Goldman Slashes Target for China Stocks

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Goldman Sachs, which started the year upbeat on the outlook for Chinese stocks, significantly slashed its target for the country's equities late Tuesday, citing deleveraging in the economy and the risk of hot money outflows in the coming months.

The U.S. investment bank, which sees "no rainbow" ahead for mainland equities, cut its 2013 target for the China Security Index (CS1) 300 by 15 percent to 2,380 from 2,800. The new target represents 8 percent upside over the next six months.

The bank also downgraded its earnings outlook for components on the CSI 300 to earnings per share (EPS) growth of 6 percent from an initial estimate of 10 percent. The CSI 300, which is designed to mirror the performance of stocks traded on the Shanghai and Shenzhen stock exchanges, has a heavy weighting of financial stocks.

(Read More: Is Meltdown in China Stocks About to Get Worse?)

"Despite potential easing in funding costs after the quarter-end, we expect liquidity in the second half of 2013 to see a tightening bias, given the central government's seeming intention to control financial risks by deleveraging, with a higher tolerance for slower growth," strategists at the bank wrote in a report.

In mid-June, interbank lending rates soared to record highs, with the seven day repo rate rising to above 10 percent, compared to an average of 3-4 percent seen over the past year.

Chinese equities, among the worst performing globally this year, have been hit hard over the past month with concerns over a liquidity crunch and slowdown in the world's second largest economy weighing on investors. The benchmark Shanghai Composite, for example, has plunged 14 percent since the beginning of June.

(Read More: Goldman Sees No Rebound for Chinese Stocks)

The risk of hot money exiting the market over the coming months is also increasing, the bank said, driven by a weakness in the domestic economy and rising U.S. Treasury yields.

Goldman forecasts gross domestic product (GDP) growth will slow to 7.5 percent in the second quarter, 7.3 percent in the third quarter and 7 percent in the fourth quarter.

What Will Revive the Market?

The bank says that structural reforms are critical in turning around the domestic equity market.

(Read More: China Stocks Bear Brunt of Growth Fears)

"Investors may be reluctant to price in reforms now, given its near-term cyclical costs, already weak growth, and time lag before reform dividends appear," they said.

The Chinese government's efforts to crackdown on lavish spending by officials and to rein in credit expansion in order to reduce inefficient investments, for example, are policies that should foster more sustainable growth over the longer run, but may inflict some short term pain.

(Read More: China Reform Push Means June Turmoil May Be Just the Beginning)

"We think patience is needed to see meaningful valuation re-rating, even though we believe investors should eventually appreciate a more balanced economy even with somewhat lower growth," they added, referring to China's efforts to rebalance its economy to become more consumption led than investment driven.

—By CNBC's Ansuya Harjani