There has been no shortage of crises in the Western World lately with heightened concerns over Brexit, Italian Banks, Portugal’s sovereign debt rating, Fed decisions, etc, all rattling the nerves of investors. But amid all the chaos in the West, Donna Kwok of UBS recently pointed out that China has been relatively “calm”. That said, UBS sees 3 things that could disrupt the relative “calm” in China by the end of the year. In summary, downside risks remain in China’s continued effort to work through sizable inventory overhangs in their real estate market as well as in the restructuring of State Owned Enterprises (SOEs) which need to undergo substantial capacity reductions and management realignments. Failure of property developers to return to the market with new developments and/or an increase in unemployment related to capacity reductions at SOEs could derail the “China Calm.”
With that, here are the details:
1. Property developers have lagged on investment in new real estate projects despite the rebound in sales of existing properties. Many believe the lack of new investment is a sign that property developers see a slow down in 2H16. Despite the strong double-digit growth prints in YTD sales (26%y/y) and new starts (14%y/y), YTD construction and investment have expanded only by around 5%, with little sign of more pipeline momentum to come. Soft property developer sentiment and caution over the longevity of the sales rebound is partly to blame, as is a still sizeable inventory overhang and sharp land price rally so far this year.
UBS currently sees property sales and new starts cooling to a mid/low single digit growth rate for the rest of 2016, and construction and investment growth holding broadly flat. However, it notes that if developer sentiment deteriorates more than expected (e.g. because sales slows much more, or the government tightens more aggressively), then property construction activity go into outright contraction, further dragging down China’s heavy industrial activity and investment, overall economic growth and commodity demand.
2. While noting that China has been able to manage a modest RMB depreciation while stabilizing FX reserves in recent months UBS points out there is risk of greater market pressures on capital outflows and the currency – due to sudden expectation shifts on US Fed moves or USD strength, and/or concerns for China’s domestic economy or asset markets. Such pressures may lead to higher global investor risk aversion, a revival of China macro concerns and further FX reserve losses, which could negatively impact China’s capital markets before the end of 2016.
3. Third, UBS points out that credit spreads have recovered since the April selloff and primary issuance has rebounded but sees further upside in bonds capped by current money market rates while fundamental downside risks remain relative to China’s continued restructuring of SOEs. A sudden liquidity squeeze or temporary credit crunch could be triggered by an unexpected rise in defaults, or a sudden tightening of regulations. The former could arise from the further worsening of issuer asset quality, or SOE restructuring and excess capacity reduction events.
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