(Bloomberg) -- Morgan Stanley is turning more bullish on China’s banking sector, saying global investors are too pessimistic about the impact of the nation’s property downturn and weak economy on profits.

Measures by policymakers in recent months have put a floor under the real estate market and will cushion the risk exposure of lenders, preventing any worst-case scenarios, according to Richard Xu, the US bank’s chief China financial analyst. Reduced risks in the property sector and for local government financing vehicles suggests the costs of supporting the nation’s ongoing industrial upgrades are also manageable, underpinning growth, he said. ​

Morgan Stanley joins UBS Group AG and Goldman Sachs Group Inc. in voicing more optimism on China stocks as the government steps up support to the ailing property sector, even as investors expecting an earnings recovery are losing patience. 

Morgan Stanley raised price targets for Chinese lenders this month by as much as 36%, partly on expectations that property sales at current levels are enough to support a rebound in mortgage loans, which would lead to higher profit margins and lower capital burdens, Xu said. 

“Bank shares have yet to reflect such expectations,” he said in an interview in Beijing. 

UBS earlier raised its recommendations on a key Chinese stock index to overweight in April as the market recovered from a meltdown earlier in the year. Morgan Stanley Investment Management has also been increasing exposure to Chinese stocks on cautious optimism that share buybacks will help boost prices. 

Bank shares have rallied this year from rock-bottom valuations. Industrial & Commercial Bank of China Ltd., the world’s largest lender by assets, is up 19% this year in Shanghai. The lender’s price-to-book ratio has improved to 0.58. 

China’s government announced its most forceful attempt yet to rescue the property market in May, relaxing mortgage rules and urging local governments to buy unsold apartments. Yet home prices still fell at a faster pace that month. The nation’s biggest banks reported a rare drop in profits in the first quarter, as a combination of weak loan growth, margin contraction and lower fee income weighed on earnings. 

Even if the pace of property destocking remains flat, Xu said, lower mortgage rates and down payments can help boost demand for the more profitable residential loans, which will improve bank margins. The program for local governments to purchase apartments could amount to providing a floor to home prices, preventing steep declines, he said. 

Xu and colleagues maintained their “attractive” industry rating for China banks in a June 4 report and raised their price targets, saying that “the seasonal share price pullback before and after dividend payments should create a good buying opportunity.”

China’s policy shift since 2021 to prioritize risk containment, particularly in property and local government financing vehicles, while pushing industrial upgrades is paying off earlier than expected, Xu said. 

In a report in May, Xu and colleagues estimated that banks will need to digest an estimated average of 2.2 trillion yuan ($303 billion) in non-performing loans from manufacturing in the next three years, which would be “a manageable level of costs for the level of industrial upgrades achieved.” 

Investors have been skeptical that China can break away from the reliance on property for growth and shift to manufacturing “because they think the ditch is too deep to cross, and therefore they have no confidence,” Xu said. “But we believe China has made it.” 

--With assistance from Amanda Wang and Zheng Li.

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