"What Could Go Wrong" - China's "Worst Case Negative Loop"
Yesterday, as we reported, in a surprisingly scathing report, Goldman announced that it was now positioning for an "imminent" two year real estate property downturn, which has significant probability of becoming a hard landing as many others, most notably Barclays in recent days, have pointed out. Which is perhaps why Goldman was one of the few banks this morning to trash last night's "better than expected" HSBC manufacturing PMI report, as a softish landing is now clearly Goldman's base case.
But under what conditions could the soft landing scenario become a hard landing? In other words, what could go wrong?
Here is Goldman's answer:
We are concerned about policy uncertainties, and the possibility that potential policy changes could be too little or too late. In particular, we believe potential policy missteps could lead to a self-fulfilling bear-case scenario, i.e. further property market weakness, which could in turn lead to weak corporate earnings, rising unemployment, forex outflow, lower GDP and bank asset quality risks.
We believe the two policies discussed below are critical in preventing a prolonged property market slowdown while not increasing the property over-investment risks:
- Lower the minimum down-payment ratio for property upgrades, e.g. to 50% from the current 60% (nationwide) and 70% (in some big cities).
We note that during the housing reform in 2001 when many government and SOE employees obtained subsidized houses from the government at much reduced prices, China house-ownership within urban areas already reached c. 80%, according to the Ministry of Housing.
As such, property demand has been mainly driven by households improving their living standard, or upgrading need. In 2011, to control housing prices, China adopted a mortgage policy that imposed minimum 60% downpayment ratios for second home purchases. Second home purchase is defined as: 1) a family that already has a flat; or 2) a family that historically already borrowed a mortgage (even though the family already paid off the mortgage and no longer owns the flat).
We believe such a high down payment for second homes effectively significantly hurt property upgrade needs, which is the main demand for property markets, rather than the first home purchase.
As such, we believe lower downpayment ratios for second home purchases will be fundamentally positive for increased property demand, while not increasing property bubble risks as China still prohibits the purchase of third homes.
- Lower the funding costs for mortgage and corporate sectors, by RRR cut, removal of loan/deposit ratios, etc., per our earlier discussion.
That said, we are not sure whether these policies will be changed, and when.
In the bear case, if China fails to address the above-mentioned policy mix, we believe worse-than-expected mortgage rate rise could lead to a more severe property downturn, a FAI/GDP slowdown, and corporate earnings weakness, and in turn, could lead to higher unemployment, forex outflow, and more GDP/property/banks’ asset quality downside risks.
We define our base case assumptions for bank earnings estimates below:
- China selectively eases mortgage policies for property upgrade needs in certain areas in 4Q14 (on May 12, 2014, PBOC held a meeting with banks to encourage mortgage offering);
- No RRR cut. China banks’ funding costs continue to rise, which retain relatively high corporate/mortgage funding costs.
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A simple way of grasping the above is with this useful diagram which summarizes the negative loop that China's economy (which essentially means housing market which as SocGen recently explained is indirectly responsible for 80% of local GDP) could fall into should the government not promptly move to address the emerging dangerous situation, i.e., resume aggressive easing.
So is China taking this warning seriously? Why yes: as the WSJ reported today, China's central bank is set to inject the most cash this week into the financial system since late January to help meet rising demand from companies and to boost the sluggish economy.
The People's Bank of China will pump a net 120 billion yuan ($19.2 billion) into the interbank market this week, said traders participating in the operation Thursday. That's the most since the last week of January.
"It's to a certain extent a form of monetary policy easing as looser funding conditions will definitely facilitate the ongoing economic recovery," said Steve Wang, research director at Reorient Financial Markets Limited.
Keep in mind that this is happening as China is also easing at the fiscal and macro level, having pushed the Yuan to its lowest official fixing since September, a move which in itself has largely offset the concerns about liquidity following the ongoing credit drought. However, the favorable impact of FX may be passing:
Despite the supply of funds, it wasn't enough to cool rising stress in the financial system. A seven-day benchmark cost of short-term loans among banks rose to 3.43% Thursday, from 3.39% Wednesday.... China's central bank and financial institutions bought a net 116.92 billion yuan ($18.8 billion) of foreign currency in April, compared with a net purchase of 189.20 billion yuan in March.
Yet on the surface, it appears that China's liquidity injection is merely being implemented to sooth the memory of last year's near collapse of the nation's money market when the 7-day repo rate briefly exploded as high as 25%.
"This week's large injection is also aimed at stabilizing sentiment in the market, because obviously the authorities don't want the cash crunch to repeat itself," said Mr. Wang. "To achieve stable economic growth, you need to stablize people's mood first," he added.
In other words, once this temporary liquidity injection passes, the storm clouds over China's "negative loop" may promptly gather once again...
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