our conclusion is that the pandemic led to a significant deterioration in the fundamentals of the real estate market, evidenced by both a sharp decline in rents and a significant downward revision of long-term income expectations. Against the backdrop of a severely deteriorated fundamental, the valuation of the real estate sector as an asset subsequently underwent a drastic correction. This correction included both the absolute price level and the relative price levels between cities. The correction in relative price levels closely tracked the fundamentals. The greater the deterioration of the fundamentals, the greater the correction, closely following the fundamentals. This indicates that, overall, we tend to believe it was a necessary and unavoidable, but generally normal adjustment process in response to the deterioration of the fundamentals. After several years of adjustment, the market valuation has shown significant corrections in many key valuation indicators.

On some key valuation indicators, the levels appear to have returned to a relatively reasonable range. For example, the housing price-to-income ratio has returned to the level of early 2015, the rental yield may have returned to the level of around 2017, and the absolute housing price level may have returned to the level between 2016 and 2017. In these aspects, including the deterioration relative to long-term income, the decline in long-term mortgage interest rates has largely offset the impact of income expectations. Long-term housing affordability, in terms of mortgages relative to income, has actually shown significant improvement.

On all these fronts, we can say that the real estate market has undergone a significant adjustment, and many valuation indicators appear to have returned to very reasonable levels.

However, there is no doubt that in the recent period, we have seen a continued acceleration of the decline in real estate prices and a search for a bottom. Anyone who has been in the stock market for a long time knows that a reasonable price is not the bottom. A bottom is formed when there is a significant divergence and prices fall below reasonable levels. Currently, many indicators may be in the reasonable range, and some may even be on the lower side, but reasonable does not equate to the bottom. The formation of a bottom is very complex. If the market relies solely on its own forces to form a bottom, the bottom is usually below the reasonable price level. What we have seen in the recent period is that despite significant corrections in many indicators, housing prices are still accelerating downwards.

This brings us back to the second question: the deterioration of fundamentals is a major reason for the adjustment in the real estate market, but it is not the only reason.

We believe there is another very important reason for the significant adjustment in the real estate market: the domino effect among real estate enterprises, leading to a liquidity crisis. This is because the business model of Chinese real estate enterprises is built on high turnover. The high-turnover business model requires high stability in debt and cash flow. Due to a series of market and policy reasons, the stability of cash flow and debt for real estate enterprises has been severely impacted in recent years. Under these conditions, creditors have concentrated their efforts to withdraw funds from real estate enterprises, leading to a widespread industry-wide liquidity crisis and a domino effect. This domino effect has led to a passive and rapid contraction of the balance sheets of real estate enterprises. This contraction has had a series of macroeconomic impacts and is a crucial and very important background to the severe adjustment in the real estate market. A key piece of evidence is our comparison of the primary and secondary markets.

The transaction volume in China's secondary housing market is currently maintained at the 2019 level, which historically is quite high. However, the transaction volume in the primary market, and new construction sales, have returned to levels seen over a decade ago. The significant divergence in transaction volume between the primary and secondary housing markets is very rare. We believe one of the important reasons is that homebuyers are concerned about whether delivery can be guaranteed, and purchasing new homes carries delivery risks, in addition to other reasons that have suppressed the performance of the real estate market.

Therefore, the adjustment in the real estate market, the adjustment at the macroeconomic level, including the decline in rents and the decrease in income expectations, are to some extent linked to the domino effect among real estate enterprises.

What are the latest developments on this front? Let's look at some related data.

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First, let's look at the stock price indices of state-owned and private real estate sectors in the A-share market. What we want to highlight by comparing these stock price indices is that in the recent period, the government has introduced a series of new, strong intervention and rescue policies for the real estate market. In the past month, the government has introduced a series of new, strong intervention and rescue policies for real estate enterprises. Against this backdrop, the stock price indices of the real estate sector have seen a significant rebound.

What we want to say is that based on these stock price performances, the magnitude of the rebound in the real estate sector index over the past month is comparable to the rebound during the COVID-19 reopening, it is in the same order of magnitude. We know that at the end of 2022, when the COVID-19 restrictions were suddenly lifted, there were very optimistic expectations for the subsequent economic recovery, market recovery, and real estate recovery. Under those conditions, the entire market rebounded sharply, and the real estate sector rebounded sharply. However, in the past month, for many key sector price indices, the magnitude of the rebound in the real estate sector index is in the same order of magnitude as the rebound during the COVID-19 reopening.

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If we observe the performance in the Hong Kong stock market, it is similar. The rebound in the stock price index of the private real estate enterprise sector is even larger than during the COVID-19 reopening. The stock price index of the state-owned real estate sector has also seen a rebound of a similar magnitude. This rebound also appears in the high-yield bond market of Chinese dollar bonds, in the junk bond market, showing a significant decline in their yields to maturity.

Although the magnitude of this decline did not catch up to the period of COVID-19 reopening, from the perspective of the bond market, the magnitude is also very large, and it is the largest since the COVID-19 reopening. In the stock market, by calculating the indices one by one, we see that on most indicators, it is similar to the period of COVID-19 reopening. In other words, the market has very positive and full expectations for the real estate policies introduced in the past month, which can even be compared to the COVID-19 reopening, indicating that the market has very positive, very full, and optimistic expectations for the real estate policies introduced by the government in the past month.

The reason the market holds such expectations, in my personal opinion, is that the new round of real estate regulation, while relaxing purchase restrictions and adjusting real estate interest rates, and stimulating and expanding demand for real estate, has begun to target and rescue the liquidity pressure of real estate enterprises.

Through measures such as purchasing their land, purchasing completed housing to convert into affordable housing, etc., it intervenes and rescues the liquidity pressure faced by the real estate market.

And the liquidity pressure faced by real estate enterprises is the most fundamental root of all problems. When government policies begin to directly address and attempt to solve this most important root cause, the market price indices have seen a significant rebound. In the market's view, this rescue has identified the key to the problem, hit the right pulse, found the root cause of the illness, and the direction of the measures is correct.

Only in this way can we explain the strong performance of the A-share market, the Hong Kong stock market, and the bond market in the context of the COVID-19 reopening. And in my personal opinion, the market's interpretation of the policies, the situation of the real estate market,

Read, I think the market's interpretation is effective, objective, and correct.

Compared to the "toothpaste squeezing" policies of the past few years, this round of intervention in the real estate market has found the key to the problem. The policy direction is correct, but we also know that even the best policies are useless if they are only written on paper. The best policies must ultimately be implemented and translated into action.

Therefore, those who have been trading for a long time can easily understand a fact: during the period when policies are introduced and for a while after, the market is driven by expectations. However, after all policies are released, the trading based on expectations shifts to an assessment of the policy implementation effects. Initially, everyone traded based on expectations, but after the policies are fully released, trading based on expectations ends, and it shifts to trading based on the assessment of policy effects. In this transition from trading based on expectations to trading based on the assessment of policy effects, it is completely normal for the market to experience some technical pullbacks and adjustments in trading.

Regarding the assessment of policy effects, whether the policies can achieve the expected results is something we can only observe over time. We can only say that the current policies have identified the key issues and can achieve a leverage effect. If they can be smoothly implemented, they may gradually promote the bottoming out and reversal of the real estate market. However, the policy implementation process is full of uncertainties, and close tracking is required.

We believe that this change in trading rhythm was clearly visible in the market trading last week. As the policies have basically been fully announced, the market trading has begun to shift to an assessment of their effects, which will undoubtedly take several months, at least several months.

If the assessment of the effects falls short of expectations, and there are no further follow-up policies, it is not impossible for the market to experience another significant adjustment. However, we believe that the current policy direction is correct. We believe that the real estate market itself has already undergone a significant adjustment, and many valuation indicators have returned to reasonable ranges. We believe that with strong policies, there is a possibility of gradually promoting the market's bottoming out and reversal. However, the policy implementation process is the biggest uncertainty, and many things still need to be observed as we go.

Next, I will move on to the discussion of the second issue, concluding the discussion of the first issue, which is a brief summary of the economic and market situation over the past few years.

Next, we will move on to a discussion of long-term interest rates.

In June 2021, in Hangzhou, three years ago, at our mid-year strategy meeting, we studied China's long-term capital return rate. Our basic view was that after 2010, China's long-term capital return rate began a long-term downward trend, which would last at least until 2030, and perhaps even longer.

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The decline in the long-term capital return rate will lead to a continuous decline in the overall interest rate center of China. At that time, in June 2021, we believed that by 2030, the interest rate on China's 10-year government bonds might fall to around 2%. The basic reason is that we believe that as China's economy has successively crossed the Lewis first turning point and the Lewis second turning point, the law of diminishing marginal returns on capital has begun to play a dominant role, and relying on technological progress to counteract the decline in marginal returns is only achievable at relatively low return levels. During this transition period, the continuous decline in long-term capital returns is difficult to resist, and it will not be until the economic growth rate returns to around 3% or lower that technological progress can reverse and balance this trend.

Therefore, from 2010 to 2030, over such a long period, we are destined to see a continuous decline in long-term economic growth, a decline in long-term marginal capital returns, and a decline in the long-term interest rate center. We have also seen similar trends in the transition processes of other East Asian economies such as Japan and South Korea.

We also reported this chart at that time. This chart includes two data points. One data point can be directly calculated, which is the Incremental Capital Output Ratio (ICOR).

Simply put, it is the marginal return on capital. The other is the return on capital of existing capital, which is directly calculated. Both indicators show that since around 2010, China's long-term capital return has been continuously declining, and theoretically, we believe it will continue to decline until around 2030. The decline in the overall marginal capital return and capital compensation is bound to pull down the overall interest rate center of the economy, which is easy to imagine. Unless the overall savings rate of the economy also declines significantly during the same period, and the marginal return on capital declines, leading to a sharp decrease in the demand for capital from savings, unless the savings rate also declines significantly during the same period, the overall interest rate center of the economy will inevitably continue to decline.

This logic is very simple and powerful. Against this backdrop, we believed that in 2021, the long-term interest rate was still at the level of 3% plus, but we predicted that by 2030, it would fall to around 2%.

Of course, at that time, most market participants found such a prediction somewhat shocking and bold. However, in the past year or so, the decline in long-term interest rates has exceeded many people's expectations, and people have begun to seek explanations from various technical aspects.

I believe that technical explanations are reasonable for short-term trading, but when viewed over a longer historical period, technical explanations for trading are actually quite superficial. The fundamental reason is the decline in long-term capital returns, which is a driving force like gravity, the most fundamental force.

However, against this backdrop, this was a discussion from June 2021, three years ago. We are reviewing it here not for the purpose of showing off, because our predictions are often wrong, but because we want to further discuss long-term interest rates. It is not because long-term interest rates have fallen significantly recently and there is a lot of market discussion; we want to further discuss long-term interest rates.

[caption id="attachment_1322" align="aligncenter" width="910"] Gao Shanwen Internal Speech Full Text 13[/caption]

The starting point for further discussion is here. We calculate an indicator from the perspective of the bank's balance sheet. From the bank's perspective, there are two types of assets: loans and government bonds. We can calculate the interest rate on bank loans minus the interest rate on government bonds held by the bank. There is also an asset on the bank's balance sheet, which is government bonds, and another asset is loans. We can calculate the interest rate on bank loans minus the interest rate on bank government bonds to get a difference. What is this difference? This difference is the risk premium. In the definition of finance, the difference is simple: it is the risk premium, which is because banks hold loans, which are less liquid and riskier than holding government bonds, and thus require more risk compensation. This is a simple fact in the definition of finance textbooks.

So, we calculate such a risk compensation. After calculating the risk compensation, we observe its performance over the 13 years from 2011 to 2024. We will find that during these 13 years, this risk premium has generally declined significantly and continuously. Although there were fluctuations and rebounds in between, it has been continuously and significantly declining over more than a decade.

At its peak in 2012, it was around 4.5, and now it is only around 1.5, a decrease of 300 basis points. If you are a first-year undergraduate student of finance, you can easily conclude that this indicates that China's credit market risk has significantly decreased, profitability has significantly improved, and economic growth has been stronger, with peace and prosperity throughout the country over the past 15 years.

Therefore, compared to government bonds, your credit risk compensation has decreased significantly. Due to these fundamental changes, if you are a first-year undergraduate student of finance, and you follow the finance textbooks, you can easily draw this conclusion. That is, over 15 years, your credit assets, compared to government bonds,

Liquidity and risk must have improved significantly, otherwise how could the risk premium fall from 4.5 to 1.5? It's only 1/3 of what it was then.

However, those of us who are engaged in practical work find it difficult to accept this conclusion. We always feel that the current economic situation is not as good as it was back then. Perhaps some people disagree, but we feel it's not as good as in 2011, at least in terms of growth rate and many other indicators.

Many people now recall the feeling of those years and say, "The old palace maids are still here, idly gossiping about Emperor Xuanzong." They feel that the economic growth rate at some level seemed better then than now, but the performance of financial market prices indicates disagreement with this view. Why does this phenomenon occur? This is what we want to discuss.

In more than a decade, you cannot explain it with temporary factors, nor can you explain it with the decline of the interest rate center, because this is not an interest rate center, it is a risk premium. Treasury bonds are also interest rates, and loans are also interest rates. This is a risk premium, and you cannot explain it with the decline of the interest rate center.

Some people say that early Chinese currency issuance was all through foreign exchange purchases, and later currency issuance shifted to MLF, etc., causing this difference. However, if the difference in currency issuance affects loan interest rates, it also affects treasury bond interest rates. If loan interest rates are too low and risk compensation is insufficient, you can turn around and hold treasury bonds. Since banks can adjust their allocation between treasury bonds and loans, the difference in currency issuance is also difficult to explain this phenomenon.

However, we believe it is important because it is closely related to a series of asset price valuations and the changes in long-term treasury bond interest rates that we are currently seeing in the treasury bond market.

Regardless, a risk premium indicator that is so important in the financial market and has been significantly declining for a long time is worth paying attention to. If the risk premium has fallen significantly, and this phenomenon occurred in the stock market, then stock prices and valuations should have risen significantly. However, we haven't seen that in the stock market. In more than a decade, stock valuations have generally declined. The risk premium implied by the stock market and the risk premium implied by the credit market are moving in opposite directions.

What is the core reason? I believe the core reason is that in 2011 and before, in order to smoothly complete the commercialization reform of state-owned banks and to smoothly digest the burden formed by their historical non-performing assets, the policy design for a long time during the reform of commercial banks consciously maintained a high credit spread. Through policy settings, a high spread was artificially maintained, making it easier for commercial banks to achieve profitability, digest historical burdens, clear non-performing assets, and continuously replenish capital. This was an important policy design at the beginning of the commercialization reform of the banking system.

In practice, these policy designs meant suppressing deposit interest rates, suppressing bond interest rates, and suppressing risk-free interest rates to raise loan market interest rates. The methods to raise loan market interest rates were, on the one hand, through interest rate restrictions, preventing interest rates from falling, and on the other hand, by controlling credit availability, by restricting banks' lending capacity, artificially creating a credit shortage in the credit market, thereby maintaining market-based interest rates at a high level.

From the banks' perspective, the amount of credit they could extend was limited, so the interest rate in the credit market was pushed up. With the interest rate pushed up, they couldn't extend as much credit, and the excess funds flowed back to the treasury bond market, causing the interest rate in the treasury bond market to fall even lower. They still had excess funds that couldn't be lent out, and this force fed back into the deposit market, putting downward pressure on deposit interest rates as well.

Because of this mechanism, the spread between credit interest rates and treasury bond interest rates in 2011 and earlier was not at an equilibrium level, but was artificially maintained at a relatively high level through policy design. By restricting credit lending capacity, credit interest rates were set very high, which in turn restricted credit lending capacity. Excess funds flowed back to the bond market, causing bond interest rates to be relatively low, thus artificially creating a very large risk premium at the beginning of the century.

In reality, it corresponded to a very large credit spread. The spread made banks highly profitable at that time. The ROE of the bank asset market was high, and valuations were high. Everyone in the banking sector felt that times were good back then, which is why they said, "The old palace maids are still here, idly gossiping about Emperor Xuanzong." Because the spreads were high and life was good, but as the commercialization reform of banks basically concluded, policies began to guide interest rates back towards marketization. The lower limit of loan interest rates was continuously lowered, the upper limit of deposit interest rates was continuously lowered, and the constraints on bank lending gradually weakened. At the same time, banks also lent out a lot of loans indirectly through the shadow banking system.

What is the result of these forces? The result of these forces is that the spread has gradually moved towards an equilibrium level. Because it was originally at an unbalanced level, maintained by policy. Now that these maintaining policies are gradually withdrawn, the spread is gradually moving towards an equilibrium level. And the past decade has been the process of this spread returning to an equilibrium level.

In the process of this spread returning to an equilibrium level, if we look at treasury bond interest rates alone, they are influenced by two forces. One force is the return of the spread, which pushes treasury bond interest rates up. The influence of the spread's return is to push treasury bond interest rates up. At the same time, the decline in the long-term interest rate center and the decline in the long-term capital return rate, which we just discussed, are pushing long-term treasury bond interest rates down.

Long-term treasury bond interest rates are subject to two opposing forces. One is that as interest rate liberalization progresses and spreads gradually move towards equilibrium, long-term treasury bond interest rates face upward pressure. On the other hand, with the decline in the marginal return on capital in the overall economy, the decline in the interest rate center puts downward pressure on long-term interest rates. While one asset price is influenced by upward forces, it is also influenced by downward forces. The result is that in the decade from 2010 to 2020, the decline in long-term treasury bond interest rates was relatively mild, at least much milder than that of loan interest rates.

For loan interest rates, the long-term interest rate center is declining, and it is declining. With interest rate liberalization and the lifting of these controls, it is also declining, so the decline in long-term loan interest rates is significant. However, during the period from 2011 to 2021, the decline in long-term treasury bond interest rates was very mild.

Can we extrapolate the trend of the mild decline in long-term treasury bond interest rates? Can we assume that it declined less from 2010 to 2020, and therefore it will decline less from 2020 to 2030? Can we make this trend extrapolation?

If we extrapolate solely based on the decline in marginal capital returns, this extrapolation is possible. However, if we consider the impact of interest rate liberalization and interest rate controls that we just described, this extrapolation is not possible. The reason is that we believe the process of interest rate liberalization, the decline in long-term interest rates, and the decline in spreads should be nearing its end. Although I will mention later that I am not yet certain it has ended, it should be nearing its end. Therefore, in the next decade, the decline in treasury bond interest rates will be more influenced by the decline in the interest rate center, and the influence of interest rate liberalization pushing them up should be relatively weak.

This trend further supports the view that in the long run, by 2030 or 2035, there is significant room for long-term treasury bond interest rates to decline. Of course, we acknowledge the impact of short cycles, the worsening of the real estate market, the scarring effect, overcapacity, and various short-cycle economic factors, which also contribute to interest rate declines in the short term. Once these short-cycle factors disappear, it is not impossible for interest rates to experience cyclical rebounds. However, the decline and cyclical rebound of interest rates are driven by economic conditions. Behind this decline and rebound, the interest rate center should be in a downward channel, and for treasury bond interest rates, it will accelerate downwards in the next 10 years.

Why do I think the process of interest rate liberalization is nearing its end but has not yet ended? The most straightforward observation is the market impact of the ban on manual interest rate adjustments since April. The widespread existence of manual interest rate adjustments and the market performance after the ban clearly indicate that the mechanism we described and the process of full interest rate marketization have not yet been completed.

If we infer from some grassroots levels, such as the extent of manual interest rate adjustments, compared to the complete marketization of interest rates and the full end of this convergence process, perhaps interest rates still have a gap of 25 basis points, or maybe 30 basis points, to the relatively equilibrium level for one-year interest rates. And this is based on the current low economic sentiment, and the consideration of economic sentiment in the overall equilibrium interest rate.

On a lower base, it has been significantly corrected relative to 2011, but it may still have a long way to go.

To summarize this part of the discussion, we want to say that after 2011, the marginal return on China's long-term capital has continued to decline significantly, driving down the overall interest rate center. Commercial-oriented reforms and interest rate controls have artificially widened the interest spread, resulting in less decline in long-term government bond yields over the past decade, and more decline in loan interest rates. But the good news is that in the future, the interest rate of long-term government bonds itself will catch up by falling, although in the short term, the decline in interest rates is influenced by factors such as poor economic prosperity and a very weak real estate market. It is not ruled out that interest rates may rebound significantly with the recovery of prosperity, but in the long run, the trend of declining interest rates is difficult to resist.

In this sense, the issuance of ultra-long-term government bonds by the Ministry of Finance some time ago was sought after by the market, and to some extent, the market pricing has reasonable components. From now to 30 years, it will basically reach 2054. After 2035, if you look at the economic growth, long-term interest rates will be at a very low level. So, looking at long-term government bond yields from the present, it is reasonable to set their prices a bit lower.

Going global has been a very popular investment theme in the capital market since this year. At the same time, due to the significant appreciation of the Japanese yen before and after the bursting of the bubble, Japanese companies have gone global in a big way, providing us with a case study that is helpful for us to learn from and draw on.

We observe the globalization of Japanese companies, which has many backgrounds. For example, from the perspective of Japan, the significant appreciation of the Japanese yen has affected competitiveness; for example, the bursting of the Japanese real estate bubble and the resulting long-term weak demand have led to a lack of market growth; the aging population and the decline in the overall population growth rate have affected the long-term competitiveness and demand of the Japanese economy, all of which are very important backgrounds for Japanese companies to go global.

On the other hand, China's reform and opening up, Comrade Xiaoping's southern tour, China's accession to the WTO, the end of the Cold War, the period when the world entered a theme of peace and stability, and the acceleration of economic globalization, as well as a series of technological changes in fields such as information technology, aviation, and shipping, have also provided a very important external environment for companies to go global. Under these conditions, Japanese companies have continuously explored overseas markets for decades and achieved what many consider to be proud results.

When we analyze the globalization of Chinese companies today, the background is similar on many levels. For example, many people believe that China is facing the shadow of insufficient long-term demand due to the significant adjustment and bursting of the real estate bubble, the impact of population decline, the impact of the long-term decline in the total population due to the 90s generation not getting married or having children, and the decline in the young and middle-aged population, the impact of geopolitical uncertainties, and the need to enhance supply chain resilience, which leads to the relocation of production capacity and more balanced allocation. It also includes the impact on competitiveness caused by the long-term rise in domestic labor costs, environmental costs, and factor costs.

Therefore, internally, many people believe that there is the impact of the real estate bubble, the impact of long-term population decline, and the impact of rising labor costs, environmental costs, and factor costs, which affect competitiveness. Externally, there is the impact of geopolitical uncertainties, including the emphasis many countries place on economic growth and attracting foreign investment, which creates an external environment that has some similarities with Japan's globalization at that time.

Therefore, analyzing the performance of Japanese companies going global will have some reference value for our understanding and prediction of the future globalization of Chinese companies.

[caption id="attachment_1323" align="aligncenter" width="901"] 高善文内部演讲全文14[/caption]

Let's first look at the performance of Japanese companies going global in terms of total volume. The denominator of this chart is the total capital stock in Japan. In Japan, there are factories, equipment, subways, airports, etc., all organized into a quantitative concept, which is its capital stock in Japan. What is the numerator? The numerator is a red line representing the stock of direct investment by Japan abroad, outside of Japan, over the years. Japanese companies have direct investments abroad. Japanese companies have many joint ventures in China and North America. From Japan's perspective, these joint ventures hold certain shares and represent a stock of direct overseas investment.

Another blue line represents a broader measure of investment stock. This investment stock includes not only direct investment but also credit, stocks, foreign exchange reserves, etc. Through financial markets and credit markets, they also have increasing claims abroad, and these claims are also part of their overseas capital. So these are two measures. Direct investment is a narrower measure, because a factory also has certain liabilities to operate, so the total capital stock corresponding to this factory may not be one-to-one with the overseas ODI statistics compiled by the Japanese themselves.

From this indicator, it is easy to see that the total stock of Japanese overseas investment, in the most recent period, accounts for 40% of Japan's capital stock. If Japan's domestic capital stock is 100, then the total stock of direct and indirect investment by Japan abroad is equivalent to 40% of its capital stock. Overseas direct investment accounts for 8% of Japan's capital stock, which is 20% of the total overseas investment. This is a concept of magnitude.

Secondly, let's look at the sales revenue of Japanese overseas companies. The sales revenue of Japanese overseas companies is not equal to, but roughly comparable to, GDP. It has similarities with GDP statistics, but they are not precisely equal.

The sales revenue of companies invested by Japan abroad is equivalent to more than 40% and less than 50% of Japan's GDP in recent years. So many people say that Japan has rebuilt half of Japan outside of Japan, and this is in this sense.

That is to say, the sales revenue of the companies they control outside of Japan is equivalent to 40% to 50% of Japan's domestic GDP. Their direct and indirect capital stock abroad is also equivalent to 40% of the domestic capital stock. These two indicators are somewhat similar, but direct investment accounts for 8%. So, rebuilding half of Japan outside of Japan is a more vivid description used by many people.

[caption id="attachment_1325" align="aligncenter" width="907"] 高善文内部演讲全文16[/caption]

Let's look at their investment income abroad. Because Japan has these investments abroad, these investments always generate income. If we compare Japan's investment income abroad with its domestic investment income, we find that this ratio has risen sharply since the pandemic, which is somewhat confusing, and we cannot fully understand the reasons. Since the pandemic, the return on Japanese overseas investment has risen sharply, and we cannot fully understand the reasons. Perhaps it is because overseas economies are expanding significantly, but China's economy has not expanded much, and we cannot fully understand this fact.

[caption id="attachment_1326" align="aligncenter" width="898"] 高善文内部演讲全文17[/caption]

However, looking at the period before the pandemic, Japan's overseas direct investment accounted for 8% of its capital stock, and its return accounted for more than 10%. From this indicator, the return on its overseas direct investment was higher than that of its domestic investment. The return on its direct and indirect investment was more than 20% before the pandemic, but its capital stock accounted for 40% of Japan's capital stock. This is because the red line above represents...

The report includes the overseas bonds he holds, the foreign exchange reserves he holds, the credit he holds, etc., which is not a concept of purely direct investment.

Therefore, in terms of overseas direct investment returns, it is about 10% more than domestic investment returns. For direct and indirect investment returns, it can be close to 30%. This is an overall indicator. Against this backdrop, we can directly compare the return on investment in Japan's overseas investments with the return on investment in its domestic market, making a direct interval comparison over 5 or 10 years. We can easily see that in most cases, the return on Japan's overseas investments is higher than that of domestic investments.

On the surface, Japanese companies investing overseas possess excellent management and engineering technologies, extensive business networks, and can utilize relatively cheap overseas labor, a relatively friendly policy environment, tax-exempt or reduced-tax environments, be closer to their customers, and benefit from higher growth rates in their target markets, while also avoiding many trade frictions.

On the surface, these factors make overseas investments more likely to yield higher returns, while for Japan domestically, economic growth stagnation and population decline make it more difficult to achieve returns.

On the surface, overseas investment returns are higher than domestic ones, and overseas growth is higher than domestic growth. On the surface, this seems obvious. However, the important problem with this observation is that going overseas is a selective opportunity; not all companies go overseas. Some companies do, and some don't. Companies that choose to go overseas are usually more competitive, or perhaps they couldn't make it domestically and are taking a gamble overseas.

However, we believe that intuitively and based on experience, most companies that choose to go overseas are already very competitive domestically. If the companies choosing to go overseas are already very competitive domestically, their domestic return rates are already high. Naturally, their return rates will also be high after going abroad, so their overseas return rates will be higher than the overall domestic return rates. This does not explain that going overseas increases return rates.

[caption id="attachment_1327" align="aligncenter" width="905"] Gao Shanwen Internal Speech Full Text 18[/caption]

That is, higher returns from overseas companies do not mean that going overseas increases returns, but rather that companies going overseas are those with high returns. Those that go overseas have high returns, while those that stay domestic usually have lower returns. If you have more companies going overseas, the overall overseas return rate will be higher than the domestic one.

If this is the explanation, then the impact of going overseas on stock prices and valuations is limited, because if going overseas does not increase your return rate, it is basically the same as domestic operations, and its impact on improving your stock price and valuation level is limited.

However, there is also a possibility that going overseas genuinely increases return rates. If this is the explanation, going overseas makes your return rate higher, and increases your sales revenue growth. Under these conditions, going overseas itself will lead to better stock price performance and higher valuations. The key is to distinguish between these two explanations.

Before distinguishing these impacts, let's look at some overall performance. We have calculated this at the industry level. On the horizontal axis are different industries, showing the extent of their overseas expansion. For some industries, the proportion of overseas sales in their total industry sales is high, indicating a high degree of overseas expansion. For some industries, most of their sales revenue and investments are domestic, indicating a low degree of overseas expansion.

[caption id="attachment_1328" align="aligncenter" width="910"] Gao Shanwen Internal Speech Full Text 19[/caption]

We first measure the degree of overseas expansion for different industries, and on the vertical axis are the return rates of these industries. We can easily see that the higher the degree of overseas expansion, the higher the return rate. The larger the proportion of export companies overseas, the greater the return rate.

[caption id="attachment_1329" align="aligncenter" width="917"] Gao Shanwen Internal Speech Full Text 20[/caption]

If we calculate the net profit margin by industry, it is the same: the more overseas exposure, the higher the net profit margin. The growth rate of sales revenue is also the same: the more overseas exposure, the higher the growth rate of sales revenue. However, these only indicate a correlation between overseas expansion and better profitability, not that overseas expansion leads to higher profitability, higher net profit margins, and higher sales growth.

[caption id="attachment_1330" align="aligncenter" width="894"] Gao Shanwen Internal Speech Full Text 21[/caption]

This is because the causality might be reversed; it might be that these industries are more inclined to expand overseas due to their stronger competitiveness. In this case, there is still a positive correlation, but the causality is reversed. If the causality is reversed, it has less significance in terms of investment. To distinguish this impact, we introduced a two-way fixed-effects statistical analysis.

[caption id="attachment_1331" align="aligncenter" width="905"] Gao Shanwen Internal Speech Full Text 22[/caption]

Simply put, we control for the influence of industry and time for a large number of companies simultaneously. We control for the impact of high or low industry profitability and high or low profitability in certain years. Then we observe the impact of variables that change simultaneously in both time and industry dimensions on the profitability of companies.

We believe that the statistical results strongly support this conclusion. We can definitively say that going overseas has boosted corporate profitability, not that companies go overseas because of high profitability.

We may not be able to rule out all influences, but we can certainly say that after companies go overseas, due to the mechanisms we described earlier, their profitability has increased, sales growth has increased, and their net profit margins have improved.

If companies going overseas can boost their profitability, and consequently stimulate better stock price performance, then it is meaningful for the capital market in the long run. This is the analysis we have done based on the company's financial data and the so-called panel model. You do not need to delve into the technical details of this analysis, but we want to convey that its basic conclusion is that going overseas helps to boost corporate profitability. If this is correct, then the stock prices of sectors with significant overseas expansion should perform better in the long run, which is a natural inference.

[caption id="attachment_1332" align="aligncenter" width="887"]![Gao Shanwen Internal Speech Full Text 23](https://www.fanzei.net/wp-content/uploads/2024/12/高善文内部

Full text of the speech 23.webp) Gao Shanwen Internal Speech Full Text 23[/caption]

A large number of companies going overseas have higher profits and returns abroad, leading to better stock price performance compared to companies operating entirely domestically. Therefore, this is what we will observe in the long-term stock price performance of Japan. If we set the index to 100 in 1995, the red line represents the stock price performance of 50 stocks that have gone overseas extensively, and the blue line represents the performance of 50 stocks concentrated entirely in the domestic market.

[caption id="attachment_1333" align="aligncenter" width="900"] Gao Shanwen Internal Speech Full Text 24[/caption]

From 1995 until very recently, we see that the red line has risen from 100 to approximately 800, while the blue line has only risen from 100 to less than 200.

Even if we focus on the period before the pandemic, before the outbreak of the pandemic in 2020, the long-term performance of the red line was significantly better than the blue line. Many people believe that before the pandemic, Japan's stock market did not grow for a long time and remained at a very low level after the bubble burst. This observation of the Nikkei index is certainly correct. However, if we look at the composition of its sectors, under the condition of a generally weak market, its overseas sector has performed not badly over 20 years, from 1995, 2005, to 2015, over 20 years. At least it is not worse than our Shanghai Composite Index.

From 1995 to the present, the performance of its overseas index has risen from 100 to perhaps 300 or 400 by 2020. Of course, it has risen a lot after the pandemic, but even before the pandemic, its growth rate has been considerable for Japan, an economy that has almost no growth, and a market that has almost no growth. More importantly, its relative performance domestically is significantly better.

If we focus on the period since 2003, the external demand index has generally been better most of the time, but the gap between the two was not that large before the outbreak of the pandemic. Even within this period of more than a decade, we can say that the performance of the external demand index was slightly stronger than the domestic demand index. However, after the outbreak of the pandemic, the external demand index has been extremely and significantly stronger than the domestic demand index, and there is a similar performance in terms of profitability, which we cannot explain very well.

Therefore, combining the performance of these stock markets, we believe that although there are some details in the stock market performance that require further research, the relatively long historical data tends to support the view that in a stagnant economy, competitive companies going overseas in large numbers can further stimulate and improve their rate of return, and the performance feedback is reflected in the stock prices, making their stock prices perform better than the domestic demand index in the long run. This conclusion is also very robust.

In this sense, the overseas index that has appeared in China in the past few quarters, driven by bottom-up forces and tracking overseas sectors, is reasonable from the perspective of international experience and sound economic logic, and is attractive in the long term.

Due to time constraints, I will stop here. To briefly summarize, my discussion today mainly covers three aspects.

One is the observation of the macroeconomic situation.

The adjustment of the real estate sector and the severe trade imbalance it has caused are the most critical features of the economy in recent years. The scarring effect may have played a role. In very recent data, the marginal drive and improvement of some economic data in China have come from the release of new production capacity in emerging industries. The real estate market itself has undergone significant adjustments, and valuation indicators have clearly entered a reasonable range, but this does not mean it has hit the bottom. However, the recent policies targeting the real estate sector, the most critical issue is the liquidity crisis of real estate companies burning like wildfire.

Against this backdrop, the market has shown great enthusiasm and high expectations for these policies, but the uncertainty mainly lies in their implementation in the coming months. We need to pay close attention. If the implementation effect is ideal, there is a possibility that it will promote the gradual bottoming out and slow reversal of the real estate market. However, we must also be prepared for the risk of policy implementation falling short of expectations.

Our second part discussed long-term interest rates.

We want to say that the decline in China's long-term marginal capital returns has led to a decline in the interest rate center, which is the most important background for the decline in long-term interest rates. However, from 2011 to 2021, during the process of interest rate liberalization and deregulation, the government bond market simultaneously experienced upward pressure on interest rates, making its interest rate decline less pronounced. However, this impact will be significantly reduced in the future. Although the process of interest rate liberalization seems to be not over, there are still 25 to 30 basis points in the one- to two-year market.

Against the backdrop of long-term economic stagnation and domestic and international uncertainties, companies going overseas in large numbers helps to boost corporate profits and competitiveness. This performance is also reasonably confirmed at the stock price level.

Due to time constraints, I will say this much. Thank you all.

Gao Shanwen Speaks Out: Will the Real Estate Market Bottom Out and Rebound? Will Treasury Yields Accelerate Downward?

Real estate prices continue to decline, has the bottom been reached? With the continuous issuance of major real estate policies, A-shares and Hong Kong stocks' real estate sectors have continued to rebound sharply. Can the policies achieve the market's expected effects, and where will the market go in the future? Long-term treasury yields continue to decline sharply, what is the future outlook? On May 28th, Gao Shanwen, Chief Economist of SDIC Securities, gave a keynote speech titled

We performed a rolling calculation over four consecutive quarters to smooth out the data. We also considered changes in the price index in our calculations to control for the impact of price factors. In other words, we calculated trade surpluses and GDP at constant prices to observe the changes in China's trade account over the years.

Perhaps the vast majority of people have not noticed an important fact: since 2022, 2023, and 2024, China's trade account has once again shown a huge surplus relative to GDP. After excluding price factors, this surplus level is the highest on record.

We know that the last time China's trade account showed a huge surplus was around 2007. At that time, the RMB exchange rate faced tremendous appreciation pressure. Overall, the exchange rate was somewhat undervalued, and the exchange rate formation mechanism lacked flexibility. Coupled with other domestic and international factors, the current account showed a huge surplus. The surplus level at that time was at least the highest since the reform and opening up.

However, in the past few years, after excluding price factors, the volume of trade surplus has exceeded the level of 2007. However, if we compare the macroeconomic environment before and after 2007, we can easily see that the RMB may still face some depreciation pressure overall.

Completely opposite to 2007, the RMB exchange rate formation mechanism is generally more flexible than in 2007. In 2007, the economy faced severe inflation and high growth. In the past few years, price growth has been weaker than expected, and economic growth has remained at a relatively low level. Under these important macroeconomic conditions, there are significant differences in the domestic and international economic environment, the formation of the exchange rate, and its level. But even so, the surplus is still higher than the level at that time.

We can compare, if we do not exclude price factors and only calculate nominal values, i.e., nominal trade surplus and nominal total economic output, we will find that the degree of imbalance in the current trade account is much milder. It is nearly half lower than the level in 2017, and slightly lower than the level around 2015.

[caption id="attachment_1335" align="aligncenter" width="640"] Gao Shanwen Internal Speech Full Text 26[/caption]

The data performance after excluding price factors, and the significant performance of data after excluding price factors recently, indicate that China's terms of trade have seriously deteriorated in recent years.

In other words, the price of the goods you sell has fallen sharply, while the price of the goods you buy has risen sharply. Because the prices of the goods sold in large quantities have fallen sharply, and the prices of the things you try to procure and buy have risen sharply, there will be such a significant difference between the first and second charts. However, from the perspective of analyzing the performance of the real economy, the performance after excluding price factors is obviously more reasonable.

The most important explanation for the imbalance is the significant adjustment in real estate

The question we need to ask is, why has China once again experienced such a severe trade account imbalance in recent years?

One attractive explanation is that during the pandemic, due to widespread risk controls globally, supply chains were severely disrupted. China, at least in 2020, 2021, and for a period in 2022, managed the pandemic very successfully, and its economic life ran very normally. China's manufacturing production process and supply chains remained relatively normal.

As global economic activity returned to normal, the trade surplus should have contracted significantly. However, we have only seen a slight decrease in the trade surplus in 2023 at most. In 2024, the trade surplus has increased again, and the explanatory power of this data performance for the overall performance of the data in these years is relatively limited.

A second explanation that many people tend to propose is that during the pandemic and in recent years, China's manufacturing investment has remained at a relatively high level overall. Furthermore, China has made technological breakthroughs in emerging industries such as new energy vehicles, significantly enhancing its competitiveness and thus driving the growth of trade surplus. However, we believe that explaining the unprecedentedly large trade surplus solely by the significant improvement in manufacturing capabilities and competitiveness may not be convincing enough.

The important counter-evidence is that the overall economic growth during the entire period has been relatively low, price performance has been weak, and the exchange rate performance has also been weak. If the significant improvement in China's competitiveness has led to a substantial expansion of the trade surplus, then at the exchange rate level, we should not see such a weak performance.

Furthermore, from the perspective of growth rate, the economic growth rate during the entire period may also be significantly lower compared to the historical normal trend. This leads us to consider a third explanation.

In fact, this explanation has been proposed many times in previous private discussions, but because the data has not been processed from this perspective, it has often been confusing.

The third and most important explanation is the significant adjustment in China's real estate market. Since 2021, China's real estate market has undergone a significant adjustment, with continuous sharp declines in real estate development investment, new construction starts, and sales. This also includes a significant decline in demand from upstream and downstream industries.

Under these conditions, accompanied by the rapid contraction of demand in these areas, the corresponding production capacity has been forced to turn to the international market, leading to an increase in trade surplus.

We can see that in terms of magnitude, they are relatively close.

Although we must also emphasize that due to the impact of the scarring effect since the end of the pandemic, and the overall weak demand due to the damage to the balance sheets of residents, enterprises, and local governments, and the overall low consumption propensity, the resulting insufficient demand has also been reflected in the expansion of trade surplus to some extent.

In the chain of logic, the starting point of the problem is the significant adjustment in the real estate market and the contraction of demand caused by the scarring effect. This force has led to weak economic growth, low price levels, and weak exchange rate performance.

Due to weak demand, economic prosperity is low, prices are weak, economic growth is weak, and the exchange rate is weak. Similarly, due to low demand, the corresponding supply capacity is forced to turn to the international market, resulting in a very large expansion of trade surplus.

Similarly, due to weak demand, and because China is such a large economy, it has led to a significant deterioration of China's terms of trade. Because your demand is weak, the prices of industrial products are very weak. When the prices of industrial products are very weak, you can gain competitiveness in the international market when you export.

So, with weak demand and weak prices in China, industrial products such as steel and many other chemical and manufactured goods are more competitive in the international market. From the perspective of your trading partners, they feel the strong competition from Chinese products and begin to complain about China's overcapacity.

When real estate significantly recovers and the scarring effect diminishes, the imbalance will be significantly corrected

Although this is not the focus of the discussion on China's overcapacity problem, it is indeed one of the important backgrounds driving the narrative about China's overcapacity.

From this analysis, we can say that at some point in the future, if China's real estate market significantly recovers and the scarring effect subsides, leading to a significant increase in aggregate demand, then the imbalance we are currently seeing will be significantly corrected.

The main macroeconomic narrative since 2021 has been real estate, and it has recently changed

Against this background, we will now discuss the second related issue at the macroeconomic level, namely the real estate problem.

Before delving into the real estate issue, I would like to add an observation, although it is not very important, regarding the situation since 2024. Since 2024, we have generally seen that the trade surplus continues to expand.

At the same time, we are paying attention to the price level of industrial products, especially their month-on-month changes.

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Since the second half of last year, we have observed that the month-on-month changes in industrial product prices have generally been below zero. In fact, for most of the time since 2022, the month-on-month changes have been continuously below zero, indicating that the price level has been slightly declining overall.

Further observation reveals that commodity prices in the current context have risen significantly in the past few months, reaching new highs since the pandemic. Both domestic commodity prices in China and the Goldman Sachs commodity price index show similar trends.

This means that in the past few months,

In the middle of the month, we see on the one hand that China's trade surplus continues to rise, and on the other hand, although industrial product prices have generally remained below zero, appearing stable on the surface, prices of basic commodities have risen sharply.

In other words, if we exclude the impact of basic commodity prices, the prices of industrial manufactured goods have actually accelerated their decline in recent months.

This is because we see that the prices of basic commodities are strengthening. These data, taken together, suggest that we cannot explain all phenomena solely by the contraction of the real estate market. Data from recent months indicate that the contraction of the real estate market can explain the increase in trade surplus and the decline in industrial product prices, but cannot explain the significant rise and new highs in basic commodity prices.

In the data from recent months, although the adjustment of the real estate market and the scarring effect are considered the most important trends and characteristics of macroeconomic data since 2021, we note that some new additional changes have emerged against this background and on this basis.

We believe that the most important background for the emergence of these new changes is that China's production capacity in some emerging fields is forming new competitive capabilities. The emergence of this new competitive capability has not only promoted the expansion of China's trade surplus but also contributed to the improvement of economic growth, exceeding market expectations. At the same time, it has also driven up the prices of upstream basic commodities.

However, the formation of these new supply capacities has further exerted downward pressure on the prices of manufactured goods.

In other words, although we believe that the significant adjustment of the real estate market and the continued impact of the scarring effect in the past few years are the most important features in the macroeconomic narrative, in recent months, China's rapid technological progress and the formation of new production capacity in the manufacturing sector have marginally driven the performance of many new data, thereby driving up upstream commodity prices and driving down midstream and downstream prices.

Since the end of 18, second-hand housing prices and residential rents have fallen sharply, indicating a significant deterioration in the fundamentals of the real estate market.

Let's look at the second-hand housing price and rent indices for 25 cities.

[caption id="attachment_1337" align="aligncenter" width="640"] Full text of Gao Shanwen's internal speech 28[/caption]

The housing rent price index in these areas is set at 100, with the end of 2018 as the benchmark. First, let's look at the performance of the housing price index, also with the end of 2018 as 100. At some point in 2021, the housing price index rose to over 105, but then began to fall sharply. Currently, the housing price index has fallen to just above 80, meaning the adjustment in the housing price index may be close to 30%.

Such an adjustment magnitude may be close to everyone's perception at the micro level. Although the adjustment magnitude may vary across different housing projects and cities, the overall data for the country suggests that the magnitude and perception should be similar. It is particularly important that in recent months, housing prices have generally shown a trend of accelerating decline.

Next, let's look at the rent index. It is worth noting that since the outbreak of the epidemic, the rent index has begun to fluctuate downwards.

Since the outbreak of the epidemic in 2020, the rent index has continued to fall. By April to May of this year, the decline in the rent index compared to the end of 2018 may be close to 15%, or between 10% and 15%. This is similar to our perception at the micro level.

The prices mentioned here are the rent price indices for residential properties; if we consider the rent price indices for office buildings, the adjustment magnitude may be even larger.

The housing prices discussed here are also housing price indices for residential properties. Our perception at the micro grassroots level also generally points to a significant decline in residential rents in recent years.

Combining these two sets of data, I believe they contain a wealth of information and are extremely valuable for understanding the current state of the real estate market and predicting its future direction.

The first important piece of information is that the rent price level has significantly declined over several consecutive years.

Looking back to the period before 2018, for example, from 2010 to 2018, or even if we exclude the impact of the financial crisis, from the beginning of this century to 2018, almost all data show that the housing rent index has generally been rising.

This is consistent with rapid economic growth, continuous urbanization, and rising income levels, and the absolute level of urban housing rents has been rising.

However, in the past few years, about four to five years, the absolute level of rents has been declining.

If we consider real estate as a very important asset, its pricing basis is undoubtedly the cash flow generated by long-term rents. And the prediction of long-term rental cash flow is naturally based on current or recent rental performance.

The significant decline in residential rents over four to five consecutive years indicates that, for whatever reason, from a valuation perspective, the fundamentals of the real estate market have significantly deteriorated.

Previously, rents continued to rise, and people generally expected rents to at least remain stable. But now, rents have not only fallen sharply, but this decline has been going on for a long time. Even if rents rebounded after the epidemic, it was only temporary, and soon reached new lows.

From a valuation perspective, the fundamentals of this capital good or asset have significantly deteriorated, and its long-term expected rents and expected cash flows have also significantly declined. This deterioration of fundamentals inevitably leads to a significant adjustment in asset prices. We believe this is one of the most important backgrounds for the significant adjustment of real estate prices.

Now the valuation represented by the rental yield has returned to the level of 17-18, and the valuation is not considered high.

Next, let's look at the rental yield. Since the fundamentals are deteriorating, we should pay attention to the rental yield. In fact, the reciprocal of the rental yield is equivalent to the price-to-earnings ratio. It borrows the concept of the price-to-earnings ratio, which is the ratio of price to rent.

Before the middle of 2021, we observed that on the one hand, housing rents were falling, and on the other hand, housing prices were rising. The price trend was contrary to the direction indicated by the fundamental rents. Therefore, the valuation of real estate as a capital good rose sharply at that time.

Although profits decreased, stock prices and valuations became higher and higher. The sharp rise in valuation indicates that the market at that time believed that the decline in rents was temporary. People still had strong confidence in future urbanization, economic growth, and rising rents. Therefore, although rents were falling, valuations and stock prices were rising.

However, in the second half of 2021, possibly starting from 2022, expectations for rising rents began to change. The market began to realize that the expectation of continuous rent increases might not be accurate, and coupled with the impact of the epidemic and a series of risk control measures, rents were difficult to increase.

In this context, people's understanding of the fundamentals began to align with reality. The result of this alignment of understanding with reality is a significant correction of valuation and a sharp decline in housing prices. By the second half of last year, valuations had basically returned to the level of the end of 2018.

Currently, with the continued rapid decline in the housing price index, the valuation level represented by the rental yield is likely to have fallen back to the level between 2017 and 2018. Last year, it returned to the level of the second half of 2018. Now, it may have returned to the level of 2017 or between 2017 and 2018.

In the long run, these levels are not significantly high. Compared to the past decade or so, we cannot consider it to be at a significantly very high position. This is our commentary on these data.

The adjustment of the real estate market closely follows the fundamentals, not driven by a bubble burst.

Let's further compare the changes in second-hand housing prices and rents.

We know that the real estate market has undergone a valuation correction, and there was a certain bubble. When people's cognition aligns with the fundamentals, a valuation correction occurs. Valuation correction leads to a significant adjustment in housing prices.

This is a scatter plot where one axis represents the change in urban rent prices, and the other axis represents the change in housing prices. The horizontal axis represents the change in rent in a city over a period of time, and the vertical axis represents the change in housing prices over a period of time.

Overall, there is a very strong correlation between the change in rents and the change in housing prices: the less rents fall, the less housing prices fall; the more rents fall, the more housing prices fall. This reflects the adjustment of market prices.

From a cross-sectional perspective, the market adjustment closely tracks the fundamentals. When the fundamentals show a small decline in rents, housing prices also decline less; when the decline in rents is large, housing prices also decline more. However, overall housing prices are still falling, because in 2021, the overall valuation was at a high bubble level, and compared to the changes in fundamentals, the changes in valuation went too far (too advanced).

If we select a specific time period to observe, we will find that the adjustment of the entire market is not disorderly, but is closely tracking the fundamentals on the basis of the overall price level returning to reasonable valuations. This is different from the market model in countries where bubbles burst, where housing price declines are proportional to previous increases and have no direct relationship with rent changes. On the contrary, with

The adjustments closely related to rent changes indicate that the market is following fundamentals, further illustrating that market adjustments are driven by fundamentals, rather than by irrational bubbles and their bursts.

The price-to-income ratio has the potential to return to 2015 or earlier levels.

Against this backdrop, we further observe the performance of the real estate market's adjustments so far.

The red line in the chart represents the growth rate of per capita income and its expectations, extrapolated from some survey data.

[caption id="attachment_1339" align="aligncenter" width="640"] Gao Shanwen Internal Speech Full Text 30[/caption]

For housing prices, future rent is the most important fundamental factor. However, related fundamentals must also include people's expectations of future income. If strong annual income growth is expected in the future, even if current housing prices are high, it doesn't matter. But if future income stagnates for a long time like in Japan, the price-to-income ratio becomes a particularly convincing indicator.

Undoubtedly, an important fact is that long-term income growth and expectations are declining, and during the pandemic, income expectations may have accelerated their decline for at least a period. The decline in long-term income growth undoubtedly puts pressure on real estate valuations. However, at the same time, long-term mortgage rates have also fallen significantly, by more than 200 basis points since the outbreak of the pandemic. The decline in income growth may reach 300 basis points.

In some simple valuation models, the valuation of long-term growth is the growth rate minus the interest rate, plus some adjustments for risk premium. In the context of declining growth, interest rates have also fallen significantly. Although we believe that further interest rate reductions will help support the market and there is still room for decline, the magnitude of interest rate adjustments is already quite large compared to the decline in income growth expectations.

Next, let's look at another important valuation indicator for the real estate market – the price-to-income ratio. This indicator is easy to estimate intuitively.

We mentioned earlier that the absolute level of current housing prices may have returned to around 2017 levels. If it returned to 2016 levels, it would be between 2016 and 2017. But compared to 2016-2017, the absolute income level is undoubtedly much higher now.

However, the absolute level of housing prices has returned to 2016-2017, which means the price-to-income ratio has significantly improved. These calculation results are shown in this table.

From these calculation results, the current price-to-income ratio may be even better than the indicator in 2014. This may be because the early housing price data in the data we used may have some defects and underestimations.

Even with grassroots observations, if the absolute level of housing prices has returned to 2017, it is entirely possible for the price-to-income ratio to return to 2015 or earlier.

Considering income growth, if the price-to-income ratio returns to the level between 2014 and 2015, for most cities, the price-to-income ratio will not appear excessively high in the long run.

Therefore, combining all these data, our conclusion is that the pandemic has led to a significant deterioration of the fundamentals of the real estate market. This deterioration is reflected not only in the significant reduction in rents but also in the significant reduction in long-term income expectations.

Against the backdrop of a significant deterioration in fundamentals, the valuation of the real estate sector as an asset has also undergone drastic adjustments. These adjustments include both the adjustment of absolute price levels and the adjustment of relative price levels between cities. From the perspective of relative price level adjustments, it closely tracks fundamentals, meaning the greater the deterioration of fundamentals, the greater the adjustment, indicating that overall, we tend to believe this is a necessary and unavoidable response to the deterioration of fundamentals.

Housing prices are still falling and bottoming out, and the deterioration of fundamentals is an important reason for the adjustment, but not the only one.

Overall, after the normal adjustments of the past few years, many important valuation indicators have undergone significant corrections, and market valuations have returned to relatively reasonable levels.

For example, the price-to-income ratio may have fallen back to the level of early 2015, the rental yield may have returned to the level of around 2017, and the absolute housing price level may have fallen back to the level between 2016 and 2017.

In these aspects, the decline in long-term loan interest rates has largely offset the impact of long-term income deterioration, and the long-term affordability of housing, i.e., mortgages relative to income, has actually improved significantly.

The real estate market has undergone significant adjustments, and many valuation indicators have returned to very reasonable levels. However, in the past period, real estate prices have continued to accelerate downwards and bottom out.

Long-term stock investors know that a reasonable price does not mean the market bottom; the market bottom usually requires prices to be significantly below reasonable levels to form. Currently, many indicators may be in the reasonable range, and some may even be on the low side, but reasonable does not equal the market bottom, and the formation of the bottom is very complex.

If the market relies entirely on its own forces to form a bottom, it usually requires prices to be below reasonable levels. What we have seen in the past period is that despite significant corrections in many indicators, housing prices have continued to fall rapidly.

Let's return to the second question: the deterioration of fundamentals is an important reason for the adjustment of the real estate market, but not the only reason. We believe that another very important reason for the drastic adjustment of the real estate market is the liquidity crisis faced by real estate enterprises, which is similar to a chain reaction.

The business model of Chinese real estate enterprises is based on high turnover, which requires high stability in debt and cash flow. However, the stability of cash flow and debt of real estate enterprises has been severely impacted in the past few years.

In this situation, creditors have concentrated on demanding repayment of debts from real estate enterprises, leading to a widespread liquidity crisis in the entire industry, forming a chain reaction. This situation has led to the passive and rapid contraction of the balance sheets of real estate enterprises, which has had a series of impacts on the macroeconomic level and is a key background for the drastic adjustment of the real estate market.

An important piece of evidence is to compare the situation in the primary and secondary markets. Currently, the transaction volume in China's second-hand housing market remains at the 2019 level, which is historically quite high. However, the transaction volume of new homes and new construction has fallen back to the level of more than a decade ago. The significant divergence in transaction volume between the new and second-hand housing markets is very rare.

We believe this is mainly because homebuyers are worried about whether new homes can be delivered on time, and there is a risk of delivery. In addition, other factors have suppressed the performance of the real estate market.

Therefore, the adjustment of the real estate market and the adjustment at the macroeconomic level, including the decline in rents and income expectations, are to some extent related to the liquidity crisis of real estate enterprises.

The significant rebound in A-share and Hong Kong stock real estate, comparable to the rebound when the pandemic was lifted, reflects that this round of real estate regulation has identified the key issue – the liquidity pressure of real estate companies.

Next, we will look at some relevant latest data.

First, let's observe the stock price indices of state-owned and private real estate sectors in the A-share market.

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We compare this stock price index to remind everyone that in the past period, the government has introduced a series of new and strong policies to intervene and rescue the real estate market. Especially in the past month, the government has introduced a new round of policies to intervene and rescue real estate enterprises.

Against this policy backdrop, the stock price index of the real estate sector has rebounded significantly. In terms of stock price performance, the rebound in the real estate sector index in the past month or so is comparable to that during the lifting of the pandemic, at the same magnitude.

Recalling the sudden lifting of the pandemic at the end of 2022, people had very optimistic expectations for the recovery of the economy, market, and real estate, and the market and real estate sectors experienced significant rebounds. In the past month, the rebound in the real estate sector index is also of the same magnitude compared to when the pandemic was lifted.

If we look at the Hong Kong stock market, the situation is similar.

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The stock price index of the private real estate enterprise sector has rebounded even beyond the level during the lifting of the pandemic, and the stock price index of the state-owned real estate sector has also experienced a similar magnitude of rebound.

This rebound is also reflected in the high-yield bond market of Chinese dollar bonds, i.e., the junk bond market, as evidenced by a significant decrease in the yield to maturity. Although the magnitude of this decrease is not as large as during the lifting of the pandemic, from the perspective of the bond market, the magnitude is also quite large, the largest since the lifting of the pandemic.

In the stock market, after calculating the indices one by one, we found that on most indicators, they are comparable to those during the lifting of the pandemic. This indicates that the market has very positive and optimistic expectations for the real estate policies introduced in the past month, which can even be compared to the lifting of the pandemic.

The reason for such expectations is that the new round of real estate regulation has not only relaxed purchase restrictions and adjusted real estate interest rates, stimulating and expanding real estate demand, but has also begun to target and rescue the liquidity pressure of real estate enterprises. The government has purchased land and completed buildings,

Measures such as converting properties into affordable housing directly intervene and rescue the real estate market from liquidity pressure.

The liquidity pressure faced by real estate companies is the most fundamental root of all problems. When government policies begin to directly confront and attempt to solve this most important root cause, the market's price index shows a significant rebound.

In the market's view, this rescue has identified the key to the problem, diagnosed the pulse, found the root of the disease, and the direction of the measures is correct. This is the only explanation for the strong performance of the A-share market, Hong Kong stock market, and bond market against the backdrop of the pandemic's reopening.

It is completely normal for technical pullbacks and adjustments to occur during the market's assessment of policy effectiveness

I personally believe that the market's interpretation of policies and understanding of the real estate market situation are effective, objective, and correct. Compared to the gradual, piecemeal policies of the past few years, this round of real estate intervention policies has identified the key points of the problem, and the policy direction is correct. However, we also know that no matter how good a policy is, it is useless if it remains only on paper. Good policies must ultimately be implemented and translated into action.

Those who have been in trading for a long time easily understand a fact: during and for a period after the introduction of policies, market trading is driven by expectations. But once the policies are fully introduced, trading based on expectations shifts to an assessment of the policy's implementation effectiveness.

Initially, trading revolves around expectations. After the policies are introduced, trading based on expectations ends, and the focus shifts to assessing the actual effectiveness of the policies. It is completely normal for the market to experience some technical pullbacks and adjustments during this transition.

During the process of assessing policy effectiveness, whether the policies can achieve the expected results remains to be seen. The current policies have identified the key points of the problem and can achieve a multiplier effect, with the potential to play an important role. If the policies can be implemented smoothly, they may gradually promote the bottoming out and reversal of the real estate market.

However, there is great uncertainty in the policy implementation process, which requires our close attention.

We have noticed that market trading in the past week has already reflected this change in trading rhythm. Currently, the policies have been largely announced, and market trading has begun to shift towards assessing the effectiveness of the policies. This assessment will undoubtedly take several months.

If the assessment results fall short of expectations, and there is no further policy support, the market may experience another significant adjustment.

We believe that the current policy direction is correct. The real estate market has undergone significant adjustments, and many valuation indicators have returned to reasonable ranges. Strong policies have the potential to gradually promote market bottoming and reversal. However, the uncertainty in policy implementation is the greatest, and we need to continue to observe.

In the next 10 years, national debt interest rates will accelerate downwards

Next, we will turn to the discussion of long-term interest rates. At our mid-term strategy meeting, we studied China's long-term capital returns. Our basic view is that since 2010, China's long-term capital returns have begun a long-term downward trend, which will continue at least until 2030, and possibly longer.

This downward trend will lead to a continuous decline in China's interest rate center. In June 2021, we predicted that by 2030, the interest rate of China's ten-year national debt might fall to around 2%. This prediction is based on the view that as China's economy successively crosses the first and second inflection points of the Lewis turning point, the decline in marginal returns on capital will become the dominant factor. Technology's ability to counteract the decline in marginal returns can only be realized when returns are low. During the current transition period, the continuous decline in long-term capital returns is inevitable until economic growth falls to 3% or lower, at which point technological progress may reverse this trend. From 2010 to 2030, we will witness a continuous decline in long-term economic growth, long-term marginal capital returns, and the long-term interest rate center, a phenomenon also seen in the transformation processes of other East Asian economies such as Japan and South Korea.

In the long run, by 2030 or 2035, there will be significant room for long-term national debt interest rates to decline.

We agree and acknowledge that short-term cyclical factors, such as the deterioration of the real estate market, scarring effects, and overcapacity, will promote a decline in interest rates in the short term.

Once these short-term factors disappear, interest rates may also experience cyclical rebounds. However, the long-term trend behind these fluctuations is a continuous decline in the interest rate center, especially in the next decade, when national debt interest rates will accelerate downwards.

I believe the process of interest rate liberalization is nearing its end, but not yet complete. A clear example is the impact of the policy prohibiting manual interest rate adjustments since April on the market. The widespread existence of manual interest rate adjustments and their impact after the prohibition clearly indicate that the process of interest rate liberalization is not yet complete. Inferring from the grassroots level, interest rates may still have room to fall by 25 to 30 basis points, especially considering the current low economic sentiment, this gap may be even larger. Compared to 2011, interest rates have been significantly corrected, but there is still room for decline.

In summary, since 2011, the continuous and significant decline in China's long-term marginal capital returns has driven the decline of the overall interest rate center. Commercialization reforms and interest rate controls artificially widened interest rate spreads, leading to limited declines in long-term national debt interest rates and greater declines in loan interest rates over the past decade. However, long-term national debt interest rates are expected to catch up in the future. Although short-term factors such as economic downturn and real estate market weakness may lead to a decline in interest rates, and interest rates may rebound as economic sentiment recovers, the long-term trend of declining interest rates is inevitable.

In this sense, the recent issuance of ultra-long-term national bonds by the Ministry of Finance has been sought after by the market, and the market pricing is reasonable to some extent. Looking ahead to 2035 or even 2054, economic growth and long-term interest rates will be at very low levels. Therefore, from the current perspective, pricing long-term national debt interest rates at a low level is reasonable.

What we want to say is that the decline in China's long-term marginal capital returns has driven the decline in the interest rate center, which is the most important background for the decline in long-term interest rates.

However, from 2011 to 2021, during the process of interest rate liberalization and deregulation, the national debt market simultaneously experienced upward pressure on interest rates, making its decline less pronounced. But in the future, this impact will be significantly weakened.

Japanification or Koreanization?

Shu Jiāpèi

April 15, 2024

Executive Summary

The lessons from Japan's real estate bubble in the 1990s are well-known, but South Korea's experience has been overlooked. In 1998, South Korea was also on the verge of becoming a high-income country, in the latter half of its urbanization, similar to China's current development stage. During the 1998 Asian financial crisis, South Korea experienced economic recession, falling housing prices, and pressure on banks. However, unlike Japan, South Korea subsequently experienced sustained economic growth and became a developed country.

Both Japan and South Korea experienced severe adjustments in their real estate markets, but their future paths were completely different. The decisive factor was whether real estate demand had been overdrawn beforehand. Considering the level of real estate investment, China's unique land supply system, the growth in second-hand home transactions, and inventory levels, it can be basically confirmed that China does not currently have an overdrawn real estate demand, and South Korea's path may be more referential.

Overseas experience shows that deteriorating fundamentals can also lead to pressure on the real estate market. When fundamentals recover, real estate prices and investment can quickly recover. South Korea in 1998 is a typical example; if policies are handled properly, the negative impact can be significantly reduced. The consequences of demand overdraw require a long time to digest, and policies are powerless to help. Japan in 1991 is another typical example.

Risk warnings: (1) Geopolitical risks (2) Policy introductions exceeding expectations (3) Financial risks

I. The Overlooked Korean Experience

Currently, discussions about China's real estate market and future economic trajectory are undoubtedly the focus of macroeconomics. The bursting of Japan's bubble in the 1990s and the subsequent lost decades are deeply impressive. Market participants, both domestic and international, have conducted in-depth research on this [2], comparing 1990s Japan with present-day China and using this as a benchmark to judge China's future. Such research and thinking are undoubtedly highly inspiring.

But have we overlooked the experience of another East Asian neighbor, South Korea, during the 1998 financial crisis and the subsequent sharp decline in real estate prices?

Compared to Japan in 1991, South Korea before the 1998 Asian financial crisis may have had more similarities with present-day China.

First, let's look at the economic development stage. In 1994, South Korea's per capita GDP exceeded $10,000, just crossing the threshold for a high-income country at that time according to the World Bank (about $9,000). China's per capita GDP reached $12,700 in 2021, approaching the high-income country threshold for 2021. Japan's per capita GDP in 1990 reached $25,000, far exceeding the high-income country threshold at that time ($7,600), and it was already among the leading developed countries.

In terms of urbanization, Japan's urbanization was largely completed in the 1990s [3]. South Korea's situation in 1998 may be more similar to China's current situation, both having passed the fastest stage of urbanization but still having some room for urbanization in the next decade, which is consistent with being near the threshold of high-income countries. Due to differences in national systems, urbanization rates may not be directly comparable. The proportion of the non-agricultural labor force provides another perspective. It also shows that in 1998, South Korea had already passed the fastest stage of urbanization.

The end has been reached, but there is still room for growth compared to the final value of urbanization.

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Secondly, let's look at the birth population. South Korea's birth population remained around 1 million per year on average between 1960-1970, then gradually declined, falling to the 600,000-700,000 level in the 1990s, and further declined to the 400,000 level after 2000, continuing for nearly twenty years. Between 1980-1990, China's birth population averaged 24 million per year, then gradually declined, stabilizing at the 16 million level in 2000, and declining again in 2018, possibly to the 9 million level. After 40 years of rapid development, both China's and South Korea's birth populations have fallen by nearly 60% from their starting points.

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However, more importantly, let's consider South Korea's performance in real estate and the economy during the 1998 Asian financial crisis. Since the 1990s, South Korean housing prices have remained generally stable, making it difficult to say that a huge bubble has accumulated due to rising prices. During the 1998 financial crisis, the OECD nominal housing price index in South Korea fell by a maximum of 13%. The current decline in this indicator in China does not exceed 5%.

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During the same period, it is difficult to say that real estate investment in South Korea was in excess. South Korea's fastest urbanization phase was around 1991 [4]. Since then, South Korean real estate investment has experienced a significant slowdown, and its proportion of GDP has significantly decreased. Starting from 1994, the proportion of housing investment to GDP began to decline steadily.

Looking back, we can clearly say that South Korea's real estate market experienced significant overshooting after 1998. As shown in Figure 4, as the high-speed urbanization phase passed, the proportion of real estate investment to GDP will continue to decline, which is a long-term trend. The deep trough during 1998-2002 was a deviation from this trend, which led to a rebound in the proportion of real estate investment after 2002. Looking back at the continuous rapid rise in housing prices in South Korea after 2002, the insufficient supply caused by the overshooting of the real estate market may be an important reason.

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From the perspective of early 1999, South Korea could see rapidly falling housing prices, rapidly declining real estate investment, a sharp depreciation of the exchange rate, extremely serious corporate debt problems, high non-performing loans in banks, economic recession, pressure on the financial system, and defaults on external debt. Terms like "hard landing" and "ugly deleveraging" seem to accurately describe South Korea. South Korea also faced pressure from long-term trends such as the nearing end of urbanization and a significant decrease in the birth population. Narratives like "South Korea peaked" and "lost thirty years" also seem applicable.

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In the end, South Korea did not lose thirty years. After 2010, per capita GDP exceeded $25,000, successfully entering the ranks of developed countries, and the economy continued to grow thereafter. South Korean housing prices also rose rapidly, and real estate investment rebounded synchronously. Considering that China's future urbanization space may be larger than South Korea's, the demand in the real estate market may be better.

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Why did Japan and South Korea take completely different paths in the twenty years after their crises? The debt pressure and falling housing prices accompanying the bursting of real estate bubbles do not seem to explain the difference between Japan and South Korea. So what is the key to the problem?

II. Decisive Criterion - Demand Overdraft or Not

Generally speaking, a sharp rise in real estate prices is often accompanied by a rapid increase in the proportion of real estate investment to GDP and an increase in debt. The process of prices returning to fundamentals also brings investment and leverage back to normal levels. The former leads to demand overdraft, making demand significantly weaker than the equilibrium level in the following years, while the latter may lead to a large number of bad debts in financial institutions, triggering financial risks. This process is called the bursting of a real estate bubble.

Since 2015, while housing prices in China have risen rapidly, the proportion of real estate investment has remained generally stable, which is extremely different from the real estate bubble in almost all other countries. In the previous annual strategy report "Clear Despite the Fog," we pointed out that China's real estate investment as a proportion of GDP has fallen below the reasonable medium-term level of around 8%. Some investors have doubts about our estimate of the long-term real estate medium, believing that the long-term residential investment proportion of 4% in the United States and Japan is a comparable object. However, this undoubtedly lacks consideration for the cost differences between different types of housing. [5] Since Chinese residences are mainly multi-story and high-rise buildings, if this living model continues in the future, the medium of China's residential investment after urbanization should be higher than that of most developed countries, rather than aligning with the lowest levels in developed countries like the US and Japan. Considering this, our previous investment level cannot be said to be too high.

Observing the common characteristics of countries that have experienced typical real estate bubbles may provide some inspiration.

The report "The Long Tail" shows that real estate bubbles bring long-term losses [6], and we believe that the presence or absence of demand overdraft is the most important criterion for real estate bubbles. We also use the classification standards of Qust [7] and Laeven [8] to divide countries into three categories: countries that experienced real estate crises, countries that experienced banking crises, and countries that experienced dual crises. [9]

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Countries that only experienced real estate crises without banking crises mostly occurred in the 1970s-1980s. The possible background was that global inflation was high at that time, and interest rates in various countries were at high levels, making it difficult to use leverage. The real estate crisis did not lead to a banking crisis. However, this period is earlier, the data availability is poor, and it is not the focus of this article.

We will focus on comparing dual-crisis countries and countries with only banking crises. As shown in Figure 7, if the year of crisis is defined as 0, and the economic growth rate before and after the crisis is compared, both types of countries suffer severe losses in economic output, and the time for economic activity to recover is also prolonged. [10]

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However, there are significant differences in the fundamentals between the two groups of countries, especially in real estate. We measure this using the proportion of real estate investment to GDP. As shown in Figure 8, countries that experienced dual crises had severe overcapacity in real estate investment before the bubble burst, and the time and space required to digest this overdraft were more intense. Countries that only experienced banking crises had much less overcapacity in real estate investment, so the intensity of adjustment in real estate investment itself was much smaller.

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Observing unemployment rates, both groups of countries experienced prolonged high unemployment, with dual-crisis countries suffering greater losses. However, countries with real estate bubbles experienced a significant decrease in unemployment rates before the crisis, indicating that vigorous real estate investment may have significantly boosted domestic demand, pushing the economy into overheating.

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Observing changes in core CPI and policy interest rates also confirms this. Excessive investment associated with real estate bubbles pushes the economy into overheating, leading to a significant rise in core CPI and a corresponding response in policy interest rates. Interest rate hikes lead to the bursting of the bubble. This pattern is not significant in countries without real estate bubbles. Core inflation and rising policy interest rates are not significant. After the crisis, a sharp interest rate cut is a common coping strategy.

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By comparison, countries with real estate bubbles exhibit a series of significant characteristics, the key being the overdraft of real estate demand and oversupply, and the subsequent overheating of the economy. However, countries that experienced banking crises, without significant real estate overdraft, also suffered significant economic losses. In these countries, financing availability declined due to pressure on banks, and residents' income and confidence declined due to economic slowdown, all of which put pressure on housing prices and led to insufficient demand.

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The above research has the following problems: the global economic and inflation environment varied across different time periods, the practice and theory of monetary and fiscal policy responses were significantly different, and the capabilities and fundamentals of different countries varied greatly. These are merely statistical observations and do not imply causality.

The performance of EU countries before and after the 2009 financial crisis is, to some extent, a better natural experiment. Eurozone countries share the same currency, exchange rates and inflation do not need to be controlled, fiscal policy differences are limited, and national governance capabilities do not differ significantly. The samples are basically large developed countries with relatively close development levels.

These countries all faced a sharp deterioration in financial conditions at that time, but their real estate markets were in different states. For example, Spain was undoubtedly at the peak of its bubble, while German real estate investment had been at its bottom for decades. Other European countries were between these two extremes of Germany and Spain. Merging them can provide a better understanding of the reasons for and sustainability of the decline in real estate demand and housing prices to some extent.

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If we assume that the pressure of the financial tsunami faced by these countries was similar in degree, then merging these countries can measure the impact of the financial shock on their economies and real estate markets.

As shown in Figure 15, the vertical axis is the largest OECD nominal housing price decline in these countries after 2007, and the horizontal axis is the average proportion of real estate investment to GDP in these countries from 2003-2007 divided by the average proportion of real estate investment to GDP from 2000-2022, expressed as a percentage. A value of 0 means that the real estate investment levels in the two periods are equal. This percentage is a proxy variable for the degree of excess investment in the bubble period (or the degree of decline in real estate investment). Even after excluding Spain, the slope and intercept reported by the regression equation are

There has been little change.

The significant meaning of the regression equation coefficient is that the greater the over-investment representing the overdraft of demand, the greater the correction needed in prices.

On the other hand, the intercept of the regression equation is also statistically significant, meaning that even if there was no prior over-investment in real estate, the real estate market was operating normally, and demand was not overdrawn, housing prices still faced significant downward pressure. [11]

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At the end of 2010, European countries were generally facing significant pressure in their real estate markets, with prices undergoing substantial adjustments and demand at low levels. Looking from the left, it might be difficult to determine whether this pressure originated from the real estate market itself or from other areas of the economy. It could even be argued that real estate in EU countries, including Germany, had previously experienced demand overdraft.

However, looking at the right side, after European countries generally emerged from the financial crisis, observing the changes in housing prices in these countries at the end of 2016 compared to the end of 2010, countries that did not have prior over-investment in real estate saw significant rebounds in housing prices, while countries with prior over-investment mostly saw prices remain flat or decline. The statistical significance of the intercept implies that if the real estate market is relatively normal, its housing prices will statistically significantly rebound afterward.

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Similarly, if we observe the real estate investment situation in these countries, as shown in Figure 17, the horizontal axis is defined the same as in Figure 15, representing the average of real estate investment as a percentage of GDP from 2003-2007 divided by the average of real estate investment as a percentage of GDP from 2000-2022. The vertical axis is defined as the average of real estate investment as a percentage of GDP from 2013-2017 divided by the average of real estate investment as a percentage of GDP from 2000-2022. A value of 0 indicates that investment in these countries is at a normal level. The very clear conclusion is that countries with prior over-investment and demand overdraft remained in a state of very low real estate investment for a long time afterward, while countries without demand overdraft saw real estate investment quickly return to normal levels.

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Furthermore, observing economic growth, countries with more prior over-investment in real estate also experienced significantly worse economic performance in the five years after the crisis (2008-2012). At the same time, the intercept of the regression equation is -0.9, which is also statistically significant, meaning that even if the real estate market was in a very normal state prior, economic output significantly declined in the five years after the outbreak of the financial crisis.

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Looking at a longer timeframe, during the period of 2013-2017 after emerging from the European debt crisis, economic activity in most countries improved marginally but remained generally sluggish. The intercept reported by the regression equation is also significantly negative, indicating that even with a normal real estate market, the economy was significantly impacted. During the same period, housing prices in countries where the real estate market was not overdrawn had already significantly rebounded, and real estate investment had recovered to normal levels.

From a pre-crisis and during-crisis perspective, in the context of the financial crisis, most European countries' real estate markets faced insufficient demand, price pressure, and declining investment. However, in hindsight, whether or not there was prior demand overdraft was the decisive factor in the subsequent real estate market and economic trajectory of these countries.

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European countries also encountered various negative impacts, including sovereign debt crises and financial system crises. According to data provided by Baron [13], the maximum decline in bank indices for major European countries during the financial crisis was generally close to 70%, indicating that the financial system suffered a huge shock, and the safety of the banking system was widely doubted.

Combining the real estate bubble, banking crisis, and the performance of European countries during the financial crisis, it can be confirmed that even without demand overdraft, fundamental changes such as financial risks can also exert significant pressure on the real estate market. The mechanism might involve current resident unemployment, wealth loss, worsening long-term expectations, and so on.

If the

The Ministry of Finance's budget preparation includes government fund revenue. The vast majority of local governments' government fund revenue comes from land transfer fees, which makes local governments' land supply need to meet the amount budgeted at the beginning of the year and the construction land quotas for the year. This makes it difficult to increase land supply by pushing up housing and land prices.

Our previous research reports also pointed out that "a significant transformation for Chinese real estate companies after 2015 was the shift from a land hoarding model to a high-turnover model." This makes new construction essentially dependent on the land supply of the current period, and the impact of developers' land inventory on new construction may be weakening.

As shown in Figure 23, rising housing prices cannot increase the supply of residential land at the macro level. This is a result of China's unique land system. This is also the fundamental reason why, despite the rise in housing prices in China, real estate demand has not been overdrawn.

Residential supply data shows that China has not experienced oversupply, nor has demand been overdrawn. This has some explanatory power for the current second-hand housing market.

Although the bursting of the real estate bubble can explain many phenomena, the decisive criteria – oversupply and demand overdraft – may not exist in aggregate. This allows us to witness the phenomenon of "trading price for volume," which does not exist in other real estate bubble countries.

IV. A Rare "Trade Price for Volume"?

Generally speaking, countries experiencing real estate bubbles have gone through a process of price increases – increased supply – and demand overdraft, leading to a decline in both price and volume in both the second-hand and new housing markets at the time of the bubble burst.

As shown in Figure 24, comparing sales volume two years after the bubble burst with that before, sales of both new and second-hand homes in almost all countries have fallen sharply. Compared to these countries, the decline in China's new home sales volume is roughly comparable, but China's second-hand home transaction volume has actually increased slightly. Such a sharp divergence in sales volume between new and second-hand homes is difficult to explain from the demand side.

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A more reasonable explanation comes from the supply side. Comparing the sales growth rates of completed and pre-sale homes in new home sales, as shown in Figure 25, before June 2021, the growth rate of pre-sale homes was significantly higher, while after that, the growth rate of completed homes was significantly better than that of pre-sale homes. While there are certainly delivery risks behind this high growth, it also indicates that the current decline in sales is not entirely due to insufficient aggregate demand.

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According to the statistical bulletin for 2023, the online contract signing volume for second-hand homes was 709 million square meters. By extrapolating the year-on-year changes in second-hand home transactions in cities with different statistical scopes to the national historical online contract signing volume for second-hand homes, and combining it with new residential home sales, we can estimate the total sales area of new and second-hand homes in previous years. Our estimates are basically consistent with the Ministry of Housing and Urban-Rural Development's announcement of a year-on-year positive growth in combined new and second-hand home sales from January to November 2023 [14]. If we assume that aggregate demand remained roughly stable in 2022 and 2023, then the further divergence between new and second-hand homes, and pre-sale and completed homes in 2023 cannot be explained by insufficient aggregate demand.

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Many market participants attribute the strong sales of second-hand homes to "trading price for volume," but this is merely a description of reality. In countries where real estate bubbles burst, housing price declines may be greater than in China currently, but the transaction volume of second-hand homes is much lower. Why have other countries not achieved "trading price for volume"?

The most important reason is that China does not have oversupply and demand overdraft accompanying price increases. As shown in Figure 27, the correlation between the increase in housing prices by state in the United States before the bubble and the decrease after the bubble burst is very strong. One possible mechanism is that regions with larger price increases saw more supply increase and more severe demand overdraft, thus experiencing larger subsequent declines. Furthermore, a bubble means that prices have temporarily deviated from fundamentals, and the process of returning to fundamentals means prices return to their original point, with areas that experienced larger price increases facing greater downward pressure.

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Similar typical bubble burst scenarios do not exist in China. As shown in Figure 28, even if we use the data for the 25 cities tracked by Beike, which have larger price fluctuations, they are basically second-tier cities. The magnitude of housing price decline in the sample cities is not related to the magnitude of the previous increase, which is consistent with the discussion that price increases in China are difficult to drive an increase in supply. This means that the housing price decline in the past period is difficult to explain as a bubble burst.

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How then should we understand the downward pressure on housing prices faced by large cities in this round? In previous real estate cycles, large cities performed relatively well, and after the relaxation of demand-side policies, the real estate markets in large cities often recovered quickly and prices rebounded. However, since 2022, despite continuous policy relaxation, housing prices have remained in a downward trend, which is the core evidence for the current belief that China is experiencing a real estate bubble burst.

We also discussed in the report "Is It Sunny or Cloudy?" that the pandemic has led to a significant slowdown in population inflow into large cities in the past few years, which is one of the important reasons for weak demand. Comparing rental data, this explanation can be further confirmed. Although marginally, consumers entering the rental market and consumers entering the home-buying market are not the same group, overall, both groups are closely related to population inflow.

If we assume that the supply of the rental market is difficult to change significantly in the short term, then rental prices mainly reflect changes in demand. As shown in Figure 29, in 2020, due to the impact of the pandemic, population inflow slowed down significantly, leading to a significant decline in rental prices in large cities. During the same period, due to low interest rates and loose liquidity, housing prices were supported. From the second half of 2020 to the first half of 2021, the pandemic was controlled, the economy recovered, and everyone had good expectations for the future, with housing prices and rental prices rising synchronously.

In the second half of 2021, affected by Evergrande's default and the tightening of real estate demand policies in various regions, second-hand housing prices回调, and rental prices seasonally declined. However, by the end of 2021, housing prices still significantly outperformed rents, reflecting optimistic expectations for the future, with the belief that the economy would further recover, people would flow back, and rental prices in large cities would have further room for increase.

However, the outbreak of the pandemic in 2022 exceeded everyone's expectations. The expected population inflow disappeared, rental prices further declined, and housing prices also dropped a notch. But at the beginning of 2023, with the adjustment of pandemic policies, the return to pre-pandemic life became the expectation for many. This also led to a synchronous recovery of housing and rental prices in the first quarter. However, subsequent developments showed that the return of people did not meet expectations, and housing prices in large cities further converged with rents. The price-to-rent ratio in large cities has basically returned to pre-pandemic levels. This is also very clear in meaning: this is not a valuation decline associated with a bubble burst, but rather a downward revision of fundamentals.

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Statistical data shows a very close correlation between rental prices and housing prices. We believe the logic behind this is that both are proxy indicators for the number of new urban population. The statistical results for 2023 are basically the same as in 2022. Cities with larger declines in rental prices also experienced larger declines in housing prices. This, to some extent, explains the phenomenon in Figure 30: the decline in housing prices reflects more of the changes in the fundamental population of cities, rather than a process of returning to fundamentals after a bubble burst.

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In this sense, comparing housing and rental price indices in the US before and after the bubble, as shown in Figure 31, further confirms that we are not currently experiencing the asset valuation decline associated with a bubble burst. If we follow the Chinese situation and set the starting point for changes in US housing and rental price indices two to three years before housing prices peaked.

There are significant differences between the two sets of data. China is affected by urbanization and the pandemic, factors that were not present in the US at the time. However, from a price perspective, it is very clear that even more than two years after housing prices peaked, US housing prices fell far more than rental prices, and the housing price-to-rent ratio significantly decreased.

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This largely indicates that a bubble burst is accompanied by a significant decline in valuation, which has not occurred in China. This is closely related to the active transaction volume in the second-hand housing market and the fact that demand has not been overdrawn. The decline in Chinese housing prices reflects the fundamental change of reduced population inflow into large cities. Under this fundamental condition, the previously extremely effective demand-side relaxation measures appear to have little effect.

The core criteria for many market participants believing that China has a real estate bubble are that the price-to-income ratio and the price-to-rent ratio are relatively high globally. This requires considering multiple factors. Some possible factors include: China's unequal rights between renting and buying, especially the rights to school districts and household registration that renters do not enjoy; China does not have property taxes, so holding costs need to be factored into housing prices; China's unique land supply system, etc.

This article does not intend to discuss the absolute level of the price-to-income ratio, but rather to compare relative values to understand the current real estate market. In addition to these factors, another important factor is income expectations and mortgage interest rates. An extreme scenario is: the mortgage interest rate is 5%, and the expected income growth is as high as 30%. In this case, a price-to-income ratio of over 30 may not necessarily be high. After working for a few years, with significant income growth, the previous housing prices may appear relatively reasonable.

Considering that most developed countries are in an environment of low growth and low inflation, the difference between income growth and mortgage interest rates can be ignored, while this was not negligible in China previously. If we use the price-to-income ratio of 50 large and medium-sized cities from Wind, at

After the 2020 data stopped updating, data from Beike's 25 cities on housing prices and disposable income of urban residents were used for continuation. What can be confirmed is that in the past few years, with continuous income growth and a slight decrease in housing prices, the nominal housing price-to-income ratio has significantly improved.

However, on the other hand, the expected income growth rate may continue to decline. As shown in Figure 34 below, before 2023, the average annual income growth rate of urban residents over the past 4 years was used as a proxy for future income growth expectations. To conservatively estimate the decrease in housing affordability, we chose a relatively low income growth expectation. Assuming that in 2024, residents will have a long-term nominal income growth expectation of 4%. This is based on a real income growth of around 3% and inflation of around 1%, which is undoubtedly a pessimistic estimate.

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Compared to 2019 before the pandemic, the income growth expectation decreased from 8% to 4%. However, at the same time, mortgage interest rates also decreased by 2%, offsetting half of the negative impact. Even under such a pessimistic assumption, if we consider the average duration of home purchase funds to be 8 years, and use the income growth expectation minus the mortgage interest rate as the discount rate, combined with the static housing price-to-income ratio to estimate the actual difficulty of purchasing a home. This estimate takes into account the pessimistic expectations of future income and changes in mortgage interest rates, and better measures the difficulty of purchasing a home. But even under pessimistic assumptions, the current difficulty of purchasing a home has significantly decreased compared to a few years ago.

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There was no pre-emptive demand before, and the current price is relatively attractive. These two points are the fundamental reasons why the second-hand housing market can achieve "price for volume." Such conditions do not exist in other countries with real estate bubbles, which is also the reason why other countries with real estate bubbles are in a "price and volume decline" mode.

The unique "price for volume" in the second-hand housing market further supports the fact that China has not had excessive real estate demand pre-empted, and "Koreanization" may be a more likely path in the future.

V. How Much Inventory Pressure Is There?

Many market participants worry about the real estate market due to the huge area under construction. The area under construction announced by the National Bureau of Statistics is close to 9 billion square meters. Compared to current sales, such a large inventory will undoubtedly take a very long time to clear.

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The area under construction includes residential and non-residential buildings. The area of residential buildings under construction is much smaller, in the range of 5-6 billion square meters. The huge area under construction can be divided into two parts: completed for pre-sale and awaiting sale. Observing the growth rates of sales data and new construction starts, as shown in Figure 35 below, for most of the time, the growth rate of new construction starts has been flat or lower than the growth rate of sales area. This means that most of the area under construction may belong to commodity housing that has been pre-sold.

In this sense, the inventory awaiting sale may be far less than the data on the area under construction.

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Furthermore, the growth rate of completed area has always been low, corresponding to the significant increase in the area under construction. If we observe the gap between completed and sales growth rates, we can see that this gap has basically persisted. If the completion data and sales data are equally reliable, it means that a large amount of sold but uncompleted buildings have been accumulated over the past twenty years. However, large-scale reports of delivery risks and corresponding "guaranteed delivery" policies began after Evergrande's default in 2021. Moreover, the phenomenon of not being able to deliver on time is unlikely to be widespread.

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So, what is the actual area under construction? How many un-sold buildings are under construction? This requires us to clarify the relationship between new starts, completions, construction, completed property sales, pre-sale property sales, and inventory for sale.

Let's start with the completed area. Although the National Bureau of Statistics points out that the time intervals for calculating new starts, completions, and construction areas are different, and there is no quantitative or accounting relationship. [15] However, from the definition of the indicators, assuming no work stoppages and restarts, the construction area in the next year = construction area in the previous year + new starts in the next year - completed area in the previous year (Equation 1).

Based on Equation 1, we can calculate the completed area each year without work stoppages and restarts (Method 1). Considering that the proportion of work stoppages was not severe before the first half of 2021, this impact is ignored for now.

As shown in Figure 37 below, before 2007, the calculated completed area was basically consistent with the published value. Between 2007 and 2013, the annual error was within 20%, and the direction was consistent, while the error was larger thereafter.

An explanation for this gap at the micro-grassroots level is that when real estate companies confirm completion, they need to pay engineering settlement prices to the construction party, and also pay corporate income tax, land value-added tax, urban land use tax, property tax, stamp duty, and other taxes. To delay the outflow of cash, there may be situations where the houses have been delivered but completion has not yet been confirmed. [16] After the real estate enterprise completes the delivery, the project company mainly handles subsequent tax issues and may lack enthusiasm for filling out the completion statistical forms, leading to an underestimation of completion data.

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So, what is the actual completed area? The National Bureau of Statistics also points out that the sales area includes a large number of pre-sold properties, so the completed area is often smaller than the sales area. According to the case in the National Bureau of Statistics' Statistical Knowledge Q&A [17], we get the following equation: Completed area in the current year = area of completed properties sold in the current year + change in inventory for sale + area of pre-sold properties delivered this year + unsellable area under construction + area held by real estate companies. (Equation 2).

The area of pre-sold properties delivered this year needs to be estimated. Most pre-sold properties are delivered 3 years after completion, but some may be sold after a longer opening period, with a slightly shorter delivery time. For calculation convenience, we uniformly set it as the pre-sold property area from 3 years ago, and then consider the proportion of undelivered properties. Chinese real estate companies are generally mainly engaged in development business, and the scale of holding residential projects is relatively small compared to sales, so it is ignored. Other data can be obtained from Wind and the Real Estate Statistical Yearbook. We can calculate the completed area of residential buildings (Method 2).

Before 2022, the completed area calculated by the two methods did not differ much, and the fluctuations in between may be due to the differences in the area of pre-sold properties delivered this year in different years. This may be closer to the real completion situation. Since 2022, the delay in completion and the implementation of "guaranteed delivery" projects provide a good explanation for the gap between the two calculation methods.

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Before 2022, the reliability of the completed area calculated using the changes in new starts and construction areas might be significantly higher than the directly reported completed area. It is possible that the National Bureau of Statistics adjusts the construction data when real estate companies no longer report the construction table in the following year, making the construction data more credible.

We substitute the completed data obtained by Method 2 back into Equation 1 to calculate the construction area under the condition of no work stoppages and timely delivery, and compare it with the construction area directly reported by the National Bureau of Statistics. As shown in Figure 39 below, in 2022 and before, the two were relatively consistent. After 2022, there were more work stoppages and failures to deliver on time. The former suppressed the actual value, and the latter suppressed the estimated value, so the difference between the estimated value and the actual value was also limited.

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The reliability of the construction area announced by the National Bureau of Statistics is good. So, are we facing a supply of over 5 billion square meters of residential space, which will undoubtedly require a very long time to complete the painful digestion and clearance?

However, the actual situation is not so pessimistic.

Up to now, pre-sale properties still account for the main part of residential sales, so the un-sold construction area constitutes the future potential supply. The definition of construction area includes the completed area of the current year, so it needs to be deducted by the area to be delivered in the current year and the area to be delivered in the coming years. Un-sold residential area under construction = residential construction area - pre-sale residential sales area in the previous 4 years.

As shown in Figure 40 below, the calculated construction area assumes no work stoppages. Due to the delay in delivery, the construction area is relatively larger. However, both data sets show that the volume of un-sold residential space is in the order of 1 billion square meters. Moreover, from a time series perspective, this area has been gradually decreasing over the past decade. If the delivery problem is resolved, the current inventory level may be at a historical low in many years.

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Observing the proportion of un-sold residential space to the total residential construction area also confirms this point.

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The macro data is also confirmed at the micro level. Observing the ratio of inventory to contract liabilities in the financial reports of A-share listed real estate companies, as shown in Figure 42. Inventory includes the value of projects under construction and land not yet started, the latter being the value of pre-sold properties. [18] Observing this ratio, it can also be seen that the proportion of un-sold inventory in the total inventory of the corporate sector has been continuously decreasing since 2014. Even considering the impact of inventory write-downs, the conclusion has not changed much. The increase since 2022 may reflect the combined impact of reduced new starts and declining gross profit margins on sales.

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Overall, concerns about inventory pressure due to the large area under construction may be unnecessary. China's previous land supply model determines that it is difficult to have systemic real estate oversupply at the macro level. The actual inventory in the hands of developers is currently at a ten-year low. Moreover, as new starts continue to be lower than sales, the inventory in hand continues to decrease. Our current supply pressure may be much less than what the construction area indicates.

In addition to the inventory held by real estate companies, whether residents' housing is over

Remaining concerns for many people in the context of housing price adjustments.

One view is that according to the Seventh National Population Census data, the per capita living area in China reached 41.76 square meters in 2020, which is already higher than in many developed countries. Based on this, it is argued that there is currently a significant over-consumption of demand.

However, we believe that such a comparison does not take into account that China's gross floor area calculation includes common area, while per capita living area in overseas countries does not include this part, making the two incomparable due to different metrics. If we assume a usable area ratio of 80% in China [19], the per capita living area in China, after adjusting the metrics, would not be higher than in most overseas countries.

Another comparative approach is to observe the relative relationship between per capita living area in cities, towns, and rural areas. During the Fifth and Sixth National Population Censuses, the per capita living area in cities was slightly lower than in towns and rural areas. Considering that the urban-rural income gap has narrowed to a limited extent over the past decade, the difference in per capita living area may primarily reflect the impact of land supply.

In towns and rural areas, real estate can be considered to have almost no financial attributes, being purely a super-durable consumer good, and demand is not over-consumed due to speculation. With relatively less constraint on land supply, the per capita living area in towns and rural areas is much larger than in cities. The lower per capita living area and higher housing prices in large cities may both reflect the pressure of insufficient supply, rather than speculation. The pressure of land supply constraints was relatively limited during the Fifth and Sixth National Population Censuses; at that time, income levels were the limiting factor for improving living area in rural areas and towns.

Considering that the per capita income level in cities is higher than in towns, and except for a few megacities with extremely high population density, the scarcity of land in other cities may not be that severe. If the land supply model changes in the future, it is also very likely that the difference in per capita living area between cities, towns, and rural areas will revert to levels seen ten or twenty years ago. This implies that there is still significant room for improvement in per capita living area in cities.

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VI. Summary

Perhaps we already have a relatively clear answer regarding the future direction of China's real estate and macroeconomy.

First, we believe that whether real estate demand is over-consumed determines whether the future will be Japan-like or Korea-like. After demand is over-consumed, it takes a long time to digest, and the situation of price pressure and insufficient demand will continue for a long time, with Japan being a typical example.

Second, when the real estate market is completely normal, it will face similar pressures due to the deterioration of fundamentals. This was the case in South Korea in 1998 and many European countries in 2009. However, after the headwinds pass, the real estate market will recover relatively quickly.

Third, a common pattern overseas is that rising housing prices drive increased supply, which in turn leads to demand over-consumption. China's unique land supply system does not have such a mechanism.

Fourth, due to previous demand over-consumption, countries that have experienced real estate bubble bursts have not seen a