Beijing, China: A pedestrian crosses the road in front residential buildings. Bloomberg
Morgan Stanley has upgraded China’s property sector from "attractive" while worried investors are closely watching to see if Evergrande, a debt-saddled company, might default and whether contagion will occur. According to the U.S. investment bank, policy easing in China's property sector is likely to begin. This will help Chinese real estate stocks. Elly Chen, an equity analyst at the bank, stated that "we believe the default risks as well as property market weakness" in a note dated October 10. "Property stock will react to policy easing, which seems more likely now."
We believe systemic risk can be managed by property stocks, which are pricing in a portion of these risks. Morgan Stanley equity analyst Elly Chen
Chen admitted that there have been "many defaults" since 2020, and that there is an escalating chance of a major developer default in 2021. Chen stated that the "adjustment process" to reduce debt and to implement policies to "manage excesses" would likely continue for six to twelve months. Chen stated that property stocks are pricing in some of these risks and that systemic risk is manageable. China's property developers have experienced rapid growth after years of high debt. Authorities introduced the "three redlines" policy last year to address this issue. This policy sets a limit on debt relative to cash flows, capital and assets of a company.
After the policy began to restrict developers, things came to a halt. Evergrande, the world's largest developer and most indebted, warned twice last month that it might default. Five offshore bonds that were due in September or October have been missed by Evergrande, which has also missed interest payments. Other Chinese property developers have been downgraded by rating agencies due to tight liquidity and default risk.
Approaching the 'inflection' point in policy
Morgan Stanley however stated that a "policy tipping point" is near. Analysts believe there could be "potentially upcoming easing actions" as policymakers will likely further relax mortgage quotas as they try to increase bank loans. This year's slowdown in home purchases was due to Chinese cities imposing curbs, including home purchase restrictions. Chen stated that policy is the best indicator of property stock levels.
According to Morgan Stanley, 6.5% of China's gross national product is made up by residential property investments, and 7.3% from property-related services. According to Morgan Stanley, a 10% decline in residential property activity could slow down GDP growth by approximately 1%. Chen stated that further spillovers could occur in the form of a negative wealth impact, which would dampen private consumption. He also said that policymakers will likely offer "meaningful" easing to stabilize and support the economy.
Morgan Stanley reports that most developers are on track for meeting the "three redlines" criteria by 2022. These three red lines set a limit on debt relative to cash flows, capital and assets of a company. 16 of 26 developers the bank covered met all three red line criteria in the first half 2021. Nine met only two of the three criteria. The bank stated that only one of the 26 developers it covers failed to meet all three criteria.
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