The governing dynamics of central policies in China now are the politics of the once-every-five-year changeover of government officials, due next in early 2013. Officials in local governments (and their vested interest groups), while they hold office until 2H12, are keen to invest in projects and spend money. This underlying behavior drove the explosive loan growth in 1H09 and is why the central government lost control when they opened the credit gates in 1H09. Will Beijing run the risk of losing control again and thereby introduce further economic volatility ahead of 2012? We think it's very unlikely. Policy changes from now and into 2011 will likely be very gradual and targeted at specific areas. During this adjustment period, China's stock market will likely remain sector and stock specific, as will our investment policy.

Housing
This sector is a socially and politically sensitive area in the run-up to 2012. In tier-one cities such as Beijing, Shanghai, Shenzhen and Guangzhou, the ratio of housing prices to household incomes are at multiples in the high teens.

The lack of growth in completions in 2006-09, despite housing prices up over 2x (Chart 4), indicates land hoarding by developers. Presale payment terms greatly favored the cash flow of developers, allowing them to build land banks.

Developers can often obtain 100% of sale proceeds on presales even though two-thirds or more of the total construction costs remain to be spent in project completion over the next 12 to 18 months. Home buyers thus finance the construction cost as mortgages are drawn when purchase contracts are signed.

The central government's policy is now targeted at squeezing the cash flow of developers to force them to develop idle land banks. This is done by 1) restricting bank credit, and 2) tightening presale rules. The only source of cash flow for developers is to sell land, i.e., start more projects for presale. This has driven a surge in housing starts, more than doubling the rate of the last few years (Chart 4): The surge in supply of housing for sale over coming months will depress housing prices. Should the cash flow squeeze continue into early 2011, we can expect highly geared, smaller developers to fail, marking the end of this downturn, at which point the sector will be interesting again-one example of sector opportunities we see emerging in China.

Eoin Treacy's view In a controlled economy such as China, government policy and the perception of what that is will always be an important factor in investor actions. The focus of tightening measures over the last year has been to rein in the property market and it seems reasonable to expect that restrictions will remain in place until the desired result has been conclusively achieved.

The domestic Chinese stock market continues to show signs of renewed investor interest with the Shanghai A-Shares so far holding the move above 2800 for the first time since May. A downward dynamic would now be needed to question potential for some additional upside.

The Hong Kong listed H-shares has been ranging mostly above 11,000 since July 2009 and has sustained a gradual progression of higher reaction lows since May. These would need to be taken out with a decline below 11,250 to question scope for continued higher to lateral ranging.