UBS: China's Property Sector Is Approaching Its Tipping Point

Talk of a Chinese property bubble is back in the headlines.

Recently, leaked recordings showed that Mao Daqing, vice chairman of Vanke Group, made some bearish comments on the property sector.

The recent slump in property sales and housing starts prompted Societe Generale's Wei Yao to write "the housing sector now poses the biggest downside risk to the Chinese economy."

UBS' Tao Wang is out with a new note titled "Bubble Trouble: Are We There Yet?" Wang sees a 15% probability that a sharp property-market correction could cause GDP growth to slump to 5% in 2015.

For the most part, chatter on property bubbles tends to focus on home prices, but when it comes to China, Wang thinks we should focus on construction volume.

That's because Chinese homebuyers use large down payments: 30% for their first home and 60% for their second mortgage. So a decline in prices doesn't trump up the pressure to sell homes, and the risk of mortgage default is smaller than what we have seen in the U.S., for instance.

"A big drop in construction activity even without a large price correction would likely have serious negative impact on the industrial complex and, through that, economic growth and bank balance sheets," Wang writes.

"Given that property investment accounts for almost a quarter of fixed investment, construction value-added is 13% of GDP, and there are extensive linkages between property and industrial sectors including steel, cement and construction machinery, the impact on the economy from a drop in construction volume is bigger than that from a worsening household balance sheet and consumption," she writes.

A 10-percentage-point drop in construction-volume growth could cause a 2.5-percentage-point drop in GDP growth.

The other thing to remember is that new urban housing supply has outpaced demand. That's because Hukou, China's residency-permit system, largely leaves migrants out of the urban housing market.

Wang writes that there are a few "tipping factors" that could trigger a sharp property-market correction:

1. A nationwide property tax could lower demand for housing.
2. Rise of alternate investment channels that could lower investment demand for housing.
3. Opening up of the capital account along with weaker RMB could cause money to leave the country.
4. "Stronger corporate governance at SOEs and the banking sector (including higher SOE dividend payments) could lead to reduced financing for land and property."
5. Improvements in infrastructure and land reform could increase urban land supply.
6. A slump or stagnating property prices that could reduce investment demand.

Wang writes that she doesn't see a big shift in these tipping factors but argues that the "risks are clearly rising."

A national property tax looks closer than it did before, though it isn't expected this year or the next. Households have access to alternate investment products, such as wealth-management products and properties abroad, and the pace of urbanization is expected to slow. China's efforts to deleverage means there will be less credit growth and less money to fuel construction.

While Beijing is willing to act to stave off a sharp property crash, "there is a sizable and growing risk that the government's measures may not be sufficient to stabilize property activities and overall investment," writes Wang. "As investment demand for housing changes significantly and developers cut their construction more aggressively, which could aggravate difficulties at the local government level."

Wang expects that the property downturn will "remain manageable." She modestly lowers her 2014 GDP forecast to 7.3% and her 2015 forecast to 6.8%.