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China's capital controls give bubbles fresh fuel

Money floods into real estate, shadow banking for lack of options

China's booming real estate market has brought a wave of new construction.

SHANGHAI/BEIJING -- China's efforts to rein in the sliding yuan have sparked a domestic feeding frenzy, reigniting fears of potentially destabilizing asset bubbles.

Echoes of Japan

Xiaokunshan, a town outside Shanghai dotted with factories, is not the most convenient location. Yet the Shanghai city government sold a plot of land there in late March for 36,000 yuan ($5,210) per sq. meter -- on par with property values in Tokyo's Setagaya Ward. Rumors are circulating among residents that building condominiums on the site would lift the value to 50,000 yuan per sq. meter.

Housing prices in China's big cities have soared to levels unaffordable for many, surpassing even the Tokyo market's highs during Japan's economic bubble. The typical newly built home in Shanghai cost 20.8 times the average household's annual income in 2015, data from the Nomura Institute of Capital Markets Research shows. This figure compares with 18.1 times in Tokyo in 1990, toward the end of the bubble, according to real estate research firm Tokyo Kantei. And prices in Shanghai have climbed another 40% since 2015.

The situation is similar in Beijing and Shenzhen. Housing prices rose in 62 of 70 major cities in March, while revenue from land sales by 300 cities jumped 50% on the year in the January-March quarter. Bullish investors are piling into the market, pushing prices higher still.

China's shadow banking problem is rearing its head again as well. Outstanding peer-to-peer loans topped 950 billion yuan at the end of April, up 70% from a year earlier.

Entrusted loans, in which businesses lend out excess cash through banks or other channels, have grown 20% over the past year to more than 13 trillion yuan. So-called wealth management products, which often do not make clear what the buyer is investing in, are also popular. Shadow banking, using a narrow definition that encompasses these and similar activities, totaled nearly 60 trillion yuan at the end of 2016 -- equivalent to some 80% of China's gross domestic product.

Unintended consequences

With capital controls discouraging overseas investment, money is flowing back into China, said Han Weiwen, managing partner of Bain & Co.'s Greater China offices.

Beijing began tightening restrictions on capital movements in mid-2016, looking to curb the yuan's rapid depreciation and capital flight after the U.S. raised interest rates. This effectively hit the brakes on any overseas deals valued at more than $5 million. Though the government had taken steps to limit cross-border transactions before, this time it left the country awash in money by closing off more potential exits.

Some of these funds are returning to the stock market, which had suffered a steep drop in summer 2015. The Shanghai Composite Index has rallied nearly 20% from a nadir in early 2016, even as aggregate net profit at roughly 3,200 companies rose just 5% for the fiscal year ended Dec. 31. Initial public offerings between January and April quadrupled from a year earlier to 167.

Venture capital investment totaled 53.5 billion yuan in the January-March period, rising for the first time in three quarters. Bicycle-sharing company Ofo raised $450 million in March, entering the ranks of unicorns, as private companies valued at $1 billion or more are called. The virtual currency bitcoin is hovering in record territory, around 9,000 yuan.

Deteriorating data

People's Bank of China Gov. Zhou Xiaochuan has warned that excessive liquidity could cause high inflation and asset bubbles. Yet the government is among the forces fueling the investment boom.

China's primary deficit totaled 155.1 billion yuan in the January-March period, the largest for a first quarter since 1995. Beijing is boosting infrastructure investment in hopes of keeping the economy stable ahead of a leadership reshuffle at this fall's Communist Party congress. Total excavator sales volume at 25 major construction equipment companies surged 98% on the year in the first quarter. Average wholesale prices rebounded sharply, climbing 7.4% that quarter compared with a 1.4% drop for 2016 as a whole.

Excessive domestic investment weighs on China's current-account balance, which plunged 86% on the year to $11.8 billion in the October-December quarter.

The country's trade surplus in goods and services sank 64% on the year to $18.7 billion for the January-March period, the worst quarterly figure since the deficit recorded in January-March 2014. Imports of goods such as iron ore doubled to keep up with the rise in domestic investment. Net income, another component of the current-account balance, was negative for two straight years through 2016.

Some fear that the current-account surplus could keep shrinking, sparking a loss of confidence in the yuan.

With China's economy reportedly still enjoying growth in the upper 6% range, financial markets remain at ease for now. But private-sector debt, excluding financial companies, exceeds 200% of GDP -- a level also seen toward the end of Japan's economic bubble.

An increasingly alarmed Chinese central bank is steering monetary policy in a tighter direction, a move that already is spurring companies to put off or cancel bond floats. Defaults could surge if the PBOC cannot rein in excessive speculation, and global investors could begin watching for "China risk" once again.

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