September 9,2008 Goldman Sachs China:Banks Property developer loans:S/T risks,low systemic risks;be selective Continued cash burn at developers poses n-t NPL/macro risks Real estate loan credit quality has held up so far despite weakening prices Property transactions slowed materially and transaction volumes,partly due to the high profit margins on property projects that attracted continued financing flow in 1H08.However,we believe the continuing decline in transaction volumes,weakening buyer sentiment,inventory build-up and falling gross margins will lead to a cash squeeze for some developers,particularly in 4008 and 1H09;we see this as an emerging real estate NPL risk for China banks in 4008/2009. Moreover,we see the scaling back of real estate investment,which is critical for developers to survive,posing risks to macro growth(20pp yoy slowdown in property investment growth may reduce GDP growth rates by~1 pp). Source:CIA. Potential cash flow squeeze at developers Systemic risk low;recovery hinges on affordability,policy easing Unlike US/Japan,we believe systemic risk is low/manageable,as:(1) ing cash indow 0.8 7.7471 affordability is an issue for select cities (e.g.Beijing/Shenzhen)rather than a nationwide problem.We expect affordability in these cities to return to their uow090731.8785 c3shn6L2102065,11245.52235,823 1998-2007 average in 2010,based on our forecast of~12%p.a.rise in China Net cash inflowoulow) 10.022172865,1096379 Ending cash balance 50,17159,70278,12224,330 household income and a 5%-20%property price decline from 2008 to 2009; Source:Wind,and Gao Hua Securities Research estimates. (2)total property loans,including mortgages,are at a manageable 18%of total loans,vs.53%of total commercial bank loans in the US;(3)China Earnings sensitivity to 3%real estate loan mortgages carry recourse and households have low leverage;(4)just as in and mortgage NPL formation the US and Japan,banks prefer to work out restructuring/M&A for distressed developers so long as underlying profitability/viability are intact;and(5) banking liquidity remains high in China,and China has pro-growth policies. We would be more positive if China eased tightening policies,or if inflation %% pressure fundamentally eased post utilities/energy price adjustments. Downside risks include:hard landing of the Chinese economy,behind-the- curve policy easing;collapse of property prices dampening sentiment. Source:Gao Hua Securities Research estimates Be selective;wide differences in lending practices,P&L resilience We see some potential credit loss on property NPLs,partly due to lending For special disclosures as to Goldman Sachs' loopholes despite high collateral levels and tight regulatory requirements. investment in ICBC,see the statement preceding the Reg AC certification. We favor banks with low exposure to developers,low NPL sensitivity to earnings,and conservative lending risk management.We believe ICBC (1398.HK,Buy)is best placed to control risks,while we think SPDB (600000.SS,Sell),Huaxia(600015.SS,Sell)and Industrial (601166.SS, Neutral)are more vulnerable to real estate market deterioration Richard Xu,CFA +86(10)6627-3192|richard.xu@ghsl.cn Beijing Gao Hua Securities Company Limited The Goldman Sachs Group,Inc.does and seeks to do business with Y2Vi.wangghslcn B ao Hua Securities Company Limited eerhat coud anod ning.ma@gs.com Goldman Sachs (Asia)LLC. oniyeactorn neirnvestent esion orc certificatio 1.see the end of the text.Other important disclosures follow the re e c arch/hedo e html 0judy hangghal.cn Bejing aoHua Securitie Company Limited eg Ac certification, m/rese Analys research analyst with FINRA in the U.S. are not registered/qualified as The Goldman Sachs Group,Inc. Global Investment Research
September 9, 2008 China: Banks Goldman Sachs Global Investment Research 1 September 9, 2008 China: Banks Property developer loans: S/T risks, low systemic risks; be selective Continued cash burn at developers poses n-t NPL/macro risks Real estate loan credit quality has held up so far despite weakening prices and transaction volumes, partly due to the high profit margins on property projects that attracted continued financing flow in 1H08. However, we believe the continuing decline in transaction volumes, weakening buyer sentiment, inventory build-up and falling gross margins will lead to a cash squeeze for some developers, particularly in 4Q08 and 1H09; we see this as an emerging real estate NPL risk for China banks in 4Q08/2009. Moreover, we see the scaling back of real estate investment, which is critical for developers to survive, posing risks to macro growth (20pp yoy slowdown in property investment growth may reduce GDP growth rates by ~1 pp). Systemic risk low; recovery hinges on affordability, policy easing Unlike US/Japan, we believe systemic risk is low/manageable, as: (1) affordability is an issue for select cities (e.g. Beijing/Shenzhen) rather than a nationwide problem. We expect affordability in these cities to return to their 1998-2007 average in 2010, based on our forecast of ~12% p.a. rise in China household income and a 5%-20% property price decline from 2Q08 to 2009; (2) total property loans, including mortgages, are at a manageable 18% of total loans, vs. 53% of total commercial bank loans in the US; (3) China mortgages carry recourse and households have low leverage; (4) just as in the US and Japan, banks prefer to work out restructuring/M&A for distressed developers so long as underlying profitability/viability are intact; and (5) banking liquidity remains high in China, and China has pro-growth policies. We would be more positive if China eased tightening policies, or if inflation pressure fundamentally eased post utilities/energy price adjustments. Downside risks include: hard landing of the Chinese economy, behind-thecurve policy easing; collapse of property prices dampening sentiment. Be selective; wide differences in lending practices, P&L resilience We see some potential credit loss on property NPLs, partly due to lending loopholes despite high collateral levels and tight regulatory requirements. We favor banks with low exposure to developers, low NPL sensitivity to earnings, and conservative lending risk management. We believe ICBC (1398.HK, Buy) is best placed to control risks, while we think SPDB (600000.SS, Sell), Huaxia (600015.SS, Sell) and Industrial (601166.SS, Neutral) are more vulnerable to real estate market deterioration. Property transactions slowed materially - 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 - 20,000 40,000 60,000 80,000 100,000 120,000 140,000 160,000 180,000 200,000 GFA Sold Revenue ('000 sqm) Rmb mn Source: CIA. Potential cash flow squeeze at developers Rmb mn 1H07 2H07 1H08 2H08E Operating cash inflow 70,839 120,689 86,521 72,905 Operating cash outflow 78,053 147,747 118,184 153,934 Net operating cash inflow/(outflow) (7,215) (27,058) (31,663) (81,030) Net investing cash inflow/(outflow) (3,809) (10,731) (8,687) (8,585) Net financing cash inflow/(outflow) 21,020 55,112 45,522 35,823 Net cash inflow/(outflow) 10,022 17,286 5,109 (53,792) Ending cash balance 50,171 69,702 78,122 24,330 Source: Wind, and Gao Hua Securities Research estimates. Earnings sensitivity to 3% real estate loan and mortgage NPL formation -13.3% -12.0% -10.7% -8.5% -8.5% -8.3% -8.2% -8.0% -7.0% -6.5% -6.5% -6.2% -4.2% -11.1% -14.0% -12.0% -10.0% -8.0% -6.0% -4.0% -2.0% 0.0% Industrial BOBJ Minsheng SPDB CCB SZDB Hua Xia BONJ CNCB BoCom CMB ICBC BOC (Domestic) BONB Source: Gao Hua Securities Research estimates. For special disclosures as to Goldman Sachs' investment in ICBC, see the statement preceding the Reg AC certification. Richard Xu, CFA +86(10)6627-3192 | richard.xu@ghsl.cn Beijing Gao Hua Securities Company Limited Yi Wang, CFA +86(10)6627-3022 | yi.wang@ghsl.cn Beijing Gao Hua Securities Company Limited Ning Ma +852-2978-1677 | ning.ma@gs.com Goldman Sachs (Asia) L.L.C. Judy Zhang +86(10)6627-3095 | judy.zhang@ghsl.cn Beijing Gao Hua Securities Company Limited The Goldman Sachs Group, Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification, see the end of the text. Other important disclosures follow the Reg AC certification, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S. The Goldman Sachs Group, Inc. Global Investment Research
September 9,2008 China:Banks Table of contents Continued housing market weakness squeezes developer cash flow Real estate market fundamentals continue to deteriorate Why real estate loan NPLs have not shown up so far 5 Risk of cash flow squeeze increasing,particularly in 4008/2009 6 Lending loopholes and fall in collateral value could lead to some real estate loan losses 9 Real estate investment scale-back is a macro downside risk 10 We view the likelihood of systemic risk as low 11 Property market turnaround hinges on inflation and policy easing 16 Be selective;lending practices and earnings sensitivity matter 17 Appendix I:Lending loopholes expose banks to credit risks 22 Appendix ll:Earnings sensitivity to total real estate loan and mortgage credit quality deterioration 27 Appendix lll:Real estate transaction volume slowed notably in major cities 27 Disclosures 32 The prices in the body of this report are based on the market close of September 5,2008. Exhibit 1:China banks valuation comparison 12m PB PE闲 EPS growth() Price 202 0 12HK Bu 500 218 58 15% 2.54 118 22.1 26.3 236 25 109 70 42 CHB H-shns 2.11187 106 9.5 6.7 58 4.14.5 110 0 207 D132155Buw 451 220 53 10% 2.形 2.50 23 12.1 0.3 73 65 42 4.9 53.0 170 28.5 22.1 235 28.3 945 326 1.5 1.93 1-7 118 t0.0 74 61 38 4.5 17. 185 18.5 40 12 250 2.3 210 104 .7 59 5.3 24 239 51 3 山 002 08.4 274 109 224 2 7 1.7 2.11 140 2.7 10.8 88 17.0 900. 8D116a55N 851 1.64 1.79 93 8.8 20.3 19. D.6 105 -19% 1.15 192 Note: The exchange rates we use to estimate the EPS/BVPS data for H-share listed banks:HKD/CNY=0.87 in 2008(8%appreciation),2009 and 2010 Our 12-month price targets for H-shares and A-shares(market-relative)are based on a mid-point P/B,i.e.the average between growth fully loaded P/B and ex-growth P/B.Risks to our Buy-and Neutral-rated stocks include macro hard landing,asset quality and eamings misses.Risks to our Sell-rated stocks include better-than- expected asset quality and eamings,and a significant stimulus package in China For important disclosures,please go to http://www.gs.com/research/hedge.html Source:Company data,Goldman Sachs Research estimates. Since our China banks/property report of April 18 entitled,"Developers/banks:analyzing property price falls:watch 20 volume",the real estate market has continued to weaken,as seen in a further decline in transaction volumes,softening property prices,and accumulating inventory levels in major China cities.While weakened real estate sector fundamentals have not yet had a material negative impact on China banks'asset quality, we see a prolonged weakness in the real estate market as a looming risk for China banks in 4Q08/2009 Goldman Sachs Global Investment Research 2
September 9, 2008 China: Banks Goldman Sachs Global Investment Research 2 Table of contents Continued housing market weakness squeezes developer cash flow 3 Real estate market fundamentals continue to deteriorate 3 Why real estate loan NPLs have not shown up so far 5 Risk of cash flow squeeze increasing, particularly in 4Q08/2009 6 Lending loopholes and fall in collateral value could lead to some real estate loan losses 9 Real estate investment scale-back is a macro downside risk 10 We view the likelihood of systemic risk as low 11 Property market turnaround hinges on inflation and policy easing 16 Be selective; lending practices and earnings sensitivity matter 17 Appendix I: Lending loopholes expose banks to credit risks 22 Appendix II: Earnings sensitivity to total real estate loan and mortgage credit quality deterioration 27 Appendix III: Real estate transaction volume slowed notably in major cities 27 Disclosures 32 The prices in the body of this report are based on the market close of September 5, 2008. Exhibit 1: China banks valuation comparison 5-Sep-2008 Mkt Cap 12m Upside Target Ratings Price (US$ bn) Price tgt /downside P/B (X) 2008E 2009E 2008E 2009E 2008E 2009E 2008E 2009E 2008E 2009E 2010E 2008E 2009E 2010E H-shares (HKD) ICBC(H) 1398.HK Buy 5.09 218 5.86 15% 2.60 2.54 2.26 11.8 10.1 7.2 6.3 4.3 5.0 17.0 53.0 26.5 22.1 23.5 26.3 BOC(H) 3988.HK Neutral 3.30 107 3.57 8% 1.57 1.59 1.45 9.7 8.2 6.1 5.0 4.7 5.5 17.8 33.4 15.9 17.1 18.5 18.5 CCB(H) 0939.HK Neutral 6.00 180 6.39 6% 2.36 2.52 2.22 11.0 9.9 7.1 6.2 4.3 5.1 11.0 55.6 19.5 24.6 23.9 23.9 BoCom(H) 3328.HK Sell 8.47 53 7.38 -13% 1.87 2.43 2.15 11.9 11.1 7.6 6.6 3.9 3.6 7.5 45.7 13.3 21.5 20.6 20.6 CMB (H) 3968.HK Neutral 23.40 44 22.87 -2% 2.85 3.62 2.92 12.5 11.3 8.4 7.2 2.0 2.2 10.5 56.9 19.9 31.8 28.7 28.7 CNCB (H) 0998.HK Neutral 4.11 21 4.20 2% 1.32 1.46 1.29 8.6 8.1 5.4 4.7 3.2 3.7 6.1 93.5 19.2 17.9 16.8 17.8 H-share average 2.36 2.05 10.9 9.8 7.0 6.0 3.7 4.2 11.6 56.3 19.1 22.0 22.5 22.6 Excluding CMB H-shares 2.11 1.87 10.6 9.5 6.7 5.8 4.1 4.6 11.9 56.2 18.9 20.7 20.7 21.4 A-shares (Rmb) ICBC(A) 601398.SS Buy 4.51 220 5.38 19% 2.76 2.60 2.31 12.1 10.3 7.3 6.5 4.2 4.9 17.0 53.0 26.5 22.1 23.5 26.3 BOC(A) 601988.SS Neutral 3.48 129 3.26 -6% 1.65 1.93 1.77 11.8 10.0 7.4 6.1 3.8 4.5 17.8 33.4 15.9 17.1 18.5 18.5 CCB(A) 601939.SS Neutral 4.93 168 5.85 19% 2.50 2.39 2.10 10.4 9.4 6.7 5.9 4.6 5.3 11.0 55.6 19.5 24.6 23.9 23.9 BoCom(A) 601328.SS Neutral 6.79 49 6.72 -1% 1.97 2.25 1.99 11.0 10.3 7.1 6.1 4.2 3.9 7.5 45.7 13.3 21.5 20.6 20.6 CMB(A) 600036.SS Neutral 20.00 43 21.01 5% 3.03 3.57 2.88 12.3 11.1 8.3 7.1 2.0 2.2 10.5 56.9 19.9 31.8 28.7 28.7 CNCB (A) 601998.SS Sell 5.09 29 3.79 -26% 1.38 2.08 1.85 12.3 11.6 7.7 6.7 2.2 2.6 6.1 93.5 19.2 17.9 16.8 17.8 SPDB 600000.SS Sell 17.99 19 14.08 -22% 1.74 2.75 2.22 9.5 9.5 7.4 6.4 1.9 1.9 (0.0) 94.4 14.5 32.7 25.7 24.8 Industrial 601166.SS Neutral 18.94 14 18.49 -2% 1.72 2.06 1.76 7.5 7.1 5.1 4.4 4.2 3.2 5.5 44.3 20.8 29.2 26.8 27.5 Minsheng 600016.SS Neutral 5.49 15 5.29 -4% 1.52 1.77 1.58 8.4 8.2 5.0 4.3 2.5 3.0 1.7 80.4 21.4 22.6 20.5 21.9 SZDB 000001.SZ Neutral 18.24 6 19.16 5% 1.96 2.31 1.87 10.4 9.8 5.2 4.7 0.0 0.0 5.9 38.4 25.7 25.7 21.0 21.3 Hua Xia 600015.SS Sell 9.64 6 4.78 -50% 1.19 2.74 2.39 10.9 11.4 4.2 3.8 3.7 3.5 (3.8) 76.2 10.2 26.4 22.5 21.7 BONB 002142.SZ Sell 7.69 3 7.29 -5% 1.77 2.11 1.86 14.0 12.7 10.8 8.8 1.4 1.6 10.6 27.4 24.0 15.6 16.0 17.0 BOBJ 601169.SS Neutral 8.57 8 8.87 4% 1.64 1.79 1.58 9.3 8.8 6.4 5.6 3.2 4.0 6.3 46.3 22.7 19.1 20.3 20.6 BONJ 601009.SS Sell 8.97 2 7.22 -19% 1.15 1.55 1.43 11.0 11.0 8.4 7.8 1.7 2.0 0.6 31.5 17.8 13.6 14.5 14.7 A-share average 1.97 2.28 10.79 10.08 6.93 6.01 2.8 3.0 53.6 7.3 19.2 23.1 21.3 21.8 P/B (X) P/E (X) Div yld (%) P/PPOP (X) EPS growth (%) ROE (%) Note: The exchange rates we use to estimate the EPS/BVPS data for H-share listed banks: HKD/CNY= 0.87 in 2008(8% appreciation), 2009 and 2010. Our 12-month price targets for H-shares and A-shares (market-relative) are based on a mid-point P/B, i.e. the average between growth fully loaded P/B and ex-growth P/B. Risks to our Buy- and Neutral-rated stocks include macro hard landing, asset quality and earnings misses. Risks to our Sell-rated stocks include better-thanexpected asset quality and earnings, and a significant stimulus package in China. For important disclosures, please go to http://www.gs.com/research/hedge.html Source: Company data, Goldman Sachs Research estimates. Since our China banks/property report of April 18 entitled, “Developers/banks: analyzing property price falls: watch 2Q volume”, the real estate market has continued to weaken, as seen in a further decline in transaction volumes, softening property prices, and accumulating inventory levels in major China cities. While weakened real estate sector fundamentals have not yet had a material negative impact on China banks’ asset quality, we see a prolonged weakness in the real estate market as a looming risk for China banks in 4Q08/2009
September 9,2008 China:Banks In this report,we try to answer the following questions: 1.Is an escalation in real estate NPLs likely to surface,and when? 2.Is there a systemic risk associated with the real estate market downturn? 3. What would reduce real estate NPL risks and make us more positive on banks with higher real estate loan exposure? 4. Which listed China banks are more defensively positioned in terms of real estate weakness? Continued housing market weakness squeezes developer cash flow Real estate market fundamentals continue to deteriorate China's real estate market'has entered a correction phase following a mini real estate bubble in 2007,in which we saw a quick surge in property prices and project starts. Recent industry data,as well as our recent trip to Tianjin,Wuhan and Chongqing, lead us to believe that there will be a further correction in real estate prices in many major cities as: 1.Total property transaction volumes in major cities in 1H08 and July 2008 declined 30% and 52%yoy(Exhibit 3),respectively,and could remain at depressed levels in light of current gloomy market sentiment,as many home buyers are waiting on the sidelines due to:concerns over further price declines,rising mortgage borrowing costs and stricter mortgage application standards following PBOC/CBRC's new second mortgage rule. Exhibit 2:Real estate transaction volumes moderated in Exhibit 3:Transaction volume declines in major cities 1H08 are even more pronounced Annual sales volume(GFA)1995-1H08 GFA sold and residential real estate sales in 12 major cities 16,000sm b8.00 14.000 B0,00 180.00 12,000 140.00 10,0 120.00 400 8,00m 100.c00 6,000 4,000 2.00 hn-07 ar-07 407 Nov-07 Jan-08 Mar-08 Mav-08 Ju03 GFA Sold Source:CEIC,Gao Hua Securities Research estimates. Source:CIA. 2.Inventory continues to build up in major cities,and inventory levels in 14 cities out of the 16 cities we follow have approached or exceeded 12 months,based on annualized July 2008 ytd transaction volume(Exhibit 5). 1 Note that there are-45 H-share and~65 A-share listed residential property developers, and -58,000 property developers in total in China. Goldman Sachs Global Investment Research 3
September 9, 2008 China: Banks Goldman Sachs Global Investment Research 3 In this report, we try to answer the following questions: 1. Is an escalation in real estate NPLs likely to surface, and when? 2. Is there a systemic risk associated with the real estate market downturn? 3. What would reduce real estate NPL risks and make us more positive on banks with higher real estate loan exposure? 4. Which listed China banks are more defensively positioned in terms of real estate weakness? Continued housing market weakness squeezes developer cash flow Real estate market fundamentals continue to deteriorate China’s real estate market1 has entered a correction phase following a mini real estate bubble in 2007, in which we saw a quick surge in property prices and project starts. Recent industry data, as well as our recent trip to Tianjin, Wuhan and Chongqing, lead us to believe that there will be a further correction in real estate prices in many major cities as: 1. Total property transaction volumes in major cities in 1H08 and July 2008 declined 30% and 52% yoy (Exhibit 3), respectively, and could remain at depressed levels in light of current gloomy market sentiment, as many home buyers are waiting on the sidelines due to: concerns over further price declines, rising mortgage borrowing costs and stricter mortgage application standards following PBOC/CBRC’s new second mortgage rule. Exhibit 2: Real estate transaction volumes moderated in 1H08 Annual sales volume (GFA) 1995-1H08 Exhibit 3: Transaction volume declines in major cities are even more pronounced GFA sold and residential real estate sales in 12 major cities 0 100 200 300 400 500 600 700 800 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Annualized 1H08 (mn sqm) 22% CAGR between 1995-2007 - 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 - 20,000 40,000 60,000 80,000 100,000 120,000 140,000 160,000 180,000 200,000 GFA Sold Revenue ('000 sqm) Rmb mn Source: CEIC, Gao Hua Securities Research estimates. Source: CIA. 2. Inventory continues to build up in major cities, and inventory levels in 14 cities out of the 16 cities we follow have approached or exceeded 12 months, based on annualized July 2008 ytd transaction volume (Exhibit 5). 1 Note that there are ~45 H-share and ~65 A-share listed residential property developers, and ~58,000 property developers in total in China
September 9,2008 China:Banks Exhibit 4:Inventory levels building up in major cities The earliest Current data of unsold The current The earliest unsold GFA GFA Chg data date data date (mn sqm) (mn sqm Hangzhou 2.9 1.8 57 08/31/08 01/06/08 Nanjing 4.9 3.2 51 08/31/08 02/24/08 Dalian 4.9 3.5 40 08/31/08 04/20/08 Beijing 16.9 13.3 27 08/31/08 01/06/08 Suzhou 4.6 3.6 27 08/31/08 06/01/08 Dongguan 7.1 5.6 26 08/31/08 04/20/08 Shanghai 6.7 5.3 25 08/31/08 01/06/08 Guangzhou 4.6 3.7 23 08/31/08 06/01/08 Chongqing 13.5 11.0 22 08/31/08 06/01/08 Chengdu 16.1 13.2 22 08/31/08 01/06/08 Wuhan 12.8 10.5 22 08/31/08 01/06/08 Xian 14.1 12.1 16 08/31/08 04/20/08 Xiamen 3.8 3.5 10 08/31/08 06/08/08 Shenzhen 5.6 5.2 8 08/31/08 01/06/08 Shenyang 5.3 4.9 8 06/01/08 04/20/08 Source:CIA. Exhibit 5:Inventory levels in 14 major cities will take more than one year to digest (mn sqm) GFAs0din2007 40 vg GF 05-07 Current unsold in entory to YTD sales pace 80fAug24.2008) Pan Bohai Rim Yangtze River Delta- Pearl River Delta -Mid Central China- 35 30 25 20 15 BJ TJ SY D SH NJSUZ HZ SZ GZ DG XM> WH CQ CD XA Note:Estimated annualized transaction vol.according to ytd sales pace is calculated based on the currently average weekly sales speed.BJ=Beijing,TJ=Tianjing,SY=Shenyang,DL=Dalian,SH=Shanghai,NJ=Nanjing,Suz=Suzhou,HZ=Hangzhou, SZ=Shenzhen,GZ=Guangzhou,DG=Dongguan,XM=Xiamen,WH=Wuhan,CQ=Chongqing,CD=Chengdu,XA=Xi'an. GFA numbers indicated in Beijing.Shanghai,Nanjing,Hangzhou,Guangzhou are all for residential properties only;for others, the numbers refer to total commodity properties. Source:Various city govemments,CIA. Goldman Sachs Global Investment Research
September 9, 2008 China: Banks Goldman Sachs Global Investment Research 4 Exhibit 4: Inventory levels building up in major cities Current unsold GFA The earliest data of unsold GFA Chg % The current data date The earliest data date (mn sqm) (mn sqm) Hangzhou 2.9 1.8 57 08/31/08 01/06/08 Nanjing 4.9 3.2 51 08/31/08 02/24/08 Dalian 4.9 3.5 40 08/31/08 04/20/08 Beijing 16.9 13.3 27 08/31/08 01/06/08 Suzhou 4.6 3.6 27 08/31/08 06/01/08 Dongguan 7.1 5.6 26 08/31/08 04/20/08 Shanghai 6.7 5.3 25 08/31/08 01/06/08 Guangzhou 4.6 3.7 23 08/31/08 06/01/08 Chongqing 13.5 11.0 22 08/31/08 06/01/08 Chengdu 16.1 13.2 22 08/31/08 01/06/08 Wuhan 12.8 10.5 22 08/31/08 01/06/08 Xian 14.1 12.1 16 08/31/08 04/20/08 Xiamen 3.8 3.5 10 08/31/08 06/08/08 Shenzhen 5.6 5.2 8 08/31/08 01/06/08 Shenyang 5.3 4.9 8 06/01/08 04/20/08 Source: CIA. Exhibit 5: Inventory levels in 14 major cities will take more than one year to digest 0 5 10 15 20 25 30 35 40 BJ TJ SY DL SH NJ SuZ HZ SZ GZ DG XM WH CQ CD XA (mn sqm) GFA sold in 2007 Avg GFA sold during 05-07 Annualized transaction vol. according to YTD sales pace Current unsold inventory (as of Aug 24,2008) Pan Bohai Rim Yangtze River Delta Pearl River Delta Mid & Central China Note: Estimated annualized transaction vol. according to ytd sales pace is calculated based on the currently average weekly sales speed. BJ=Beijing, TJ=Tianjing, SY=Shenyang, DL=Dalian, SH=Shanghai, NJ=Nanjing, Suz=Suzhou, HZ=Hangzhou, SZ=Shenzhen, GZ=Guangzhou, DG=Dongguan, XM=Xiamen, WH=Wuhan, CQ=Chongqing, CD=Chengdu, XA=Xi’an. GFA numbers indicated in Beijing, Shanghai, Nanjing, Hangzhou, Guangzhou are all for residential properties only; for others, the numbers refer to total commodity properties. Source: Various city governments, CIA
September 9,2008 China:Banks 3.Lastly,property prices have come off peak levels reached in 2007.We believe the continued decline in developers'cash levels,despite active financing in 1H08,will lead to more price discounts for new launches,which will further push down housing prices in 2H08 and 2009. Exhibit 6:Prices in many major cities have declined Latest price changes in major cities Primary market From Centaline (mixed-products) From Soufun Database (mixed products) Latest Chg Chg 07 Peak 07 Peak atest Chg fro Chg Dec-07 07 Peak 07 Peak date fromfrom D happened price 07 peak pri进 happened (Rmb/sqm) Shanghai Jul-08 -4%3 63 Oct-07 9879 Au9-089,154 -89 129 8,163 Jun-07 9.701 Beijing u- 3ep-07 13830 Aug-0812321 Dec-07 13600 Guangzhou Ju-0 21% -14 0ct-07 11,574 Apr-0810,997 59 10.50 Oct-0 11,574 Shenzhen Ju-的 77 4 Oct-0/ 17350 Aug-0B14,473 -24%-10%16151 Aug-07 19.169 Chongging Ju-08 3 De0-07 3967 Aug-084,130 29% 234.057 Dec-07 4057 Chengdu Jul-08-12% ,12% Nov-07 6394 Mar-0B4,162 2% 1%4.120 No-07 4247 Tianjin Jul-08 -283 -53 0ct-07 9350 Au9-086,778 49% 4s7,056 Dec-07 7058 Shenyang Ju-08-11% -10% Dec-07 3484 Ju-083,320 -28% -9%3680 Dec-07 4.516 Zhuhai Jul-08 -23% 64 Sept-07 8914 na n.a. na. n.a. na na 门唐 Wuhan JuL-08 7% Now-07 5783 Aa-0B5250 .g9% .8 5692 Nov-07 5783 Naning Feb-08 2% 2% Dec-07 5.853 gn-085.623 49% 0 5.621 Jun-07 5.857 Hangzhou n.8. n.s. n.s. n.a. n.8. Aug-0815.517 39% 8%14,334 Now-07 15.031 2ndary market From Centaline Chg Chg from D 07 Peak 07 Peak price Shanghai Jul-08 7% 7% Dec-07 12.038 Beijing Jul-08 5% 5% De-07 13246 Guangzhou Jul-08 -45% -29% Nov-07 8818 Shenrhen Jul-08 .18L -9% Aa-07 14910 Chongqing Ju-08 10% 105% Dec-07 2545 Chengdu Feb-08 -10% 14 Dec-07 1,719 Tianiin Jul-08 6% Oct-07 4.993 Ar-0 ,10% ,10% .n8 2671 lul-08 3893 Source:Centaline Research,Soufun Database. Why real estate loan NPLs have not shown up so far Real estate loans'credit quality,according to banks'1H08 results and regulators,has been holding up fairly well in 1H08,despite deteriorating real estate market fundamentals and the relatively high leverage of China developers(see Exhibit 7). Exhibit 7:China property developers are relatively highly leveraged Historical liability/equity ratios,1995-2006 340% 320% 321%318% 318% 309% 314% 300% 301%299% 291% 286% 286% 280% 267% 262% 260% 240% 220% 200%+ 1995 19961997199819992000200120022003200420052006 Source:CEIC,Goldman Sachs Research estimates. Goldman Sachs Global Investment Research
September 9, 2008 China: Banks Goldman Sachs Global Investment Research 5 3. Lastly, property prices have come off peak levels reached in 2007. We believe the continued decline in developers’ cash levels, despite active financing in 1H08, will lead to more price discounts for new launches, which will further push down housing prices in 2H08 and 2009. Exhibit 6: Prices in many major cities have declined Latest price changes in major cities Primary market Latest date Chg from 07 peak Chg from Dec- 07 07 Peak happened 07 Peak price (Rmb/sqm) Latest date Latest price Chg from 07 peak Chg from Dec-07 Dec-07 price 07 Peak happened 07 Peak price (Rmb/sqm) Shanghai Jul-08 -4% 6% Oct-07 9,879 Aug-08 9,154 -6% 12% 8,163 Jun-07 9,701 Beijing Jul-08 0% 5% Sept-07 13,630 Aug-08 12,321 -9% -9% 13,600 Dec-07 13,600 Guangzhou Jul-08 -21% -14% Oct-07 11,574 Apr-08 10,997 -5% 4% 10,586 Oct-07 11,574 Shenzhen Jul-08 -7% 4% Oct-07 17,350 Aug-08 14,473 -24% -10% 16,151 Aug-07 19,169 Chongqing Jul-08 3% 3% Dec-07 3,967 Aug-08 4,130 2% 2% 4,057 Dec-07 4,057 Chengdu Jul-08 -12% -12% Nov-07 6,394 Mar-08 4,162 -2% -1% 4,120 Nov-07 4,247 Tianjin Jul-08 -28% -5% Oct-07 9,350 Aug-08 6,776 -4% -4% 7,056 Dec-07 7,056 Shenyang Jul-08 -11% -10% Dec-07 3,484 Jul-08 3,320 -26% -9% 3,660 Dec-07 4,516 Zhuhai Jul-08 -23% 6% Sept-07 8,914 n.a. n.a. n.a. n.a. n.a. n.a. n.a. Wuhan Jul-08 -8% -7% Nov-07 5,783 Aug-08 5,250 -9% -8% 5,692 Nov-07 5783 Naning Feb-08 2% 2% Dec-07 5,853 Jan-08 5,623 -4% 0% 5,621 Jun-07 5,857 Hangzhou n.a. n.a. n.a. n.a. n.a. Aug-08 15,517 3% 8% 14,334 Nov-07 15,031 2ndary market Latest date Chg from 07 peak Chg from Dec- 07 07 Peak happened 07 Peak price (Rmb/sqm) Shanghai Jul-08 7% 7% Dec-07 12,038 Beijing Jul-08 5% 5% Dec-07 13,246 Guangzhou Jul-08 -4% -2% Nov-07 8,618 Shenzhen Jul-08 -18% -9% Aug-07 14,910 Chongqing Jul-08 10% 10% Dec-07 2,545 Chengdu Feb-08 -10% 1% Dec-07 1,719 Tianjin Jul-08 5% 6% Oct-07 4,993 Shenyang Apr-08 -10% -10% Jan-08 2,671 Zhuhai Jul-08 4% 9% Nov-07 3,893 From Centaline (mixed-products) From Centaline From Soufun Database (mixed products) Source: Centaline Research, Soufun Database. Why real estate loan NPLs have not shown up so far Real estate loans’ credit quality, according to banks’ 1H08 results and regulators, has been holding up fairly well in 1H08, despite deteriorating real estate market fundamentals and the relatively high leverage of China developers (see Exhibit 7). Exhibit 7: China property developers are relatively highly leveraged Historical liability/equity ratios, 1995-2006 262% 291% 321% 318% 309% 301% 299% 314% 267% 286% 286% 318% 200% 220% 240% 260% 280% 300% 320% 340% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Source: CEIC, Goldman Sachs Research estimates
September 9,2008 China:Banks We believe this can largely be attributed to the following factors: 1.While the slowdown in the real estate sector has cut deeply into China real estate developers'profitability and hurt property developers'equity holding interest,the still- high gross and profit margins of 30%+at developers provided a cushion for debt holders such as banks. Moreover,given the perceived high gross margin of residential property projects, developers managed to attract continued funding from banks as well as domestic and foreign private investors. 2. Funding for the real estate industry as a whole appears to be sufficient as of 1H08, despite moderation in loan growth to the sector,aided by a surge in financing from the private sector(Exhibits 8 and 9).Developers continued to have high funding surplus levels in 1H08. 3. China developers had a relatively high cash balance at the beginning of 2007, following active fund-raising activities in 2007(Exhibits 8 and 9). Exhibit 8:Brisk financing activity helped listed developers improve cash positions in 1H08 Cash flow analysis of 65 listed China real estate developers Rmb mn 2000 2001 2002 2003 2004 2005 2006 2007 1H08 Cash flow from operations 1.143 (1.6391 3,717 3.418 1.389 623) 112.56534.272 31.663) Cash flow from investing 2.431(1.876)29323.128)4.452)2485)【5247 (14.540 Cash flow from financing 3.831 7.314 1.6949.2939.686185532.84076.132 45.522 Net cash inflows (outflows) 2542 3799247927466.62314253115028 27320 5,109 Ending cash balance 10,962 14,745 1710621.064 28,091 27481 45,802 72.849 78122 No.of firms with net cash outflows 26 20. 19 25 2 35 25 15 39 Note:cash flow from financing includes debt and equity issuance as well as new loans from banks. Source:Wind. Exhibit 9:Funding surplus for real estate industry as a Exhibit 10:But funding growth to the real estate industry whole increased up to 1H08 as booming real estate slowed as loans and pre-sale proceeds growth declined market attracted capital to the industry YoY growth in key funding sources for property investment Rmb mn 2004 2005 2006 2007 1H08 -Selt-raled but not equlty--Equty Real estate investment completed Development costs 901.8201.109.6971.31.1321753.199915.022 Land premium other 414.004 466,235 577.114 774,766 404.545 Total 1,315,8241,575,9321,938,2462,527.9651,319,567 Yoy growth 30% 20% 23% 30% 33% Funding Source Pre-sale 739534 774915 8135581082847 450820 Equity 234.471 307 278 356.194 184 416,593 Loans 315.841 383.467 526.341696.098405.880 Self-raised but not equity 286.285 396,617 502.514 478.016 329.890 Foreign investment 22.820 25,196 39.444 64.999 34.570 Other 118.725 229.125 449.970 724.518 279.581 Total 1.715.6762,116,5982,688,0213.725.6621,917,334 Yoy growth 31% 23% 27% 39% 23% Funding surplus 399,852 540.666 749.775 1,197697 597,767 Source:CEIC. Source:CEIC. Risk of cash flow squeeze increasing,particularly in 4008/2009 Despite still-stable credit quality at China banks,we see a looming real estate credit risk in 4008 and 2009 if the real estate market continues on its current downward trajectory. Goldman Sachs Global Investment Research 6
September 9, 2008 China: Banks Goldman Sachs Global Investment Research 6 We believe this can largely be attributed to the following factors: 1. While the slowdown in the real estate sector has cut deeply into China real estate developers’ profitability and hurt property developers’ equity holding interest, the stillhigh gross and profit margins of 30%+ at developers provided a cushion for debt holders such as banks. Moreover, given the perceived high gross margin of residential property projects, developers managed to attract continued funding from banks as well as domestic and foreign private investors. 2. Funding for the real estate industry as a whole appears to be sufficient as of 1H08, despite moderation in loan growth to the sector, aided by a surge in financing from the private sector (Exhibits 8 and 9). Developers continued to have high funding surplus levels in 1H08. 3. China developers had a relatively high cash balance at the beginning of 2007, following active fund-raising activities in 2007 (Exhibits 8 and 9). Exhibit 8: Brisk financing activity helped listed developers improve cash positions in 1H08 Cash flow analysis of 65 listed China real estate developers Rmb mn 2000 2001 2002 2003 2004 2005 2006 2007 1H08 Cash flow from operations 1,143 (1,639) 3,717 (3,418) 1,389 (623) (12,565) (34,272) (31,663) Cash flow from investing (2,431) (1,876) (2,932) (3,128) (4,452) (2,485) (5,247) (14,540) (8,687) Cash flow from financing 3,831 7,314 1,694 9,293 9,686 1,855 32,840 76,132 45,522 Net cash inflows (outflows) 2,542 3,799 2,479 2,746 6,623 (1,253) 15,028 27,320 5,109 Ending cash balance 10,962 14,745 17,106 21,064 28,091 27,481 45,802 72,849 78,122 No. of firms with net cash outflows 26 20 19 25 27 36 25 15 39 Note: cash flow from financing includes debt and equity issuance as well as new loans from banks. Source: Wind. Exhibit 9: Funding surplus for real estate industry as a whole increased up to 1H08 as booming real estate market attracted capital to the industry Exhibit 10: But funding growth to the real estate industry slowed as loans and pre-sale proceeds growth declined YoY growth in key funding sources for property investment Rmb mn 2004 2005 2006 2007 1H08 Real estate investment completed Development costs 901,820 1,109,697 1,361,132 1,753,199 915,022 Land premium & other 414,004 466,235 577,114 774,766 404,545 Total 1,315,824 1,575,932 1,938,246 2,527,965 1,319,567 Yoy growth 30% 20% 23% 30% 33% Funding Source Pre-sale 739,534 774,915 813,558 1,062,847 450,820 Equity 234,471 307,278 356,194 699,184 416,593 Loans 315,841 383,467 526,341 696,098 405,880 Self-raised but not equity 286,285 396,617 502,514 478,016 329,890 Foreign investment 22,820 25,196 39,444 64,999 34,570 Other 116,725 229,125 449,970 724,518 279,581 Total 1,715,676 2,116,598 2,688,021 3,725,662 1,917,334 Yoy growth 31% 23% 27% 39% 23% Funding surplus 399,852 540,666 749,775 1,197,697 597,767 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% Jan/07 Feb/07 Mar/07 Apr/07 May/07 Jun/07 Jul/07 Aug/07 Sep/07 Oct/07 Nov/07 Dec/07 Jan/08 Feb/08 Mar/08 Apr/08 May/08 Jun/08 Total Loans Deposits/downpayment on presales Self-raised but not equity Equity Source: CEIC. Source: CEIC. Risk of cash flow squeeze increasing, particularly in 4Q08/2009 Despite still-stable credit quality at China banks, we see a looming real estate credit risk in 4Q08 and 2009 if the real estate market continues on its current downward trajectory
September 9,2008 China:Banks We believe depressed real estate transaction volumes and slowing real estate loan growth (Exhibit 10),compounded by higher operating cash outflows due to the expansion in development driven by the optimistic industry outlook that followed last year's property price surge,could lead to a cash flow squeeze at real estate developers that expanded aggressively in the past two years. Despite the current slump in the real estate market,we see continued expansion in development,which could,in our view,aggravate developers'cash flow problems in 4Q08/2009.For instance,floor area under development rose 24%ytd until July 2008,vs. 23%yoy in 2007(Exhibit 11),and new project starts increased 15%ytd until July 2008 despite a weakening housing market outlook(Exhibit 12). Exhibit 11:Optimistic forecasts by developers in 2007 Exhibit 12:New construction starts have also risen yoy led to continued development expansion in 2008 YoY growth in residential floor space starts(%) YoY growth in floor space under development(%) 2004 2005 2006 2007 July 08 YTD 2004 2005 2006 2007 July 08 YTD National 19 18 19 23 24 National 10 13 18 23 15 Beijing 6 (13) ⑥) (4) Beijing (12) (10) (6) (12) 26 Shanghai 13 6 (1) (4) (13) Shanghai 2 (70 (15) (23) 10 Tianjin 21 20 20 10 12 Tianjin 30 29 18 5 12 Chongqing 20 23 28 16 25 Chongqing 10 19 33 22 Chengdu 0 14 52 39 35 Chengdu (13) 34 28 8 10 Guangzhou 8 (3) 5 5 12 Guangzhou 20 (24) 13 35 (19) Shenzhen 15 (3) (9) (1) (1) Shenzhen 59 (16 (37) 19 (17) Wuhan 24 14 6 9 26 Wuhan 36 17 (8) 7 9 Dalian (9) 16 43 32 30 Dalian (22) 19 91 8 (2) Hangzhou 0 0 15 (5) Hangzhou 0 0 56 (43) 44 Source:NDS Source:NDS Our study of the cash flow statements of the 65 A-share listed China real estate companies shows that aggregate net cash flows are quite vulnerable to shrinking sales volumes and moderation in outside funding growth(Exhibit 13), given the sizable operating cash outflow following aggressive investment in construction and land acquisitions(part of the operating cash outflow) We believe A-share listed developers could face a substantial decline in aggregate cash balance in 2H08 and 2009,based on weaker transaction volumes,continued expansion in development scale,and our expectation of slowing external funding via bank loans and private funding,given the shrinking profit margins. We expect the cash flow position to start recovering in 2010,as we assume a potential rebound in transaction volumes following improvement in affordability and our expectation that developers will begin scaling back development to conserve cash in 2H08, and that the scaling back will continue in 2010. Exhibit 13:Cash flow squeeze should improve in 2010 if price cuts and higher household incomes improve affordability, and if property developers continue to scale back development Cash flow statement analysis and projection of 65 listed China real estate developers yoy change% Rmb mn 1H07 2H07 1H08 2H08E 1H09E 2H09E1H10E 2H103 1H082H08E1H09E2H09E1H10E2H10E Operating cash inflow 70.839120.68986.52172.90581.37386.53193.579108.164 1% 15% 259% Operating cash outflow 78.053147,747118.184153.934111,683117.268100.515105.541 51% 4% -6% -24% -10% -109% Net operating cash inflow/(outflow) 7.215) 27.058)31.663)(81.030)30.311)(30.737 6,937 2.623 339% 199% 1% 62% Net investing cash inflow(outflow) (3.809)(10.731)(8.6870(8.585(6.950(6.868)(5,560)(5.494 128% -20% -20% -209% -209% -20% Net financing cash inflow(outflow) 21.020 55.112 45.522 35,823 38.694 32.957 35.599 30,320 117% -35% -15% -8% 8% 8% Net cash inflow/(outflow) 10.022 17.286 5,109、(53.792）1,433(4.648)23.10227,449 -49% M -72% -91%1512% NM Ending cash balance 50,171 69,702 78,122 24,330 25,764 21,116 44,218 71,667 56% 65% -67% -13% 72% 239% Source:Wind,and Gao Hua Securities Research estimates. Goldman Sachs Global Investment Research
September 9, 2008 China: Banks Goldman Sachs Global Investment Research 7 We believe depressed real estate transaction volumes and slowing real estate loan growth (Exhibit 10), compounded by higher operating cash outflows due to the expansion in development driven by the optimistic industry outlook that followed last year’s property price surge, could lead to a cash flow squeeze at real estate developers that expanded aggressively in the past two years. Despite the current slump in the real estate market, we see continued expansion in development, which could, in our view, aggravate developers’ cash flow problems in 4Q08/2009. For instance, floor area under development rose 24% ytd until July 2008, vs. 23% yoy in 2007 (Exhibit 11), and new project starts increased 15% ytd until July 2008 despite a weakening housing market outlook (Exhibit 12). Exhibit 11: Optimistic forecasts by developers in 2007 led to continued development expansion in 2008 YoY growth in floor space under development (%) Exhibit 12: New construction starts have also risen yoy YoY growth in residential floor space starts (%) 2004 2005 2006 2007 July 08 YTD National 19 18 19 23 24 Beijing 6 8 (13) (6) (4) Shanghai 13 6 (1) (4) (13) Tianjin 21 20 20 10 12 Chongqing 20 23 28 16 25 Chengdu 0 14 52 39 35 Guangzhou 8 (3) 5 5 12 Shenzhen 15 (3) (9) (1) (1) Wuhan 24 14 6 9 26 Dalian (9) 16 43 32 30 Hangzhou 0 0 3 15 (5) 2004 2005 2006 2007 July 08 YTD National 10 13 18 23 15 Beijing (12) (10) (6) (12) 26 Shanghai 2 (7) (15) (23) 10 Tianjin 30 29 18 5 12 Chongqing 5 10 19 33 22 Chengdu (13) 34 28 8 10 Guangzhou 20 (24) 13 35 (19) Shenzhen 59 (16) (37) 19 (17) Wuhan 36 17 (8) 7 9 Dalian (22) 19 91 8 (2) Hangzhou 0 0 56 (43) 44 Source: NDS. Source: NDS. Our study of the cash flow statements of the 65 A-share listed China real estate companies shows that aggregate net cash flows are quite vulnerable to shrinking sales volumes and moderation in outside funding growth (Exhibit 13), given the sizable operating cash outflow following aggressive investment in construction and land acquisitions (part of the operating cash outflow). We believe A-share listed developers could face a substantial decline in aggregate cash balance in 2H08 and 2009, based on weaker transaction volumes, continued expansion in development scale, and our expectation of slowing external funding via bank loans and private funding, given the shrinking profit margins. We expect the cash flow position to start recovering in 2010, as we assume a potential rebound in transaction volumes following improvement in affordability and our expectation that developers will begin scaling back development to conserve cash in 2H08, and that the scaling back will continue in 2010. Exhibit 13: Cash flow squeeze should improve in 2010 if price cuts and higher household incomes improve affordability, and if property developers continue to scale back development Cash flow statement analysis and projection of 65 listed China real estate developers Rmb mn 1H07 2H07 1H08 2H08E 1H09E 2H09E 1H10E 2H10E 1H08 2H08E 1H09E 2H09E 1H10E 2H10E Operating cash inflow 70,839 120,689 86,521 72,905 81,373 86,531 93,579 108,164 22% -40% -6% 19% 15% 25% Operating cash outflow 78,053 147,747 118,184 153,934 111,683 117,268 100,515 105,541 51% 4% -6% -24% -10% -10% Net operating cash inflow/(outflow) (7,215) (27,058) (31,663) (81,030) (30,311) (30,737) (6,937) 2,623 339% 199% -4% -62% -77% NM Net investing cash inflow/(outflow) (3,809) (10,731) (8,687) (8,585) (6,950) (6,868) (5,560) (5,494) 128% -20% -20% -20% -20% -20% Net financing cash inflow/(outflow) 21,020 55,112 45,522 35,823 38,694 32,957 35,599 30,320 117% -35% -15% -8% -8% -8% Net cash inflow/(outflow) 10,022 17,286 5,109 (53,792) 1,433 (4,648) 23,102 27,449 -49% NM -72% -91% 1512% NM Ending cash balance 50,171 69,702 78,122 24,330 25,764 21,116 44,218 71,667 56% -65% -67% -13% 72% 239% yoy change % Source: Wind, and Gao Hua Securities Research estimates
September 9,2008 China:Banks Key assumptions in our scenario analysis and projections include: Operating cash inflows likely to post substantial decline in 2H08/2009:We expect transaction volumes to remain weak in 2H08 and 1H09,in light of the 30+%decline in transaction volumes seen in 1H08,and high inventory levels. This,combined with our expectation of an additional 15%decline in house prices in 2H08,is likely to lead to~40%yoy decline in sales proceeds (or operating cash inflow) for China developers in 2H08. We expect transaction volumes and house prices to stabilize in 2H09 and begin turning around in 2010,given improved affordability.Hence,we expect stable operating cash inflows in 2H09,followed by 15%and 25%yoy growth in 1H10 and 2H10,respectively. ● Operating cash outflows will remain high in 2H08/2009:As shown in Exhibits 11 and 12,GSA under development continued to increase at a rapid pace of 24%ytd until July 2008.This,combined with 10%-15%yoy increase in the cost of building materials in 2008 should lead to a sizable increase in operating cash outflows,in our view. However,we believe a potential scaling back of development and potential lower land premium payments(~40%-50%of China developers'total cash operating outflows in 2H07)in 2H08 could partly offset the rising operating cash outflows from construction activities in 2H08.Hence,we expect operating cash outflows at A-share developers as a whole to increase 4%yoy and 30%hoh in 2H08. Looking ahead,we expect developers to continue to scale back development to conserve cash. Net financing cash inflows likely to moderate:We expect a moderation in growth of bank loans to developers,and a more challenging capital market for fund raising,to lead to a moderation in financing cash inflows at China real estate developers. In addition,we believe the expected lower profitability of real estate development projects could lead to a decline in private financing inflows. Accordingly,we expect cash flow from financing activities to decline 35%in 2H08 from the peak in 2H07. Exhibit 14:New loans to developers as a%of total new sector loans declined in 2008,suggesting banks are becoming cautious on this sector Consumer loans Total loans Developer loans Total consumer loans Of which:mortgages Yoy As of As%of As%of growth Yoy As of total New new Yoy total Yoy total Rmbbn Total %) Total (%loans (% loans loans(%) Total (%)1oans(%) Total (%loans (% 2004 18.85711.1 946 17 5.02 140 7 1.98826.3 10.5 1,600 35.8 8.5 2005 20,684 9.7 1.107 17 5.35 161 9 2,19410.4 10.6 1,840 15.0 8.9 2006 23,828 15.2 1.406 27 5.90 299 10 2.,406 9.6 10.1 2,250 22.3 9.4 2007 27,77516.6 1,767 26 636 361 92 327536.1 118 3,000 33.3 10.8 1Q08 29,387 16.2 1.900 19 6.47 133 8.2 3,39832.3 116 3,111 29.8 10.6 2Q08 30,50915.2 1,950 18 6.39 51 4.53,53326.8 11.6 3,300 25.6 10.8 2008E 31,802 14.5 2.015 14 6.33 247 6.1 3,799 16.0 11.9 3,540 18.0 11.1 Source:PBoC,CEIC,Goldman Sachs Research estimates. Cash inflows from active fund-raising activities have offset net cash outflows for operating and investing activities and helped developers strengthen their cash positions over the Goldman Sachs Global Investment Research
September 9, 2008 China: Banks Goldman Sachs Global Investment Research 8 Key assumptions in our scenario analysis and projections include: • Operating cash inflows likely to post substantial decline in 2H08/2009: We expect transaction volumes to remain weak in 2H08 and 1H09, in light of the 30+% decline in transaction volumes seen in 1H08, and high inventory levels. This, combined with our expectation of an additional 15% decline in house prices in 2H08, is likely to lead to ~40% yoy decline in sales proceeds (or operating cash inflow) for China developers in 2H08. We expect transaction volumes and house prices to stabilize in 2H09 and begin turning around in 2010, given improved affordability. Hence, we expect stable operating cash inflows in 2H09, followed by 15% and 25% yoy growth in 1H10 and 2H10, respectively. • Operating cash outflows will remain high in 2H08/2009: As shown in Exhibits 11 and 12, GSA under development continued to increase at a rapid pace of 24% ytd until July 2008. This, combined with 10%-15% yoy increase in the cost of building materials in 2008 should lead to a sizable increase in operating cash outflows, in our view. However, we believe a potential scaling back of development and potential lower land premium payments (~40%-50% of China developers’ total cash operating outflows in 2H07) in 2H08 could partly offset the rising operating cash outflows from construction activities in 2H08. Hence, we expect operating cash outflows at A-share developers as a whole to increase 4% yoy and 30% hoh in 2H08. Looking ahead, we expect developers to continue to scale back development to conserve cash. • Net financing cash inflows likely to moderate: We expect a moderation in growth of bank loans to developers, and a more challenging capital market for fund raising, to lead to a moderation in financing cash inflows at China real estate developers. In addition, we believe the expected lower profitability of real estate development projects could lead to a decline in private financing inflows. Accordingly, we expect cash flow from financing activities to decline 35% in 2H08 from the peak in 2H07. Exhibit 14: New loans to developers as a % of total new sector loans declined in 2Q08, suggesting banks are becoming cautious on this sector Developer loans Total consumer loans Of which: mortgages Rmb bn Total Yoy growth (%) Total Yoy (%) As % of total loans (%) New loans As % of new loans(%) Total Yoy (%) As % of total loans (%) Total Yoy (%) As % of total loans (%) 2004 18,857 11.1 946 17 5.02 140 7 1,988 26.3 10.5 1,600 35.8 8.5 2005 20,684 9.7 1,107 17 5.35 161 9 2,194 10.4 10.6 1,840 15.0 8.9 2006 23,828 15.2 1,406 27 5.90 299 10 2,406 9.6 10.1 2,250 22.3 9.4 2007 27,775 16.6 1,767 26 6.36 361 9.2 3,275 36.1 11.8 3,000 33.3 10.8 1Q08 29,387 16.2 1,900 19 6.47 133 8.2 3,398 32.3 11.6 3,111 29.8 10.6 2Q08 30,509 15.2 1,950 18 6.39 51 4.5 3,533 26.8 11.6 3,300 25.6 10.8 2008E 31,802 14.5 14 6.33 2,015 247 6.1 3,799 16.0 11.9 3,540 18.0 11.1 Consumer loans Total loans Source: PBoC, CEIC, Goldman Sachs Research estimates. Cash inflows from active fund-raising activities have offset net cash outflows for operating and investing activities and helped developers strengthen their cash positions over the
September 9,2008 China:Banks past two years,but we believe a potential sharp decline in sales volume and financing cash inflows in 2H08/2009 could quickly lead to sizable cash outflows at those listed China developers. We estimate that,based on the aforementioned assumptions,the 65 A-share listed developers as a whole would experience sizable net cash outflows in 2H08 and 2009 vs.an inflow of Rmb27bn in 2007,and lead to cash flow squeeze at some of those developers in 1H08 and 2009. We believe the cash flow issues could be even worse for non-listed developers that could have weaker cash positions and less access to the capital market than their listed peers. Real estate loan NPLs may surface in 4Q08 if sales volume remains low We believe the liquidity situation could deteriorate quickly in 2H08,particularly at some stretched,mid-sized developers that expanded aggressively in 2007,and lead to bank credit quality risk as early as 4008,because: 1.Sales volume and property prices could continue to weaken in 2H08,which could put pressure on developers'operating cash inflow. 2.Funding needs are normally higher in 4Q as developers typically pay construction companies at year-end for the part of the project that has been completed in the year. We estimate that~33%of the full-year development costs were incurred in the fourth quarter over the past three years. 3. Banks could have a lower loan quota in 2H08 as most banks have already used up 65%-70%of the 2008 full-year loan quota in 1H08,with only 30%-35%left for 2H08. Several banks indicated that new property loans in 1H08 were due to withdrawal of real estate loan commitments granted in 2007,largely on projects that are already under construction,and indicated that new loans to the property sector will be much lower in 2H08 4. Declining profitability of development projects could lead to lower funding inflow from private sources. Lending loopholes and fall in collateral value could lead to some real estate loan losses We believe the tightened lending standards and regulatory requirements for developer loans and mortgages by China bank regulators will help banks control property lending risks and minimize credit costs.These requirements include: (1)a minimum 35%of equity investment requirement by developers in a real estate development project; (2)prohibition of higher-risk land-purchase loans to developers;and (3)the implementation of a "closed"monitoring process for development loans. However,we believe lending loopholes could expose China banks to potential credit risks if developers start to fail.Some typical loopholes include: Development loans and proceeds from home sales could be diverted to land purchase and other development projects; Appraised value of real estate loan collaterals could be over-estimated; Some loans may not be fully secured and could hence expose banks to credit risks; and Goldman Sachs Global Investment Research 9
September 9, 2008 China: Banks Goldman Sachs Global Investment Research 9 past two years, but we believe a potential sharp decline in sales volume and financing cash inflows in 2H08/2009 could quickly lead to sizable cash outflows at those listed China developers. We estimate that, based on the aforementioned assumptions, the 65 A-share listed developers as a whole would experience sizable net cash outflows in 2H08 and 2009 vs. an inflow of Rmb27bn in 2007, and lead to cash flow squeeze at some of those developers in 1H08 and 2009. We believe the cash flow issues could be even worse for non-listed developers that could have weaker cash positions and less access to the capital market than their listed peers. Real estate loan NPLs may surface in 4Q08 if sales volume remains low We believe the liquidity situation could deteriorate quickly in 2H08, particularly at some stretched, mid-sized developers that expanded aggressively in 2007, and lead to bank credit quality risk as early as 4Q08, because: 1. Sales volume and property prices could continue to weaken in 2H08, which could put pressure on developers’ operating cash inflow. 2. Funding needs are normally higher in 4Q as developers typically pay construction companies at year-end for the part of the project that has been completed in the year. We estimate that ~33% of the full-year development costs were incurred in the fourth quarter over the past three years. 3. Banks could have a lower loan quota in 2H08 as most banks have already used up 65%-70% of the 2008 full-year loan quota in 1H08, with only 30%-35% left for 2H08. Several banks indicated that new property loans in 1H08 were due to withdrawal of real estate loan commitments granted in 2007, largely on projects that are already under construction, and indicated that new loans to the property sector will be much lower in 2H08. 4. Declining profitability of development projects could lead to lower funding inflow from private sources. Lending loopholes and fall in collateral value could lead to some real estate loan losses We believe the tightened lending standards and regulatory requirements for developer loans and mortgages by China bank regulators will help banks control property lending risks and minimize credit costs. These requirements include: (1) a minimum 35% of equity investment requirement by developers in a real estate development project; (2) prohibition of higher-risk land-purchase loans to developers; and (3) the implementation of a “closed” monitoring process for development loans. However, we believe lending loopholes could expose China banks to potential credit risks if developers start to fail. Some typical loopholes include: • Development loans and proceeds from home sales could be diverted to land purchase and other development projects; • Appraised value of real estate loan collaterals could be over-estimated; • Some loans may not be fully secured and could hence expose banks to credit risks; and
September 9,2008 China:Banks Asset ownership at China real estate developers is often unclear,which could lead to complicated,or even failed,foreclosure processes. Please see Appendix I for more details on real estate lending loopholes. Real estate investment scale-back is a macro downside risk In the light of slowing demand for residential properties and weakening cash flow outlook at real estate developers,it seems to be critical for China real estate developers to reduce development scale to conserve cash and to survive We estimate that when holding other things equal,a potential 20 percentage point(pp) slowdown in nominal real estate investment growth translates into around 1pp less contribution to GDP growth from the sector2.The real residential real estate investment has become a much more important contributor to GDP growth,in our view,and the share of residential real estate investment to GDP has increased to about 7%in 2007 from 4%in 2002. Moreover,weak property sales and construction growth could have a negative impact on a number of related industries due to potential lower demand for: Building material and related commodities,such as steel and cement. ● Machinery,in light of the decline in the number of construction projects. Home durable goods,such as home appliances and furniture due to fewer upgrade needs. Exhibit 15:Residential real estate investment has Exhibit 16:...slightly above that in many developed become a more important contributor to China's GDP... countries Residential real estate investment as a%of total China GDP Residential real estate investment contribution as a%of GDP growth 12% 10% 8% 5 6% % 6% 6% 4 4% 4% 2% 199519971998199920002001200220032004200520052007 Note:Residential real estate investment data overstates its contribution to GDP Note:Residential real estate investment data overstates its contribution to GDP as it includes land premium.At the same time,it does not capture GDP created as it includes land premium.At the same time,it does not capture GDP created by other industries that are real estate-related,in our view. by other industries that are real estate-related,in our view. Source:CEIC. Source:CEIC. 2 Nominal residential real estate investment(REl)in China constitutes about 17-18%of nominal fixed asset investment,which in turn takes up about 40%of GDP.From these we calculate nominal REl to be 18%*40%=7%of GDP.However,this number might be overstating the share of REl as REl statistics include about 30%land purchasing premium which should not be counted as part of the value-added GDP.Therefore,we estimate that real estate investment makes up about 5-6%of real GDP and a 20 pp decline in its growth rate reduces its contribution to GDP growth by about 1pp(5%*20pp). Goldman Sachs Global Investment Research 10
September 9, 2008 China: Banks Goldman Sachs Global Investment Research 10 • Asset ownership at China real estate developers is often unclear, which could lead to complicated, or even failed, foreclosure processes. Please see Appendix I for more details on real estate lending loopholes. Real estate investment scale-back is a macro downside risk In the light of slowing demand for residential properties and weakening cash flow outlook at real estate developers, it seems to be critical for China real estate developers to reduce development scale to conserve cash and to survive. We estimate that when holding other things equal, a potential 20 percentage point (pp) slowdown in nominal real estate investment growth translates into around 1pp less contribution to GDP growth from the sector2. The real residential real estate investment has become a much more important contributor to GDP growth, in our view, and the share of residential real estate investment to GDP has increased to about 7% in 2007 from 4% in 2002. Moreover, weak property sales and construction growth could have a negative impact on a number of related industries due to potential lower demand for: • Building material and related commodities, such as steel and cement. • Machinery, in light of the decline in the number of construction projects. • Home durable goods, such as home appliances and furniture due to fewer upgrade needs. Exhibit 15: Residential real estate investment has become a more important contributor to China’s GDP... Residential real estate investment as a % of total China GDP Exhibit 16: ...slightly above that in many developed countries Residential real estate investment contribution as a % of GDP growth 0% 1% 2% 3% 4% 5% 6% 7% 8% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Note: Residential real estate investment data overstates its contribution to GDP as it includes land premium. At the same time, it does not capture GDP created by other industries that are real estate-related, in our view. 11% 9% 9% 7% 7% 7% 6% 6% 6% 6% 6% 5% 5% 4% 4% 4% 3% 3% 0% 2% 4% 6% 8% 10% 12% Ireland Spain Switzerland China Canada New Zealand Denmark USA Finland Netherlands Australia Italy Germany Norway United Kingdom France Sweden Japan Note: Residential real estate investment data overstates its contribution to GDP as it includes land premium. At the same time, it does not capture GDP created by other industries that are real estate-related, in our view. Source: CEIC. Source: CEIC. 2 Nominal residential real estate investment (REI) in China constitutes about 17-18% of nominal fixed asset investment, which in turn takes up about 40% of GDP. From these we calculate nominal REI to be 18% *40% = 7% of GDP. However, this number might be overstating the share of REI as REI statistics include about 30% land purchasing premium which should not be counted as part of the value-added GDP. Therefore, we estimate that real estate investment makes up about 5-6% of real GDP and a 20 pp decline in its growth rate reduces its contribution to GDP growth by about 1pp (5%*20pp)