Our Take on China's Real Estate Market

China's real estate market has been booming for the past several years, causing many to wonder whether China will be the next country to suffer sharp real estate price declines, or whether it will escape relatively unscathed. After reviewing some of the recent data and the fundamentals of China's real estate market, we think China' market is likely to hold up better than those in Europe and the U.S.

China's Housing Bubble Creates Short-Term Challenges
The swift rise in China's real estate prices was largely driven by rapid economic growth and the process of urbanization, in our opinion. China's gross domestic product growth averaged 10.6% from 2003 to 2007, and the urbanization ratio--the percentage of its population living in cities-- increased to 43.6% in 2006 from 39.09% in 2002.

However, the price escalation was also caused by the appreciation of China's currency, which began in 2005 and led to excessive speculative investments in China's real estate market. We think this helped create a bubble in the housing market. The housing price/income ratio of eight major cities in China increased to 12 by the middle of 2007 from 10 in the middle of 2006, according to WIND, a financial data provider in China. Housing prices became unsustainably high, and as economic and regulatory conditions became increasingly unfavorable in late 2007, housing transaction volume declined and the housing market softened. The volume of housing transactions in China's major cities declined more than 20% in December 2007 compared with December 2006. For the past several months, transaction volume has continued to decline, and countrywide transaction volume declined 24% in July compared with same period of 2007. According to WIND, the housing price/income ratio of eight major cities in China declined to around 11 by the end of June 2008. The National Real Estate Climate index also declined for the ninth consecutive month, hitting 101.78 in August 2008, down from 106.59 in November 2007.

These signals that China's real estate bubble may be bursting have given rise to worries about its housing market and the stability of its financial system. The recent subprime crisis in U.S. has deepened those concerns. In our opinion, however, the situation in China is quite different from what we have seen in U.S. We expect the existing real estate bubble in China to cause short-term uncertainties in the real estate and banking industries, but we are excited about long-term prospects and optimistic about the stability of China's financial system.

Different Fundamentals, Different Long-Term Outcomes
While the housing price decline in China is now starting to look like what happened in U.S. during 2007, we see fundamental differences between the two economies that we think will drive different outcomes. China is still a developing country with a very low urbanization rate compared with United States. By the end of 2006, just 43.9% of China's people lived in urban areas. As China continues to urbanize, its urban population is expected to grow to 724 million by the end of 2015, according to the National Bureau of Statistics of China (NBSC), up from 577 million in 2006. We anticipate that the decade-long process of China's urbanization will continue to generate tremendous demand for urban residential properties. Growth in demand will generate a major shortage of urban residential properties, in our opinion. Moreover, household wealth and purchasing power have been increasing quickly, benefiting from favorable economic conditions. For example, the per capita disposable income of urban residents increased 10.4% in real terms in 2006. We think this growth is a long-term trend that will continue. Therefore, we think that China's real estate industry faces much better prospects than the U.S. market, and that it is still on the uptrend for the long run.

The Expected Impact on Banks
We believe the continuing downturn in China's real estate industry will increase the nonperforming loans (NPL) of banks and depress banks' earnings in the short run. However, we think it is unlikely to cause systematic damage to the banking industry both because of China's conservative lending policies and because of banks' limited exposure to real estate lending.

As of June 30, 2008, mortgage lending accounted for just 15% of banks' total lending. The downpayment requirement for a mortgage loan is 30% to 40% in China, compared with 20% or less in the U.S., which provides a large margin to cushion banks against falling prices. In addition, China's relatively conservative consumer consumption levels and its legal system ensure that most families have the ability and willingness to repay their mortgage loans, even if property prices fall such that homeowners owe more than their homes are worth. Therefore, mortgage loans are considered to be a safe asset class in the industry. In the most extreme of scenarios--where housing prices fall 50% and half of mortgage loans default--we would expect the loss for the banking system to be around 1.5% of its total lending. While losses this large would be very painful for banks, we think they would be unlikely to do long-term damage, considering the banks' high capital-adequacy ratios (more than 16% at the end of June 2008) and adequate provision ratio (nearly 130% of nonperforming loans at the end of June 2008).

Besides the mortgage loans, loans to real estate companies--which account for just under 10% of total lending--are also coming under scrutiny. As the dim economic situation continues, it is unavoidable that some real estate companies will go bankrupt, given the high leverage ratio in the industry. Falling property prices will test these banks' credit-control abilities. We have not yet seen a material increase in NPLs in this category, but given Chinese banks' relatively short track record with this type of loan, we will keep a close eye on this statistic going forward. Although we expect that China's growing demand for urban properties will help prop up sales volumes, loan losses can escalate quickly if demand fails to materialize, as we have seen Stateside.