China - short term uncertainty long term opportunities

There is still uncertainty in the Chinese housing market but can this provide opportunities for long-term investors?  

10th March 2015

Over-investment to support growth following the Great Financial Crisis partly accounts for the slowdown, as much of this capital was misallocated.  With world demand still moderate, substantial excess manufacturing capacity has continued to drag down production and margins.  Rising factor costs and the Renminbi appreciation have worsened matters, leading some industries to relocate to lower cost locations such as Vietnam and Thailand.

Continue to the other two articles in this edition of the Global Outlook...

Policy Support still crucial for the global economy

The world economy remains on track for a stronger year in 2015 but not without the support of central banks.
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Will 2015 be the year of rising real wages?

Several factors suggest that 2015 will be the year when real wage growth finally turns the corner.  What does this mean for property?  
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Policy makers are willing to allow growth to trend lower in order to contain rising financial risks, the by-product of significant leverage expansion since 2007.  In this period total debt is estimated to have quadrupled to US$28.2 trillion (from US$7.4 trillion), or around 280% of GDP, among the highest in the world.  Around 45% is debt held by the private corporate sector, which is heavily tied to local government and state-owned enterprise borrowings.  This has been increasingly financed by the shadow banking system.  About half of the total credit is estimated to have gone to real estate.  Given the size of the country’s real estate exposure (chart 1), a prolonged property market downturn will have corresponding downside impact on the economy.  Monetary easing measures in recent months, following three years of tight credit controls, are therefore targeted not just at mitigating general downside economic risks, but also housing market risks.  However, it will take time for housing conditions to normalise and growth to stabilise.

Housing correction still underway

House prices fell in 64 out of the 70 cities surveyed in January (on a y-o-y basis), with only two cities showing improvement.  By comparison, prices fell in just six cities in January 2014 (chart 2).  The slowdown in housing transactions highlights the weak sentiment underpinning prices; housing sales and starts fell 9.1% and 14.4% in December last year, respectively, the twelfth straight monthly decline.  The top tier cities, previously more resilient to slowdowns, have also faced headwinds from the tight credit and weak economic landscape.  In January this year, prices in Beijing fell by 3.2% y-o-y, the fourth fall in a row while Shanghai residential prices declined for the fifth consecutive month, contracting by 4.1%.  A similar story is unfolding in Guangzhou and Shenzhen and a worse one in Tier 2 cities, such as Hangzhou and Ningbo.

The full-year outlook remains relatively subdued.  While price declines have been marginal, unsold inventories remain high.  New construction, measured by gross floor area, has grown by 9% p.a. since 2007 in Tier 1 cities (such as Beijing and Shanghai), 11% in Tier 2 cities, and 18% in Tier 3 cities. McKinsey estimates that unsold stock in Tier 3 cities is equivalent to 48-77 months of sales (at the average monthly sales rate), about 15-30 months above historic averages.  Even in Tier 1 cities, inventory levels are 10-15 months of sales, higher than historical rates.  In these circumstances, prices will likely continue to soften as developers cut prices and offer discounts to clear inventories and achieve sales targets.

Challenging times for developers

Given the weak market fundamentals, balance sheet strength is deteriorating across the industry, with falling profit margins, narrowing interest coverage ratios and uncertain operating cash flows.  One key source of stress for developers is an increasingly tenuous ability to repay short-term debt with dwindling cash flow, reflecting an erosion of revenues and profit margins at a time of rising debt.  The recent relaxation in housing purchase restrictions across many Chinese cities and a reduction in mortgage rates can help support sentiment and modestly revive sales.  But these factors will only slow, not reverse, the pace of revenue decline.  Small and medium-sized developers with lower after-tax margins are most vulnerable to an economic and housing slowdown; sales revenue and operating profit for these developers fell 82% and 65%, respectively, in the last fiscal year (chart 3).

Despite two rounds of monetary easing since November, domestic banks will continue to exercise additional caution when lending to developers.  The collapse of a small private property firm in Ningbo together with the first corporate onshore debt default have shattered the belief that Chinese authorities will always bail out struggling firms.  There are more than 80,000 developers nationwide, many of whom formed in 2011 in an environment of easy money and unbounded optimism.  But times have changed. Further defaults and bankruptcies among smaller, unlisted developers are likely.

Opportunities will arise

The next few years will be challenging for the Chinese economy and the real estate sector.  Growth will continue to slow as reforms are implemented to tackle structural deficiencies and rebalance the economy towards more stable, domestic-led growth.  Prudent and responsive monetary policy will be needed in order to engineer a soft landing.  Efforts to deleverage and decrease the size of local government debt and the shadow banking sector will also curtail overall financing, including for real estate.  A prolonged housing downturn will weigh on the property sector and heighten banking system risk.

However, the difference between the nature of China’s debt and that of Japanese and American debt is that China’s leveraging was largely policy-induced and not the result of external deficits, fiscal imbalances and overleveraged households.  Furthermore, the debt is primarily domestically held and China’s capital account is relatively closed.  The government also has the financial resources through its US$4 trillion foreign exchange reserves to avert a full-blown financial crisis.

So while this near-term period of deleveraging and consolidation will be economically painful for China, longer-term prospects remain positive.  China is still poised to become the world’s largest economy.  China has a well-defined economic roadmap and Chinese leaders have the political willpower to implement changes.  China is already a major force in global manufacturing and overseas investments, and more than any other city in the world, Beijing is home to 52 of the world’s 500 biggest companies, ahead of Tokyo and New York.

Against the positive long-term economic backdrop, investors should pay close attention to the uncertainty in the Chinese housing market.  A period of consolidation, especially for the small to medium sized developers, is likely in the near-term.  Many of these players will have to offload investment properties at attractive pricing in order to replenish their balance sheets and/or bridge short-term financing gaps, particularly in lower tier cities.  Some will also be looking for partnerships. 

A window of opportunity, one not seen in many years, is starting to open up for investors willing to look through the short-term volatility to take advantage of the ongoing market correction ahead of the next cyclical upturn.

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