Hugh MacNally, PPM Executive Chairman and Portfolio Manager, recently went to the Chinese Province of Henan, a populous province 700 kms south of Beijing and a similar distance west of Shanghai, to see what was happening with construction in the Tier 2/3/4 cities in China. We have all heard of the ghost cities and the implications for iron ore and other commodities of a bubble in Chinese construction, we wanted to have a look at it on the ground. The purpose was to assess the implications for commodities and the Australian economy.

These smaller cities are to be contrasted with the Tier 1 cities like Shanghai, Beijing, Shenzhen and Guangzhou where A Grade office space has virtually no vacancy and their economies are richly diverse like London or New York.

The level of construction in the province is difficult to comprehend and one has to try to re-adjust one’s perception of scale. To give some context, Henan has a population of 107 million or over 4 times that of Australia. The map below shows the province super-imposed on a map centred on Sydney and gives some idea of the density of population. By comparison less than 6 million people live in the same sized region in NSW. The re-calibration of scale is not easy to make.

The capital of Henan is Zhengzhou, a city of 9 million people serviced by air and a very fast train taking 2 ½ hours from Beijing and running every 15-20 minutes (the train I went on was pretty much full). The inhabitants call Zhengzhou a Tier 2 ½ city (this is an aspirational statement) and there are another 17 cities of more than 2 million in the province. About 50 million live in rural circumstances, a fact I will return to later.

Zhengzhou’s CBD is of cavernous proportions with an entertainment precinct in the middle. Office blocks are largely untenanted and the concert hall and conference centre look like an impresario’s nightmare. There was clearly a lower level of commercial activity than had been expected by the planners. Although I was told that one of the big four accountancy firms was going to set up there, there was not the profusion of tier 1 logos that one might see in Shanghai. There was however traffic in the city and traffic jams – a status symbol. The hotel I stayed in was beautifully designed by a recognised Japanese architectural firm. It was a classy statement.

One apartment development I visited was very up-scale, beautifully constructed and landscaped (a tad baroque for my taste but no expense had been spared). The top end apartments were 600m2 and in the US$5-6 million range. The developer was about to commence stage 2 of the project. Not many people living in the development but stage 1 was sold out. Leasing firms would get no business here as the owners prefer to keep their apartments pristine. The apartment complex could be mistaken for the Shanghai hipster hang, Xintiand.

Moving out of the capital, driving to the feeder cities, where workers live who cannot afford accommodation in Zhengzhou, the situation deteriorates rapidly. Prices in these cities were more like US$800/m2 as opposed to US$2000/m2 in Zhengzhou. Along the roads and on the outskirts of these cities one sees banks of 30 story apartment buildings stuck out in the middle of nowhere, no services, just a road to the sales office entrance (See aerial photo below).

From the ground they look like unladen oil tankers sticking out of the landscape. This picture taken from above is indicative of these huge developments. Interestingly whilst much of these developments are sold, little of them are occupied and at night there are very few lights on. The developer who was accompanying me said that the intercity road we were travelling on would be built out in time – in the dark he would not have read the look of incredulity on my face.

The planning regulations might have been written by a developer and would certainly make Australian developers salivate – there is a minimum floor space ratio not a maximum and as a result there are no free standing houses built (the perception of Sydney was one of houses with water views).

My initial assessment was one of horror at the sight of all these un-occupied apartment buildings and unlit offices; clearly we were in the latter stages of a property disaster which would unfold as the hapless owners tried to unload in a non-existent secondary market. Yet the developer was concerned as to how they would ward off the challenge from major developers from the Tier 1 cities and Hong Kong. Access to land was his concern not the potential supply overhang (was this just a developer’s perspective?).

On reflection however the following calculations could be made. Over the next 10-15 years 20 million of the 50 million rural residents move to urban accommodation. This would require in excess of 5 million new apartments or 20,000 30 story towers, or 1500-2000 apartment buildings constructed per year – I might have seen 300. The job ahead is immense and equivalent to building Australia’s entire existing housing stock.

A big problem is likely to be affordability; wage levels are low in these areas and the local economies not as diverse as say Shanghai’s.

It is unlikely that the owners of apartments will achieve an acceptable IRR but perhaps that is not their expectation given the options they have to store wealth. These are: bank deposits (low yield and given the ugly balance sheets not that “safe”), “wealth management” products (gulp), stocks (not widely trusted) or property offshore (increasingly difficult to access). With the high level of household savings and the high level of wage growth the money has to go somewhere. So in part property investment is a store of wealth (however imperfect) in an environment of few attractive alternatives.

The conclusion we would draw is that the situation is more likely to be one of a lot of low return investment having been made, which, while it has implications for future growth, is not an imminent disaster waiting to unfold. Undoubtedly the GDP figures are fluffed up with this type of investment that would not have been made had rational return criteria been applied (but that is not unique to China). Our view on demand for steel making materials and other industrial commodities, the reason for the trip, is comfortable. While we think the price of iron ore is well above the price range we think sustainable (US$60-70) we are not so worried about the demand picture.