September 9,2008 China:Banks We view the likelihood of systemic risk as low While we do see rising risks of real estate NPLs in the near term,we believe the systemic risks to China banks from the weakening real estate market are likely to be limited due to: 1)Rising household income improves housing affordability We believe affordability issues are concentrated in some maior cities and not nationwide,as the current national affordability level is still largely in line with historical averages(Exhibit 17).We note our affordability calculation is based on the official average household income(rather than of the more affluent top 40%of households). We highlighted Beijing,Shenzhen and Tianjin as major cities with high property prices and low affordability ratios,partly due to the investment/living needs of high-income immigrants from the surrounding areas or from overseas. By contrast,affordability in Shanghai,Chongqing and Wuhan,and national average affordability is in line with historical average levels. Based on the assumption of a modest 12%annual household income growth in 2008 and 2009,we estimate that in some cities such as Guangzhou and Hangzhou,real estate prices may need to fall by a modest additional 5%-10%fall from 2008 levels to reach historical average affordability by 2009,while in Shenzhen and Beijing,they may need to fall 15%-20%. As such,we believe unlike US/Japan,the rapid GDP/income growth gives China the luxury of gradually absorbing the pain of house price declines,i.e."grow their way out of the problem". Exhibit 17:We expect housing affordability in major cities to return to historical averages before the end of 2009 Mortgage payment as a of total household disposable income(bank lending threshold is 45%) Home price fall from 2Q08 level if we consider 12%annual income growth in 2008/2009 Assuming Assuming affordability to affordability to End-4Q2007End-2Q2008 restore to historical restore to historical Total population affordability affordability Historical Avg.Historical period average by 2008 average by 2009 National 48% 46% 54%1Q98-4Q07 15% 25% Shenzhen 73% 68% 47%1Q98-4Q07 (30%) (20%) Beijing 112% 104% 79%1Q98-4Q07 (25%) (15%) Tianjin 67% 66% 51%2Q00-4Q07 (20%) (10%6) Guangzhou 77% 71% 61%1Q98-4Q07 (15%) (5%) Hangzhou 72% 71% 57%2Q05-4Q07 (20%) (10%) Chengdu 56% 61% 44%2Q03-4Q07 (30%) (20%) Wuhan 62% 57% 50% 2Q03-4Q07 (10%) 0% Shanghai 94% 88% 80%1Q98-4Q07 (10%)】 0 Chongqing 36% 32% 32%2Q00-4Q07 0% 5% Source:CEIC,Gao Hua Securities Research estimates Goldman Sachs Global Investment Research 2
September 9, 2008 China: Banks Goldman Sachs Global Investment Research 11 We view the likelihood of systemic risk as low While we do see rising risks of real estate NPLs in the near term, we believe the systemic risks to China banks from the weakening real estate market are likely to be limited due to: 1) Rising household income improves housing affordability • We believe affordability issues are concentrated in some major cities and not nationwide, as the current national affordability level is still largely in line with historical averages (Exhibit 17). We note our affordability calculation is based on the official average household income (rather than of the more affluent top 40% of households). We highlighted Beijing, Shenzhen and Tianjin as major cities with high property prices and low affordability ratios, partly due to the investment/living needs of high-income immigrants from the surrounding areas or from overseas. By contrast, affordability in Shanghai, Chongqing and Wuhan, and national average affordability is in line with historical average levels. • Based on the assumption of a modest 12% annual household income growth in 2008 and 2009, we estimate that in some cities such as Guangzhou and Hangzhou, real estate prices may need to fall by a modest additional 5%-10% fall from 2Q08 levels to reach historical average affordability by 2009, while in Shenzhen and Beijing, they may need to fall 15%-20%. As such, we believe unlike US/Japan, the rapid GDP/income growth gives China the luxury of gradually absorbing the pain of house price declines, i.e. “grow their way out of the problem”. Exhibit 17: We expect housing affordability in major cities to return to historical averages before the end of 2009 Mortgage payment as a % of total household disposable income (bank lending threshold is 45%) Total population End-4Q 2007 affordability End-2Q 2008 affordability Historical Avg. Historical period Assuming affordability to restore to historical average by 2008 Assuming affordability to restore to historical average by 2009 National 48% 46% 54% 1Q 98 - 4Q 07 15% 25% Shenzhen 73% 68% 47% 1Q 98 - 4Q 07 (30%) (20%) Beijing 112% 104% 79% 1Q 98 - 4Q 07 (25%) (15%) Tianjin 67% 66% 51% 2Q 00 - 4Q 07 (20%) (10%) Guangzhou 77% 71% 61% 1Q 98 - 4Q 07 (15%) (5%) Hangzhou 72% 71% 57% 2Q 05 - 4Q 07 (20%) (10%) Chengdu 56% 61% 44% 2Q 03 - 4Q 07 (30%) (20%) Wuhan 62% 57% 50% 2Q 03 - 4Q 07 (10%) 0% Shanghai 94% 88% 80% 1Q 98 - 4Q 07 (10%) 0% Chongqing 36% 32% 32% 2Q 00 - 4Q 07 0% 5% Home price fall from 2Q08 level if we consider 12% annual income growth in 2008/2009 Source: CEIC, Gao Hua Securities Research estimates
September 9,2008 China:Banks 2)Asset sales and land premium payment schedule renegotiation may provide temporary relief to the short-term cash flow squeeze of developers We estimate that~40%-50%of total developer cash outflows in 2H08 will be land premiums,and developers could renegotiate land premium payment schedules with local governments to reduce near-term cash flow pressures. We believe real estate developers may choose to sell assets such as parcels of land or projects to raise cash,though we believe such assets could be increasingly difficult to sell given the weakening housing market outlook.During our recent visit to developers in Tianjin,Wuhan and Chongqing,we noticed that asset sales have not yet become widespread practice among liquidity-challenged developers. 3)In our view,there is still ample liquidity in China's banking system to support mortgage and developer loan growth as well as asset reflation over the long run,if the long-term outlook for the property market remains sound.We are currently forecasting average 14%yoy below-nominal-GDP loan growth in 2008 and 2009,respectively,but we note that there could be upside to our sector loan growth forecasts,especially if China continues to loosen its credit quotas. 4)We see greater likelihood of real estate loan workouts rather than outright bankruptcies In the light of the still-favorable long-term housing demand outlook,we believe banks are likely to try to avoid defaults/bankruptcies at real estate developers,which could be a very costly path for both banks and developers.Rather,we believe banks will prefer to find solutions to problem loan issues with developers potentially via: 1.Facilitating project JVs,restructuring,and even M&A activities among developers 2.Asking for more collaterals and guarantees as precondition for loan workout 3.Extending the loan term,if the projects are viable based on gross margin,and if the developers can still make interest payments Our developers'gross margin projection suggested that despite a continued decline,gross margins may reach a low of-16%in 2H09,just slightly lower than the 18.8%average gross margin for A-share listed non-bank corporates in 1H08.This suggests these developers should still be viable(see Exhibit 18). We note that during the Hong Kong real estate downturn in 1997-1998,the liquidity crunch at Hong Kong developers was largely resolved by finding solutions with banks rather than resorting to bankruptcies. The decision trees in Exhibit 19 illustrate the 3-stage resolution of cash-stressed developers in China. Goldman Sachs Global Investment Research 12
September 9, 2008 China: Banks Goldman Sachs Global Investment Research 12 2) Asset sales and land premium payment schedule renegotiation may provide temporary relief to the short-term cash flow squeeze of developers We estimate that ~40%-50% of total developer cash outflows in 2H08 will be land premiums, and developers could renegotiate land premium payment schedules with local governments to reduce near-term cash flow pressures. We believe real estate developers may choose to sell assets such as parcels of land or projects to raise cash, though we believe such assets could be increasingly difficult to sell given the weakening housing market outlook. During our recent visit to developers in Tianjin, Wuhan and Chongqing, we noticed that asset sales have not yet become widespread practice among liquidity-challenged developers. 3) In our view, there is still ample liquidity in China’s banking system to support mortgage and developer loan growth as well as asset reflation over the long run, if the long-term outlook for the property market remains sound. We are currently forecasting average 14% yoy below-nominal-GDP loan growth in 2008 and 2009, respectively, but we note that there could be upside to our sector loan growth forecasts, especially if China continues to loosen its credit quotas. 4) We see greater likelihood of real estate loan workouts rather than outright bankruptcies In the light of the still-favorable long-term housing demand outlook, we believe banks are likely to try to avoid defaults/bankruptcies at real estate developers, which could be a very costly path for both banks and developers. Rather, we believe banks will prefer to find solutions to problem loan issues with developers potentially via: 1. Facilitating project JVs, restructuring, and even M&A activities among developers. 2. Asking for more collaterals and guarantees as precondition for loan workout 3. Extending the loan term, if the projects are viable based on gross margin, and if the developers can still make interest payments Our developers’ gross margin projection suggested that despite a continued decline, gross margins may reach a low of ~16% in 2H09, just slightly lower than the 18.8% average gross margin for A-share listed non-bank corporates in 1H08. This suggests these developers should still be viable (see Exhibit 18). We note that during the Hong Kong real estate downturn in 1997-1998, the liquidity crunch at Hong Kong developers was largely resolved by finding solutions with banks rather than resorting to bankruptcies. The decision trees in Exhibit 19 illustrate the 3-stage resolution of cash-stressed developers in China