APRIL 2013

GLOBAL INSigHT SPECiAL REPOrT

CHiNA PrOPErTY MArKET

BY JAY

ROBErTS & YUFEI YANG, HONG KONG, ChINA, RBC Dominion Securities Inc.

 At a time when much of the worlds economic burdens sit on Chinas shoulders, the

IN ThIS REPOrT
Introduction The Chinese Housing Market in Context Shenzhen: A Case Study Concerns About the Property Market Property Prices and Inventory The Government & Housing Recent Initiatives to Cool the Market Outlook: Short Term Outlook: Long Term 3 4 5 6 11 12 14 15 16

countrys property market has become a ash point for investors and a pivotal battleeld between China bulls and bears.
From so-called ghost towns, to property speculators, to the shadow banking system, to

the impact of corruption, we address the major concerns surrounding Chinas property market.
We also examine whether the property boom is justiable based on growth and income

trends, and dig deeper into the governments attempts to inuence housing prices.
Finally, we discuss the short- and long-term outlook for Chinas property market,

including whether there are enough catalysts to drive additional demand.

Conclusion 17

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Putting Challenges in Perspective
JAY ROBErTS HONG KONG, ChINA jay.roberts@rbc.com; RBC Dominion Securities Inc. YUFEI YANG HONG KONG, ChINA yufei.yang@rbc.com; RBC Dominion Securities Inc.

INTrODUcTION
The Chinese property market is perhaps the most widely discussed in the world. This is certainly the case for global investors who are trying to understand the path ahead for the worlds secondlargest economy and biggest contributor to global GDP growth. It is impossible, for example, to form a view on many commodities such as copper and iron ore without first having a view on China, the single-largest consumer of most industrial commodities. The stakes for investors, though, go beyond commodity demand. At a time when the world is starved of economic growth, more now lies on Chinas shoulders than ever before. In recent years, the property market has become a flash point that has come up time and time again in the financial press. It has become a pivotal battlefield between China bulls and bears. This discussion is often long on hyperbole. Dramatic prognostications abound for the Chinese property market: prices are rising, theres a bubble; prices are falling, the end is near. Videos of so-called ghost towns in Inner Mongolia in the north of China, or the worlds biggest shopping mall lying empty in Guangdong province in the south, cause fear among audiences thousands of miles away, most of whom have never been to China. Someone from afar may ask, Is it all like that? The question is valid. Could it be that the Chinese growth story is little more than a mirage? Well, no, its not all like that. China's 1.35 billion people have to live somewhere. The boom in Chinese property in that respect is different to booms in countries that are already developed. China is home to a huge number of people that have lived in a highly sub-standard housing environment for a long time. Coupled with the unprecedented industrialization, urbanization, and wealth creation that are ongoing in Chinaas well as limited domestic investment opportunities and a desire to own propertythe ingredients for a volatile housing market are clear for all to see.

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Chinas Industrial Commodities Consumption as a Percentage of Global Demand

100% 80% 60% 40% 20% 0% 89% 11% Oil (2010) Coal (2011) Iron Ore (2011) Copper (2012) 39% 54% 46% 61% 57% 43% Others China

That said, poor planning and speculative excess have impacted the market. Moreover, housing market problems in the West over the past five years have cast a long shadow for investors with respect to their perspective on Chinas position.

The municipality of Chongqing is home to more than 30 million people. The disparity between cities and provinces can be immense. Lets put the Chinese property market in some historical context, and turn the clock back to 1949. The Chinese Communists have taken power and established the Peoples Republic of China (PRC) on October 1. After hundreds of years of perceived imperial cronyism and feudal oppression, a populist group is now in power. Landlords are identified as bourgeois enemies of the people and the revolution. The government takes over all land holdings and ostensibly distributes them to the people. Communesgroups of people living together and pooling resourcesare formed all over the country. Those entering the commune give up their land titles. Private property rights are, at best, a vague concept. There isnt much codified law of any kind, let alone with respect to property. Ultimately, ownership and control of economic assets, including property, is with the ruling party, despite its populist credentials. In 1949, Chinas population is 540 million. There are approximately 130 cities, but only 10% of the population lives in those cities. Access to cities is strictly controlled via the hukou or registration system. This is basically a form of control over population movement and still exists today. (People can now move into a city if they do not have the relevant hukou, but access to the citys resources, such as education and health care, are limited.)

ThE ChINESE HOUSING MArkET IN CONTEXT

There are a number of reasons why the property market in China causes so much confusion. It boils down to the following: the market is so large and varied across the country it defies simple explanation; for historical, social, and legal reasons, there was a dearth of housing development in China for many decades, thus providing a fundamental justification for the building boom in recent years; Chinas rapid economic growth, which has led to wealth creation on an unprecedented scale in terms of the number of people lifted out of poverty; and a lack of investment alternatives for capital in China. Market size does complicate analysis. We are talking about the living conditions of one-fifth of the worlds population. Chinas population of 1.35 billion people (official estimate for end of 2012), which is still growing modestly, is four times that of the U.S. and nearly 40 times the population of Canada. Just over one-half of these people live in over 650 cities in China, the rest in the countryside. There are around 100 cities with a population greater than 1 million people. Some have populations numbering well over 10 million.

Source - BP - Statistical Review of World Energy 2010, International Energy Agency, Ministry of Industry and Information Technology of China, International Corporate Services Group

Chinas Contribution to Global GDP Growth

80% 70% 60% 50% 40% 30% 20% 10% 0% -10% 1990 1993 1996 1999 2002 2005 2008 2011

Source - International Monetary Fund (IMF), World Economic Outlook Database, October 2012

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China's Population 1949 to December 2012

1600 1400
Millions

1200 1000 800 600 400 1949 1959 1969 1979 1989 1999 2009

The population size grows quickly to 650 million from 540 million by 1957. Still, only 15% of the population is in the cities. The country remains largely agrarian, rooted in communes. In 1958, Chairman Mao Zedong encourages population growth as part of an ill-fated policy called The Great Leap Forward. It is 1970, and the population has exploded to 830 million. By 1980, the population is slightly less than 1 billion. There are fewer than 200 cities at this point. Mao dies in 1976. In 1979, with Chinas population at slightly less than 1 billion, Chinas new leader, Deng Xiaoping, decides to put the country on a completely different path labelled gaige kaifang, or the opening up reforms. One aspect of this is to grow and modernize Chinas cities. This marks a historical and highly significant move away from the previous focus on communes. In the next 20 years, the number of Chinese cities grows by over 400 to around 670. China mega-cities also develop. The population reaches 1.14 billion by 1990 and 1.26 billion by 2000. In 2013, there are 1.35 billion living in China, nearly three times more than in 1949. Over the last 20 years, there has been an emergence of private property laws. Industrialization, urbanization, and wealth creation have occurred on a vast scale powered by a huge pool of labour, an entrepreneurial people, and a government that can effect change and development very quickly due its monopoly on power. Naturally, this huge populace,

deprived for so long of modern accommodation, wants to upgrade. The housing market takes off. The number of property developers mushrooms. The number of cities remains fairly steady, but the percentage of the population living in cities continues to rise to over 52% in 2012.

ShENZhEN: A CASE STUDY

A good case study of the unprecedented changes in China since 1979 is the city of Shenzhen, which borders Hong Kong in the far south of China. In the 1980s, Shenzhen was a fishing village. Under Dengs reforms, Shenzhen became Chinas first Special Economic Zone. Today, it has a population of more than 10 million people and is the base for several of Chinas largest and best-known companies. These include Ping An Insurance, Chinas secondlargest insurance firm; Tencent, Chinas largest Internet company by market value; and Foxconn, which builds products for Apple, Amazons Kindle, and Sonys PlayStation. Foxconn employs several hundred thousand people in Shenzhen and is Chinas largest private-sector employer. Despite the fact Shenzhen is in Guangdong province, the home of the Cantonese dialect, most of its residents speak Mandarin, as they have migrated from other Mandarin-speaking parts of China. Almost every residence in Shenzhen for these 10 million newcomers has been built over the past 30 years. (More than one-half the population is migrant workers who live in dormitories and the like.)

Source - National Bureau of Statistics of China; data through December 2012

Chinas Gross Domestic Product

9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 1960

US$ Billions

1970

1980

1990

2000

2010

Source - World Bank; data through December 2012

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CONcErNS ABOUT ThE PrOPErTY MArkET

Shenzhen Then and Now
early 1980s ...

Concern 1 Ghost Towns At the more-extreme end of things, pictures and videos of empty buildings and even entire towns bereft of residents leave distant audiences in fear of Chinas ghost towns. We view such projects as either failed anomalies or works in progress. They are either the result of simply poor planning by certain local governments (perhaps even an effort to inflate local GDP figures) or traits of Chinas centrally planned economy. Also, empty buildings have a habit of filling up after a while (although there are notable exceptions to this). Shenzhen, in its day, had many empty towers. Its not easy building a city for 10 million people in a couple of decades. And, to be fair to provincial leaders, there are many more examples of entirely new areas being successfully planned, developed, built, and populated than there are of ghost towns. Perhaps the most famous ghost town in China is Ordos in Inner Mongolia. In fact, Ordos City covers a huge area divided into eight districts that have a combined population of 1.6 million people. Dongsheng is the metropolitan heart of Ordos and has a population of nearly 600,000. It is the Kangbashi New Area, a suburb built by the local government to develop a modern city, that is the ghost town. The local government plans to have, eventually, at least several hundred thousand people living there. However, the current population is just a few thousand people, most of whom are government employees that have been relocated. Kangbashi, with its thousands of houses,

Recently ...

Concerns abound over the outlook for the property market, including whether prices are excessive, whether supply is excessive, the extent of speculation, the impact of corruption, the importance of the housing market to local government financing, the potential impact of a pronounced housing downturn on banks, what a downturn in housing would mean for Chinese growth, and the influence of the property market on the equity market. The list goes on. The chairman of Vanke, Chinas largest property developer, recently noted China was caught in a property bubble. (Although somewhat confusingly, during Vankes last earnings call, management was optimistic about the 2013 outlook.) Such concerns are one reason why big Chinese banks are trading at very low valuation multiples. We will address a number of these issues. In the big picture, though, a counter argument to the overarching tone of these concerns is China is still only about half way through its urbanization process. 100 million people are forecast to become urbanites in the next decade alone. This, combined with very strong per-capita income growth, will continue to create real and significant demand for housing. The propensity for central planning adds an extra dimension to the process, too. In no particular order, the following are some of the major concerns, and our thoughts, regarding the property market.

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Chinese Ghost Towns

flashy buildings, and facilitiesit even has an art museumlies mostly empty. Interestingly, Ordos has one of the highest per-capita income levels in the country. The surrounding area is rich in natural resources, containing over 15% of Chinas coal reserves. However, the expansion of the Ordos desert has put pressure on water supplies. Ordos wealth has been key to the local governments ability to fund the Kangbashi project, while the water issue provided a catalyst. But local people have been reluctant to relocate to Kangbashi, initially for no other reason than its 25 kilometer distance from Dongsheng. Presumably, relocation then became even less appealing as Kangbashi stood empty. Other ghost town names frequently mentioned include Chenggong District in Kunming, Yunnan province, Yujiapu in Tianjin, and the Zhengdong New District in Zhengzhou, Henan province, along with the Dongguan New South China Mallthe world's largest mall based on gross leasable space which has been 1% occupied since its 2005 opening (looking like a colossal failure). One logical point to think about is if housing supply across China was indeed so ridiculously excessive, one would have expected an impact on prices by now, especially as the government has tightened the policy screws over the past several years. The issue of ghost towns has been around for quite a while. Generally, though, prices at the national level have remained steady over the past couple of years.

Concern 2 Investment and Speculation: The fact that speculative investment activity is wide-spread in the Chinese property market is of much greater concern than the ghost town phenomenon, which gets more headlines as it is visible and extreme. The line between speculation and investment when it comes to property in Asia is not well defined. Investors generally love to buy property. Talk to a (very) wealthy person in Hong Kong, for example, where property prices really are extreme, and the chances are they own multiple properties. Generally speaking, there is a greater distrust of paper assets than in the West and, consequently, a preference for real assets. For example, Chinas consumption of physical gold rose by around 300% from 2003 to 2011. We do not know how much housing demand in China is real demand for accommodation, how much is for investment, and how much of such investment is actually speculation. However, it is clear investment and speculation are widespread. The most persuasive indication of this is the central government in China deems it to be a big enough issue to have introduced many specific policies to curb such activity. However, one extremely important point to consider in regard to speculation is there are strict and very sizeable requirements for down payments on mortgages (usually about 30%), especially for nonprimary residences (sometimes as much as 70%). In the event of a serious downturn in the market, this would make it much harder for speculators

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Household Debt Level as of % GDP

120% United States 100% 80% 60% 40% 20% 0% Mar-09

to walk away without bearing a considerable loss themselves. In that case, a downturn in the property market might be analogous to a downturn in the equity market when one uses a margin account: ugly but manageable insofar as the individual bears the losses. Concern 3 The Banking Sector There is a major concern that if China experiences sustained weakness in the property market, it would lead to a meltdown in the banking sector. The risk posed to the financial sector, though, is different to that faced by banks in the U.S., for example, during the last recession. There, eroding lending standards and the overuse of sub-prime as well as various little-to-no-money-down mortgages led to people buying homes they could not afford and taking on financial commitments they could not sustain. When house prices declined substantially, such homeowners went into deep negative equity. The incentive to post the keys back to the bank and force the loss on the lender grew as the market declined. This had a much bigger consequence of concentrating the majority of billions of dollars of losses onto the books of a relatively smaller number of firms. Banks rapidly raised lending standards which, combined with falling prices, pushed many more mortgages, prime and sub-prime, underwater. Mortgage lending in China is plain vanilla. Additionally, down payment requirements are large. In a major downturn in the housing market,

it would be the homeowners who would be left carrying the can more so than the banks. Clearly, such a situation would still be negative for the broader economylosses are lossesbut not in the self-reinforcing way that acted to push prices even lower in the U.S. experience. Additionally, it is important to note consumer debt is a relatively new phenomenon in China. The consumer remains underleveraged (see chart). Concern 4 Shadow Banking Unfortunately, while Chinese consumers are underleveraged and mortgage down payments are indeed large, China has other, unique risks to its financial services sector and economy via its property market. A number of unorthodox lending channels in China boomed over the past few years. These are broadly labelled shadow banking, a catch-all term that is not well defined. Shadow is a misleading name, we would argue, as it clearly implies something shady or improper, and that is not necessarily nor usually the case. Shadow banking includes: the trust sector; offbalance sheet lending by commercial banks; financing vehicles used by local governments (Chinese law prohibits most local governments from issuing bonds); informal, or underground, lending between two discrete parties; and other items. The biggest areas of shadow banking are the trust sector which account for around one-third of assets and certain bank wealth management products which are another one-third of assets.

China

Dec-09

Sep-10

Jun-11

Mar-12

Dec-12

Source - Bloomberg, IMF, People's Bank of China, data through December 2012

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When the government cut property developers off from the banks, developers turned to other avenues for nancing, including trusts. In 2007 and 2008, the trust sector had around $160 billion in assets, and rose to nearly $1.2 trillion by the end of 2012.

In 2012, a significant part of Chinas credit growth was via shadow banking. According to our correspondent research provider, the shadow banking market is estimated to be over RMB20 trillion (US$3.2 trillion). A full discussion of the sector is beyond the scope of this article, but we shall touch on two aspects. Trust Sector: Trust financing has various permutations, but at its root it is a way to distribute capital without directly using a banks balance sheet. Trust financing in its current form in China began to expand around 10 years ago, although there have been previous waves. However, it grew rapidly after the governments fiscal stimulus package in 2008-2009 had the unwanted side effect of inflating property prices. The key reason for the sectors growth over the past few years was that in 2010 the government severely restricted bank lending to the property sector and to local governments (who are responsible for much of the countrys infrastructure spending). In 2007 and 2008, the trust sector had around RMB 1 trillion (US$160 billion) in assets. This had risen to RMB 3 trillion by end of the 2010 and nearly RMB 7.5 trillion (US$1.2 trillion) by the end of 2012. Two-thirds of this is lending to local governments and property developers. Banks had been the main conduit of capital distribution in the economy until that time. When the government cut property developers off from the banks, developers turned to other avenues for financing. In addition

to the rapid growth in trusts, there has also been rapid growth in the issuance of Chinese property developer bonds. Trusts can be passive (single-unit trusts) or active (collective trusts). About 75% of trust assets are passive and 25% are active, with active trusts growing more quickly. For passive trusts, the trust distributes capital, that someone else has raised, to borrowers. For active trusts, the trust company does everything including raising and managing the funds. When the trust partners with a bank, it is generally passive in nature and distributes the capital according to where the bank wants it to go. Because the bank is putting money through a trust and not lending directly, it can bypass central government-mandated loan quotas or lending restrictions. These kinds of arrangements with banks are probably reasonably regulated, according to research sources. Other types of trust arrangements, such as when the lender is a nonbank institution, are less well regulated. These lead to a key pointthere is nothing necessarily wrong about the trust sectors existence. The question is, is the sector being regulated and monitored sufficiently? Wealth Management: One of the biggest concerns regarding the shadow banking system is the development of certain types of wealth management products. An example might be

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It is unclear what controls are in place for Chinas property-related wealth management products. One could easily imagine someone buying such a product from a bank might mistakenly think the bank would be liable for the product if something went wrong.

when a bank partners with a trust to provide money to a third party and, in doing so, creates a product that is then sold to investors. This includes individual investors. Note that with respect to the property market in particular, this is not pooling mortgages and dividing them up into securities for onward selling to institutions (e.g. mortgagebacked security [MBS]). This is the reverse: pooling loans to firms, dividing them up, and then onward selling to individuals. One issue is whether the investor understands what he/she is buying and the associated risks. As these are widely sold (via banks), it is highly unlikely everyone buying them has full understanding of what they are. The government is partly responsible for this development, though, as it keeps depositors out of pocket with very low bank deposit rates in a fairly high inflationary environment. Depositors have looked for yield elsewhere. Better regulation of wealth management products on the occasion where banks partner with trust companies began in 2010. But these products are originated by the bank. It is unclear what controls are in place for wealth management products produced only by a collective trust that are then distributed by the bank (i.e., the bank is passive). One could easily imagine someone buying such a product from a bank might mistakenly think the bank would be liable for the product if something went wrong. This is very similar to the minibond saga that rocked Hong Kong for several

years during and after the financial crisis. Lehman Brothers investment bank structured fairly conservative products (linked to some big Chinese companies) that paid a single-digit annual return. These were widely sold to individual investors via various retail and commercial banks in Hong Kong under the misleading name of mini-bonds. In fact, they were structured notes. When Lehman went bankrupt, investors discovered these were not bonds at all. The subsequent public outcry, aimed mostly at banks that had distributed these products, was vociferous and unrelenting. Eventually, investors got most of their money back. We are not saying these wealth management structured products are being mis-marketed as mini-bonds in China, nor are we evaluating the risk of such products or forecasting something will blow up. The point is that public outcry, if and when things do go wrong and investors get burned, would likely be large, to say the least. In such circumstances, it is unlikely the public would be forced to bear all the losses, according to Hong Kongs experience. One important reason we discuss this here is the size of the market for shadow banking wealth management products is gigantic. Official government figures for 2012 put the size at RMB7.5 trillion (US$1.2 trillion). In a somewhat ironic twist, the government ultimately has caused the explosion in trust financing and shadow banking by placing muchstricter controls on bank lending.

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Concern 5 Criminal Activity Chinese Urban Household Disposable Income Growth

25,000 20,000 15,000 10,000 5,000 0 1978 1982 1986 1990 1994 1998 2002 2006 2010

Source - National Bureau of Statistics of China; data through December 2012

Chinas Secondary Home Price Index (2006 2012)

150 140 130 120 110 100 90 2006 Beijing Shanghai Guangzhou Shenzhen Tianjin

China has a big corruption problem in many areas of the economy. This trait is unfortunately shared among many emerging market economies; China just happens to be the biggest of them. Corruption and fraud have certainly permeated the property market. One of the more-common fraudulent techniques is to use multiple, fake IDs to get around restrictions on the purchase of multiple properties. A couple of cases have become famous in China. Ms. Gong Aiai, a former deputy head of Rural Commercial Bank in Shaanxi province and now known as House Sister in the press, is alleged to have fraudulently amassed 41 properties in Beijing worth tens of millions of dollars using multiple IDs. There are also other well-known cases involving House Brother, House Uncle, and even House Ancestor.

300% in Tianjin. At first glance, these are scary numbers. However, on a nationwide average China has over 650 cities, not just very expensive Tier 1 citiesaffordability of housing in China has actually modestly improved over the same time period. China housing, on average, costs six times household income, steady from about six times in 2004, but down from eight times at the end of the 1990s. The reason for improved affordability despite rising prices is because urban household disposable income (UHDI) has also been growing strongly, on average, at a high, single-digit rate per annum over the past 20 years. In the early 1990s, UHDI in China was about RMB10,000 (about US$1,600 at todays exchange rate) per annum. By 2011, it had risen to RMB63,000 (US$10,100), an increase of more than 600%. Income growth has remained robust in recent years. In 2004, UHDI was about RMB30,000 (US$4,800). So, from 2004 to 2011, UHDI doubled, implying an average compound annual growth rate of 8%. Note, though, the average hides huge differences between urban citizens and rural citizens as well as wealthy cities and poorer cities. As noted earlier, house prices in key cities have risen by much more than 100% since 2004, far outpacing growth in UHDI. Affordability in these cities has generally gotten worse, not better. (However, this varies markedly from one city to another. Affordability has gotten much worse in

PrOPErTY PrIcES AND INVENTOrY

Chinese cities are commonly categorized as Tier 1, Tier 2, or Tier 3. Tier 1 cities are the biggest, including Beijing, Shanghai, Guangdong, and Shenzhen. Tier 2 cities are those that are regionally important, and so on. As one would expect from a fast-growing economy such as China, property prices have registered robust growth for many years. Using secondary housing prices (as opposed to primary, or newly built, units), since 2004 prices have risen by more than 150% in Shanghai; more than 200% in Beijing, Guangzhou, and Shenzhen; and by nearly

2007

2008

2009

2010

2011

2012

2013

Source - Wind

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100 Cities Housing Price Index: Tier 1, Tier 2, Tier 3 (% change m/m)
2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11 Mar-12 Jul-12 Nov-12 Tier-1 Cities Tier-2 Cities Tier-3 Cities

Shenzhen, but only moderately so in Guangdong, despite the cities being only 70 miles apart.) There have been phases where price growth has been excessive. The most recent example was from early 2009 to early 2011 when prices in Chinas key cities rose by over 90%. Part of this was due to the sluggish or even negative performance of prices in the two years prior to 2009 as global economic activity peaked, the global financial crisis unfolded (hitting Chinas manufacturing and export sectors hard), and an earlier raft of tightening policies in the housing market took effect. Part of it was because Chinas large, fiscal stimulus package then gave a bid to real assets. The rapid rise in prices through to 2011 eventually led to meaningful government tightening in the sector. Primary house prices in Tier 1 cities trended downward to about RMB13,000 (US$2,100) psm by early 2012 from around RMB15,000 (US$2,400) per square meter at the start of 2011. Prices then picked up again, and at the end of 2012 were back to about RMB15,000 (US$2,400). Prices have since showed real strength in the last few months, and the government has stepped back into the fray. However, a closer look at Tier 1 cities shows that average can be misleading. For example, primary house prices in Beijing rose by 10% in 2011 but fell 7% in 2012. In Guangzhou by comparison, prices fell by 8% in 2011 but rose by 11% in 2012. In Hangzhou (not Tier 1, but a big city), which has been one of the more-volatile housing markets, prices declined by 21% in 2011 but rose by 27% in

2012. In Tianjin, a Tier 1 city, prices rose by 5% in 2011 and 2% in 2012. Prices in Shanghai fell by 8% in 2011 and 1% in 2012. Clearly, regional differences play a major role in the housing market. Even within the same city, house price data may be misleading. For example, housing developments that are increasingly concentrated in the cheaper, outlying areas of a city will make the average price appear lower. Alternatively, when the market improves, developers may bring higher-priced housing to market, pushing up the average selling price. Primary house prices in 2011 and 2012 were relatively stableon averagein Tier 2 cities (around RMB6,300 psm) and Tier 3 cities (RMB4,000 psm). One interesting point around relatively stable housing prices in Tier 2 and Tier 3 cities was sales volumes notably declined as the government turned the policy screws in 2011. Inventory levels of new housing stood between seven and eight months of demand at the end of 2012, down by several months from the end of 2011.

Source - Soufun

100 Cities Housing Price Index: Average Selling Prices

RMB per square meter 30,000 27,500 25,000 22,500 20,000 Jun-10 Dec-10 Jun-11 Beijing (left axis) Shenzhen (left axis) Guangzhou (right axis) RMB per square meter 16,000 14,000 12,000 10,000 8,000 Dec-11 Jun-12 Dec-12 Shanghai (left axis) National Average (right axis) Tianjin (right axis)

ThE GOVErNmENT & HOUSING

The table on the following page highlights some of the measures that have been introduced nationally over the years to control the market. Note, though, in times of market weakness, the government has also taken measures to support the property market.

Source - Soufun

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Property Tightening Measures

Timing 2004 China Property Policy Introduced Loan-to-value ratio raised to 70% for purchase of second property Forbid land sales through private negotiations; to take back land if sitting idle for two years; monthly payment limited to 50% of household income Mortgage rate hike (5.31% to 5.51%); Shanghai raised down payment requirement to 30% 5.5% capital gain tax on residential property sold within two years of purchase "8-point measures"; Resale of uncompleted units banned Deed tax raised to 3% for non-ordinary housing "6-point measures" 90/70% rule "5-point measures"; 5.5% tax on sales for flat resale within five years Foreign fund restriction followed by capital gain Increase land use charges and resettlement compensation Enforcement of LAT Increase down payment requirement for second home to 1.1 PBoC rate Enforce idle land penalty Ban IPO proceeds to buy land Allow foreign companies to register at provincial levels Rmb 4 trillion stimulative measures Minimum capital requirement lowered to 30% from 35% Rmb 900 billion public housing plan CBRC reiterates 40% down payment requirement for second home mortgage Reduction of transaction tax on resale of homes Sale lock-up period restored to five years from two years "11-point measures" 70% land supply on small-size and public homes New "10-point measures" Second home buyers defined Government issued reinforcement measures New "8-point measures" Shanghai and Chongqing levy real estate tax 2013 Five directives by Premier Wen "5-point measures"; tightening second home loan; 20% income tax on capital gain

The most important things to point out with respect to government policy are: the government closely monitors the housing market and clearly has a fear of runaway prices; Chinese leaders at the highest levels have provided a consist barrage of rhetoric to the public with respect to the leaders desire to control excessive gains in prices; a wide range of national and local policy initiatives have been implemented over the past decade to control the housing market; the central government has consistently pushed local governments to follow policy; recent policy initiatives are becoming more localized and flexible to take into account different dynamics between cities; and the government, through its actions, has demonstrated its ability to significantly influence the housing market and, consequently, has credibility in the eyes of the market in that regard. One notable point of comparison between the Chinese situation and the situation in the West with respect to frothy housing markets over the past few years is the direct involvement of Chinas government at the national and local levels to attempt to exert some control. In the West, the situation has broadly been left in the hands of market forces. While these points are generally positive, there are also a number of counterpoints: local governments are incentivized to keep land prices high and the property market moving because nearly one-half of their revenue comes from selling land to developersmost local governments cannot issue bonds, and most tax revenue is collected by the central government; consequently, the power of local governments is not to be underestimated; corruption is rife; just because the central government is focused on the property market does not mean it will be successful in fine-tuning the marketthe central government is dealing with a unique, huge market with many moving parts; people are constantly finding ways around government controls; land reclamation by the government against the wishes of local residents is often cited as one of the most widespread human rights violations in China. For more on this final point, type China nail houses into Google and take a look. There are several major objectives of government policy with respect to the housing market: to stabilize prices, to reduce speculation, and to meaningfully increase the supply of affordable housing.

Source - China State Council; People's Bank of China; National Development & Reform Commission

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Price Stabilization This is arguably the most important goal of policy. As the Chinese property market is relatively new, huge, and complex, property prices have gone through periods of fairly rapid inflation and weakness. Stable prices indicate a stable market and reduced risks. Some have argued the government is seeking to engineer stable prices while promoting robust income growth. Over time, this leads to improved affordability. The approach of the government is likely more refined than this. Modest price appreciation is allowedperhaps even desirableas long as it does not outpace income growth and, thereby, impact affordability. Indeed, this year, the central government has requested local governments submit housing price targets for the year. Reduced Speculation

some existing projects have simply been relabelled affordable to meet the governments demands. Even so, there is a push to introduce a significant number of new units. In 2013, for example, the government is targeting to begin construction on six million new units and completing 4.3 million according to Jiang Weixin, minister of housing and urban-rural development. Officially, the government claims to have completed six million units in 2012, having allocated US$37 billion during the year to such projects. Demand for affordable housing is huge. Hundreds of millions of people still earn very little, and many live in inadequate conditions, such as small, old housing units or dormitories. Many people living in the cities still do not own their own property.

The recent Notice from Chinas State Council clearly reminds investors the government is still rm in its resolve to control the housing market.

As discussed, the line between speculators and investors is, at best, blurred. There have been many policy initiatives over the last few years targeted specifically at speculators such as restrictions on the purchase of second and third homes and significant increases in required down payments for mortgages for such homes. Affordable Housing In 2011, former Premier Wen Jiabao announced China would seek to improve living standards by embarking on a huge project to build 36 million units of affordable housing by 2015. Some have said the target is beyond reach. Others have noted

REcENT INITIATIVES TO COOL ThE MArkET

On March 1, after several months of data showed a resurgence in Chinese house prices, China's State Council issued a Notice with more specifics regarding market controls. While much of this was either a reiteration of existing policy or a broadening of existing initiatives, it clearly reminds investors the government is still firm in its resolve to control the housing market. There were three areas in particular of note. The first was clarification regarding "home purchase restrictions" (HPRs), a range of policies such as

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The government has a ne line to walk. Excessive house price ination would clearly lead to further problems down the road. Too much tightening, though, leading to a big decline in prices, could have challenging consequences.

limiting the number of properties someone can buy and increasing down payment requirements. HPRs are in place in 46 Chinese citiesacross the whole city in 12 and in parts of the remaining 34. These 34 will now have to widen their HPRs to cover the whole city. While this is clearly a headwind for the housing market in those cities, there are a few points to note. First, China has more than 650 cities, so the widening of HPRs affects about 5% of the total. Second, a number of the biggest cities already have HPRs across the whole city, including Beijing, Shanghai, Tianjin, Shenzhen, and Wuhan. Chongqing, China's largest municipality, does not have any HPR policy in place (but it is one of the few Chinese cities to have a property tax). Of the 34 cities that will have to widen HPR to cover the whole city, most have them in place in the downtown area. The second policy was the strict enforcement of a capital gains tax of 20% payable if a property is sold within five years. This policy was introduced a number of years ago. The difference is the central government is now looking to local governments to enforce it strictly. This is a meaningful move by the government, although we would point out it should not impact fundamental demand but rather is targeted at speculative demand. The third policy concerned credit tightening. The Notice says banks can increase mortgage down payment requirements for second mortgages. What is notable about this is it shows policy is becoming

increasingly localized, presumably in order to deal with the disparity between different cities. The government also encouraged cities with oversupply and where pricing is weaker to support their housing market. All in all, the measures in the Notice are more than was expected, but, for the most part, remain a reiteration of previous policies combined with a fine-tuning of policy at the local government level.

OUTLOOk: ShOrT TErm

Over the past few months, the sector has shown some strength. Housing prices have been moving up, and the government has been more vocal. The government is set to remain vigilant on prices; excessive prices gains will inevitably lead to further policy tightening. The government has a fine line to walk in controlling Chinese housing prices. Excessive house price inflation would clearly lead to further problems down the road. Too much tightening by the government, though, leading to a big decline in prices, could have challenging consequences. It is unlikely China would go through the U.S. experience of mass defaults on risky mortgages, concentrating losses in the banks. However, the Chinese housing market is a large chunk of Chinas fixed asset investment and, therefore, growth. It also impacts consumer discretionary spending and influences the performance of the equity market.

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Chinese Urbanization versus South Korean Urbanization

90% 80% 70% 60% 50% 40% 30% 20% 10% China (1980-2012) South Korea (1970-2011)

Also, if losses were to hit the trust sector and the wealth management products tied to housing, it seems losses would not be concentrated in the financial sector, but rather to a more-dispersed group of investors. This would have a different set of consequences.

OUTLOOk: LONG TErm

There are two drivers that will lead to significant demand for housing in China over the long term: urbanization and income growth. Urbanization Unsurprisingly, the majority of housing is built in Chinas cities. The cities are growing in terms of people moving from the countryside, either permanently or temporarily. This accounts for about one-third of the increase in the urbanization level. The other two-thirds occurs when existing cities expand and engulf smaller communities that exist on their edges. Chinas urbanization trend still has a long way to go. Approximately 53% of the population live in cities. This has risen by about 1% per year for the past 30 years. At the beginning of the opening up reforms of Deng Xiaoping in 1979, only 20% of the population lived in cities. Approximately 700 million people live in cities and 650 million live in the countryside. While levels of urbanization vary across developed countries, it seems unlikely China has reached its urbanization limit. Indeed, new Prime Minister

Li Keqiang has emphasized the importance of urbanization to sustain the next leg of Chinese growth. By comparison, more than 80% of the populations in the U.S. and South Korea live in cities, and over 90% in Japan. Assuming Chinas urbanization rate eventually gets to 70% or higher, at current rates, this would still take another two decades and mean an additional 17% of the population, or 230 million people, would become urbanites and require housing. In short, there is a clear, long-term need for significant growth in Chinas housing stock. Income Growth In the Chinese governments 12th five-year plan, a target was set to double per-capita income in China by 2020. For all of its fabled growth over the past three decades, China per-capita income remains low with plenty of room to grow. Thus, with incomes potentially doubling by 2020 and approximately 6-8%, or 80-110 million, of the population transitioning to Chinas cities over the same time period, the natural bias will be for house prices in China to continue rising. Finally, one important development to watch over time will be the introduction of property taxes in China, currently only applied in a couple of locations. On the one hand, this would be a big benefit to local governments and transform their income streams. With 45% of their revenues coming from land sales, local government revenues in China are transactional. A property tax would

Source - Bloomberg, National Bureau of Statistics of China, Statistics Korea

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provide recurring revenue. On the other hand, a property tax would have a really meaningful impact on reducing investment and speculative demand. One reason investment demand is so high in China is the carrying cost of property is not high. A property tax would change that.

CONcLUSION
Chinas property market is enormous, unique, and full of challenges and opportunities. The scale of Chinas urbanization is unparalleled, backed by the biggest population migration in history. And there is undoubted, real and significant wealth creation occurring in the economy. Anyone who has been a regular visitor to China over the past 20 years can attest to that. Yet this unique market carries with it unique risks which we have already outlined. The lynchpin at the centre of the market is the government. What is good is the government recognizes the importance of controlling the property market and has been explicitly attempting to do so for years. What is bad is China needs to maintain high economic growtha crash landing of the economy is probably the biggest single risk to the incumbent Partys hegemonywhich means a continued reliance for some time yet on fixed asset investment growth, which includes housing. If there is a bubble in certain parts of the market, the government will be caught between the need to deflate it and the need for continued growth.

The lynchpin at the centre of the property market is the government.

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ImPOrTANT DIScLOSUrES
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DIScLOSUrES AND DIScLAImEr

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RESEArch RESOUrcES
This document is produced by the Global Portfolio Advisory Committee within RBC Wealth Managements Portfolio Advisory Group. The RBC Wealth Management Portfolio Advisory Group provides support related to asset allocation and portfolio construction for the firms investment advisors / financial advisors who are engaged in assembling portfolios incorporating individual marketable securities. The Committee leverages the broad market outlook as developed by the RBC Investment Strategy Committee, providing additional tactical and thematic support utilizing research from the RBC Investment Strategy Committee, RBC Capital Markets, and third party resources. Global Portfolio Advisory Committee members: Jim Allworth Co-chair; Portfolio Strategist, RBC Dominion Securities Inc. Janet Engels Co-chair; Head of U.S. Equities, RBC Wealth Management Portfolio Advisory Group, RBC Capital Markets, LLC Maarten Jansen Head of RBC Wealth Management Portfolio Advisory Group, RBC Dominion Securities Inc. Mark Allen Portfolio Advisor, RBC Wealth Management Portfolio Advisory Group, RBC Dominion Securities Inc. Rajan Bansi Head of Fixed Income Strategies, RBC WM Portfolio Advisory Group, RBC Dominion Securities Inc. Matt Barasch Head of Canadian Equities, RBC WM Portfolio Advisory Group, RBC Dominion Securities Inc. Craig Bishop Manager, Fixed Income Strategies, RBC Wealth Management Portfolio Advisory Group, RBC Capital Markets, LLC Kelly Bogdanov Portfolio Analyst, RBC Wealth Management Portfolio Advisory Group, RBC Capital Markets, LLC Frdrique Carrier Director, European Equities, Royal Bank of Canada Investment Management (UK) Ltd. George King Head of Portfolio Strategy, Royal Bank of Canada Investment Management (UK) Ltd. Ren Morgenthaler Head of Investment, RBC (Suisse) SA, RBC International Wealth Management Alan Robinson Portfolio Advisor, RBC Wealth Management Portfolio Advisory Group, RBC Capital Markets, LLC Jay Roberts Head of Asian Equities, RBC Wealth Management Portfolio Advisory Group, RBC Dominion Securities Inc.

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