Analysis: China's Reforms Switch Focus to Small Cities

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China's property developers, investors and owners have been mulling the impact of a recent major meeting of the Communist Party, which indicates how cities and land rights are intended to develop.

Investors were at first disappointed by the brief nature of the 500-word report that came out of the conference, known as the Third Plenum of the Chinese Communist Party. But the detailed announcement released a few days later was much longer, and has been praised as one of the most far-reaching reform programs announced out of such a meeting.

The 20,000-character "decision" report led to a six percent jump in the H share index of Hong Kong-listed, China-based companies on November 18. China watchers say it is the boldest package of reforms seen in decades.

The changes are intended to take place by 2020 at the latest. The most headline-grabbing change in direction is that the notorious one-child policy, will be loosened. Couples will be allowed to have two children if one of the parents is an only child.

That promises to create a meaningful difference from 2030 onwards, the bank HSBC believes, with an extra 1 to 1.5 million births per year. It will certainly create even greater long-lasting demand for housing, particularly in mid-size cities. In the biggest cities, people may be cautious about the cost of having a second child, as seen in Hong Kong.

But there are also reforms that will affect property prices more directly. Farmers will be able to sell their land directly into the market, without local governments first taking it and converting it into state land. That would give China's 650 million-strong rural population greater property security, and again encourage urbanization in less-developed areas. Groups of rural residents will also be able to form a collective scheme in which they own shares, which they can buy and sell or use as collateral.

Another major change is that restrictions on city-level residence permits, known as the hukou, will be freed up at the town level and small cities first, suggesting so-called Tier 3 and Tier 4 smaller cities will see higher property prices. The Tier 1 cities of Beijing, Shanghai, Guangzhou and Shenzhen have all seen price gains of more than 20 percent in the last year, and the communiqué said that "population in extra-large cities would be strictly controlled." While Shanghai and Chongqing have already introduced property taxes, that is expected to be rolled out to all major cities in time.

There is increasing pressure on big cities to rein in price gains, with Guangzhou, Wuhan, Nanchang, Xiamen and Shenyang all introducing recent tightening measures. The push for urbanization is undoubtedly switching to smaller cities and towns.

For shareholders, Nomura analyst Alan Jin has warned that investors who own Hong Kong-listed Chinese property developers should sell and lock in profits in the face of greater policy risk and the likelihood of tighter liquidity.

Still, Jin said that U.S. investors were generally upbeat on the sector during a Nomura trip there in the week after the Communist Party meeting. He suggests concentrating on stocks that focus on low-end property in many of the smaller cities where growth is being encouraged, his top two picks being Country Garden and Evergrande Real Estate.

New president Xi Jinping has said that he would accept a slowdown in growth to push through his plan of reforms. But after a mid-year lull that spooked markets, growth picked up to 7.8 percent in the third quarter, up from 7.5 percent in the previous three months. That has encouraged many economists to boost their forecasts for the year. The Economist Intelligence Unit, for example, raised its estimate for this year to 7.7 percent, from 7.5 percent, although it still expects slower growth next year as the government continues to curb lending.

There will no doubt be some bitter pills for some in China to swallow as the reforms take place, Wei Yao, the China economist at Société Générale believes. One major shift in the reforms is to encourage the development of the private sector and reduce the reliance on inefficient state-owned enterprises.

"Basically, any industry or company that has to continue relying on the old institutions for survival will suffer and struggle, while those who have not been able to realize their potential due to current restrictions that are subsequently lifted, will get a good chance to grow and thrive," Yao stated in a report. "Investors can be bullish, but have to be realistic and pragmatic at the same time."