JPMorgan: China Is Poised To Solve Its Real Estate Inventory Problem

Count on a centrally-planned urbanization push.

Chinese savers helped fund construction of Kangbashi, the cultural district of Ordos, where buildings have sat empty.

Photographer: Christopher Brown

As Chinese equities start the year in free-fall, one analyst has a counterintuitive call on what is perhaps the country's most-feared sector.

China's shaky real estate market is the proverbial black swan in sight; a segment in which an abrupt correction could potentially bring about a hard landing in the world's second-largest economy. While the China Developers Index is down roughly 35 percent from its 2015 peak, it began a stretch of marked outperformance relative to the Hang Seng China Enterprises Index in the final two months of the year:

ArrestedDevelopers
Bloomberg

JPMorgan Analyst Ryan Li thinks this momentum will continue in 2016. What's more, he contends that the prospect of improving fundamentals in the real estate market means this segment warrants attention not just from traders but also from investors with a longer time horizon.  

"For the first time in the past six years, the market could start looking at China Property not only from a trading perspective, but from a long-term stable demand/supply perspective," he asserts. "The sector could see a gradual but slow re-rate starting [in] 2016."

Key to Li's call are continued reforms of the Chinese household registration system, or hukou, in which a citizen's access to benefits is determined by their place of permanent residency. A little less than one fifth of China's populace lives in cities without an urban hukou, and are therefore unable to access said benefits while residing there.

In this respect, the Chinese model hearkens back to the English welfare system in the wake of the Poor Relief Act of 1662: paupers could obtain aid, but only in the parish in which they were settled.

This requirement crimped labor mobility, argued Adam Smith in The Wealth of Nations, a critique that can be transposed 350 years later to modern-day China. On a similar note, promoting urbanization by bolstering the safety net for rural migrants is an important channel through which the inventory problems (all those empty buildings) in Chinese real estate could be resolved.

"With the government's intention to encourage 'human-oriented' urbanization through hukou reform, more rural residents will move to cities with better access to social security," predicted Li.

If the Chinese government is able to realize its urbanization goal, Li calculates that the demand for homes would increase by 3.5 to 4.5 million per year through 2020—growth of 33 percent relative to 2015.

For this to be achieved, however, would entail a massive and sustained increase in the number of net new urban registrations relative to the past five years:

NewHukou
JPMorgan

The analyst reckons this would be a particular boon to developers with a higher degree of presence in the lower-tier cities that the Chinese government is looking to push its citizens towards.

"Changes might involve changing rules to allow individual ownership in rural areas and a 'go-back' mechanism; directives to induce the proper type of individual to get an urban hukou; and mechanism on how to provide sufficient funding to the local governments to support policy changes," wrote Li, speculating on reforms that could be deployed in pursuit of this target.

The elephants in the room: the lingering effects of China's one-child policy and aging population suggest that any rebalancing and inventory reductions may not endure for too long.

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