China formalises restricted capital outflow

Via AFR:

The Chinese government has moved to halt “irrational” overseas investments by restricting purchases of real estate and entertainment assets, a decision which could dent demand for Australian assets.

The move, designed to curb capital outflows and lessen downward pressure on the Chinese currency, also compels mainland companies to align themselves more closely with Beijing’s foreign policy objectives.

The State Council said it would encourage companies to invest in the $1 trillion One Belt One Road infrastructure initiative, which aims to improve China’s trade links with Europe, Africa, South East Asia and the Middle East.

The Turnbull government has not formally signed up to the initiative despite a desire by Beijing to link it with Canberra’s $5 billion Northern Australia Infrastructure Facility.

The new investment guidelines formalised a series of edicts issued by regulators over recent months and included a list of “banned, encouraged and restricted” areas for investment.

Hotels, sporting teams, cinemas and the broader entertainment sector were on the restricted list, while investments in casinos and defence technology were banned.

However it has encouraged deals in high technology, advanced manufacturing, agriculture, some areas of the service sector and oil and gas.

“This will lead to more rational investments … after a period of crazy acquisitions at any cost,” said Zhang Yansheng, chief economist at the Beijing-based China Centre for International Economic Exchanges.

“In the short term there will be fluctuation in China’s investment in Australia, but I’m sure over the longer term there will be a steady increase.”

The obvious risk for Australia is an exacerbation of the commercial property cycle where we’re already set for a dwelling construction bust. Here’s some details from UBS from late last year on this:

Non-mining business investment has been relatively weak since the GFC, with its current 9% share of nominal GDP near the lowest on record (Figure 2), and real activity showing no (net) growth in the last 6 years (Figure 3). Indeed, construction and capex ‘partial data’ showed a (largely unexpected) sharp drop in Q3-16.

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However, the key leading indicator of private non-residential building approvals spiked in recent months to a record high (albeit still only ~1% of GDP, vs dwelling investment near ~6% of GDP), its best uptrend since the GFC (Figure 1). Given its strong causality to non-residential building investment – a significant 21% of total capex, but still the ~same level as its pre-GFC peak (Figure 4) – this suggests activity should rebound sharply in coming quarters (post a likely drop in Q3-16). Within non-residential approvals, there is broad improvement over recent months. Notably, commercial property (the largest sub-category) also finally rose, after being stuck near the same value as a decade ago (Figure 5). Indeed, even offices edged up, albeit still only ~half the pre-GFC peak. (In contrast, residential approvals peaked.) By State, approvals lifted most in NSW & Victoria (Figure 6).

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We also note the ABS capex survey showed material improvement of non-mining capex intentions in the last 6 months, with implied nominal growth for 16/17 now seen down ‘only’ 2% y/y, albeit the last print was disappointingly softer (Figure 7).

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This suggests that after a long period of low investment activity in offices, which combined with record low interest rates saw prices surge in recent years, there are signs of upward pressure on office rents (Figure 8), amid lower than expected vacancy rates (see UBS REITS research). (We note that listed REITS price moves have been more correlated with bond yields than a change in underlying asset values.) Overall, the bigger driver of the overall economy and balance sheets in recent years has been housing (see UBS housing ‘supply tracker’: upgrading again… the boom is even bigger). Indeed, dwelling prices re-accelerated to a strong 9.3% y/y in November, post the RBA’s rate cuts (Figure 9), and physical activity is around a record high level, with the peak of completions/supply not until 2018. However, the ‘boom’ is shifting. While existing CP already saw prices spike, the approvals data suggests this will start to be combined with rising ‘new’ activity ahead.

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Notably, APRA-regulated Authorised Deposit-taking Institutions’ (ADIs) exposure to CP within Australia spiked ~10% y/y in Q3-16, the fastest since the GFC, to a record high level of $221bn (albeit still only ~14% of the size of housing credit), with total CP exposures up to $260bn (Figure 10). Indeed, foreign banks subsidiaries & branches spiked 53% y/y, to the highest level since the GFC, albeit growth of ‘domestic’ ADIs’ exposures eased to a multi-year low of ~5% y/y. Interestingly, with APRA ‘capping’ investor housing credit growth at 10% y/y since late-2014, despite still fast dwelling prices growth recently, there has been a slowing trend of overall housing credit to a 2½-year low of 6.4% y/y in Oct-16. This is now the furthest below the pace of CP exposures since the GFC (Figure 11).

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The sharply increasing ‘supply’ of foreign bank lending to CP follows a sustained period of strong foreign ‘demand’. Indeed, FIRB approved foreign investment in CP lifted to $25-$30bn p.a. in the last 4 years (Figure 12, vs. housing at $61bn in 14/15), with transactions of foreigner purchases spiking to a record high last year. Overall, both housing and CP markets have become increasingly driven by foreigners, and this raises their sensitivity to foreign capital flows and interest rates.

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Chinese property developers have been the marginal price setters in this commercial property cycle. Take them out and prices are going to fall.

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