Does China's property market present grand risks?

Tim Carleton

Auscap Asset Management

The residential real estate market has been a significant driver of China’s economic growth over the last two decades. Now authorities are trying to rein in the amount of leverage used by all developers, initially focused on larger companies. Evergrande, China’s second largest property developer and previously a poster child for the phenomenal growth in the sector now poses the greatest risk. The questions are, to what extent should investors be concerned about its potential collapse and what implications, if any, are there for the Australian and global economies?

Who is Evergrande?

Evergrande is a very significant Chinese property developer with some 1.5m dwellings under development, spread across 778 projects in 223 cities, in a country that produces approximately 15m new dwellings a year. Property development is an enormous driver of economic growth within China. Barclays recently estimated that if Evergrande’s development activity fell 50%, it would reduce development by 4% across the country and potentially cause a 10% contraction in the property market.

Evergrande employs 200,000 people directly and reportedly creates 3.8m jobs per annum. The problem is that it has approximately US$300 billion of liabilities, $170bn of which are due within 12 months, with only one tenth of that amount in cash on hand. To put that into context, US$300bn was approximately the net debt of the Australian Federal Government prior to the COVID-19 pandemic and is equivalent to 2% of China’s GDP. These obligations are so large that many consider the business to be systemically important, and it appears to be on the verge of defaulting on its obligations. Press reports indicate that Evergrande has missed bond payments, is late in paying employees and has not paid due invoices from suppliers and other creditors.

What precipitated Evergrande’s issues?

So how did we get here and why is Evergrande at risk of default? In August 2020, the Chinese Government announced the “3 red lines policy”. The policy created 3 measures that are used to assess the rate of allowable growth in debt for property developers. These are:

  1. a liability to asset ratio of less than 70%;
  2. a net gearing ratio of less than 100%; and
  3. a cash to short term debt ratio of more than 100%.

If developers fail to meet 1, 2 or all 3 measures, then the regulator can cap their debt growth at 10%, 5% and 0% respectively. If all three lines are passed, the limit on debt growth is 15%. Policy makers have given major developers until mid-2023 to meet all three measures. The policy is expected to be applied to the largest developers initially, before expanding to cover smaller players in the sector.

Evergrande failed all 3 tests when they were introduced in August 2020. Following this, Evergrande commenced a nationwide sales program in September 2020 offering 30% off all properties. On 9 June 2021 regulators reportedly instructed major lenders to conduct fresh stress debts on their exposure to Evergrande. On 22 June 2021, several large banks started restricting credit to Evergrande. On 21 July 2021 Standard Chartered and HSBC were reportedly declining loans to buyers of properties from Evergrande. And on 17 August 2021, the Chairman of the onshore real estate group resigned. Two days later executives were summoned by the regulator and instructed to reduce debt levels, with reported group liabilities hitting 1.97 trillion yuan, or approximately US$300bn, on 31 August 2021. Many suppliers have claimed to be owed money by Evergrande and some, such as listed piping supplier Yonngao which is reportedly owed RMB 478m (US$74m), have stopped deliveries. Further exacerbating Evergrande’s problems, on 3 September 2021, the company announced that contracted sales for August had dropped 26% year on year to RMB 38bn (US$5.9bn).

It seems increasingly likely that at some point Evergrande will cease to exist in its current form. Government officials have reportedly told Evergrande to finish their existing developments and to repay individual investors. However, the market is taking a dim view of the likely return of capital to bond holders. The listed Evergrande US dollar denominated bonds trade between 20c and 25c in the dollar. Trading in Evergrande’s shares has been suspended after a fall of 80% calendar year to date, such that the company now has a market capitalisation of just US$5bn.

Is Evergrande an isolated case?

Evergrande is not the only property developer under scrutiny. According to UBS, the largest 50 developers in China accounted for 60% of property development activity in 2019. S&P suggested that only 6.3% of their rated property developers could pass all 3 lines on the initial analysis. Of the country’s 66 major developers, nearly half passed all 3 lines at the end of 2020, up from just 14 six months earlier. Only 4 of the developers failed all 3 tests, of which Evergrande was the largest. Evergrande and Guangzhou R&F Properties were the only two major developers to not show improvement between June 2020 and December 2020.

In one sense this might seem like good news. Unfortunately there are two words of caution. The first is that we do not know how much window dressing was done to make the balance sheets of many of the developers look better than normal at year end. The second is that the tests are not particularly onerous. Anything close to a 70% liability to asset ratio would be considered extremely high in Australia. So we need to be aware of the anchoring bias created by the thresholds outlined. Whilst the majority of developers being below a liability to asset ratio of 70% might be an improvement on a year ago, that certainly does not mean that they are all in a robust financial position.

In the last few weeks Fantasia Holdings Group, a property developer of high end apartments and urban renewal projects, failed to repay a bond that came due at the start of October 2021. This happened only weeks after reporting that its operating performance was good, that it had sufficient working capital and no liquidity issue. Sinac Holdings Group also reportedly missed two interest payments on its bonds. Sunshine 100 China Holdings defaulted on its notes in August and Xinyuan Real Estate Co and Central China Real Estate both have bonds due within a month and are being watched closely.

Could Evergrande trigger a financial crisis like the GFC?

The question on many investors’ minds is whether these defaults are capable of triggering a banking crisis. Is this sequence of events and the potential collapse of Evergrande akin to China having its “Lehman Brothers moment”?

While Evergrande reportedly owes money to 171 domestic banks and 121 other financial firms, it appears unlikely that there will be a liquidity crisis in the same vein as the one many economies experienced during the Global Financial Crisis (“GFC”). China’s banking system is internally funded rather than relying on international investors and is centrally controlled, with the Chinese Government a major shareholder in the largest financial institutions, capable and willing to provide extra liquidity to the financial system during periods of stress. The Evergrande issue appears to be a consequence of deliberate action by the Government to rein in property developer debt and reduce the risk of moral hazard. The fact that any default is potentially driven by Government policy leaves many commentators assured that the Government has measured the impact on financial market stability and concluded that the system will cope with any fallout from property developer defaults.

We would tend to agree with analysis that suggests the probability of a financial crisis bearing close resemblance to the GFC happening on the watch of any sophisticated Government is unlikely. However, this argument only allays concerns around China experiencing a banking crisis as a result of bad debts and lack of liquidity in the system. Put simply, it means that China is unlikely to experience exactly what many other countries experienced during the GFC. Invariably though, the next crisis will not look like the last one. Policy makers learn from past mistakes that occur domestically or internationally, particularly in the interconnected world we live in today. So the question we would prefer to ask is whether these defaults could trigger a different type of crisis. This is a question without a straightforward answer.

If not a banking crisis, then what is the concern?

While the banking system might have sufficient Government support to withstand property developer defaults, we are more concerned with the potential impact on the residential property market in China, which Kenneth Rogoff and Yuanchen Yang estimate constitutes a remarkable 29% of GDP. The banks are only one of many stakeholders required to keep property development contributing positively to GDP growth. Bondholders, wealth management product investors, suppliers, employees, contractors, and most importantly, willing property buyers are all required to keep the property development sector growing.

Whilst the banks are funders of property development, investors and home buyers are also heavy financiers of the residential property development industry. There are currently millions of investors and home buyers likely to be anxiously waiting to see whether their off the plan housing development will become a finished product. The psychological impact on property investors and home buyers from the publicity around Evergrande’s issues is yet to be understood but could be significant. Such non-settlement risk has not been experienced by Chinese buyers on this scale before. If individuals reduce their propensity to purchase property in the future, then developers may struggle to get the necessary finance to continue their developments while staying inside the 3 red line policy requirements.

Non-repayment, or even just the risk of non-repayment, of wealth management products (“WMPs”) by a developer as large as Evergrande could have repercussions for future developers trying to raise funds this way. The Reserve Bank of Australia noted in a 2015 Bulletin that there had been no verified reports of bank WMP issuers ever not repaying investors. It is easy to see how Chinese retail investors may have assumed that the entire asset class was implicitly guaranteed. More than 80,000 people bought Evergrande WMPs that raised over US$15.4bn over the past 5 years, with some US$6.1bn of these investments still outstanding.

The bond market is another source of capital for a company like Evergrande. Non-payment of loans across multiple developers lessens the availability of capital and could materially increase its cost. Earlier in 2021 the Government cracked down on banks and wealth managers using money invested in cash management products from buying long term debt or bonds rated below AA+, with an estimated US$510bn of the products currently invested in assets that have or will soon become non-compliant.

Finally, suppliers and contractors extend credit when they conduct work prior to receiving payment for the work. If they do not get paid promptly, they may either reduce their exposure to such work or demand more onerous terms around payment for services rendered. In relation to Evergrande, there are reports that some suppliers and contractors have not been paid for work already done.

To us, the immediate risk is not to the Chinese banking system but to the broad funding of residential development. If any of the aforementioned channels break down, sector funding capacity will be impacted. The potential impact on GDP could be very substantial.

Are there potential flow on implications?

A slowdown in residential development will potentially have flow on consequences for the broader Chinese economy. China’s local governments generate 30-40% of their revenue through land sales to developers. A reduction in land sales would therefore require local governments to either increase debt or reduce expenditure.

The impact on the broader property market, in particular in relation to pricing, is unclear. Property developers might try to sell development properties at marked down prices to clear inventory and generate cash, as Evergrande has tried to do. This creates risk to the broader property market and could lead to a problematic negative feedback loop. It has been estimated that there are already more than 65 million empty apartments across China. In a country where population growth is running at the slowest rate on record at less than 0.5% per annum, there is no natural tailwind of population growth or immigration to absorb surplus supply.

Residential property prices are also substantially elevated by modern standards. Rogoff and Yang state that the property price to income ratios in Beijing, Shanghai, and Shenzen exceed a multiple of 40, compared to 22 in London and 12 in New York. It was recently pointed out that “prices in Tier 1 cities have risen more than six-fold since 2002, compared with the increase in Ireland of 100 per cent and Spain of 230 per cent in their respective housing booms.” Across China the average property price to income ratio is currently 27.9x. This compares to Japan at 11.6x, India at 10.8x, the United Kingdom at 9.5x, Australia at 7.3x and the United States at 4.0x. In short, a reduction in property development would likely have second and third order consequences that would negatively affect economic growth within China and therefore globally, given China’s position as the world’s second largest economy.

What risk does this present to Australia and the world?

The look through risk to demand for products that go into residential construction, including some of Australia’s largest exports such as iron ore and coking coal, could be very material. China produced 56.5% of the world’s steel in 2020. If China’s demand for steel goes backwards, the combined growth in consumption in the rest of the world is unlikely to be enough to offset the decline.


Any reduction in bulk commodity demand from China will have an impact on global commodity prices and volumes, negatively affecting Australia’s terms of trade and Government receipts. There are also potential flow on implications for employment and consumption to consider. We remain cognisant of potential risks emanating from China as a result of the deleveraging process that is currently being undertaken in relation to domestic property developers. While there is a reasonable probability that the Chinese Government successfully navigates this issue, there is certainly a non-zero probability attached to the risk that there are material flow on consequences that negatively impact China’s economic growth. While we remain positively disposed to domestic and global economic growth as the world emerges from the COVID-19 pandemic, an awareness of the potential implications of any fallout from a significant slowdown in the property sector in China helps us to map our approach to investing while these risks are present. 

References

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Tim Carleton is a Principal and Portfolio Manager at Auscap Asset Management (Auscap), a boutique equities long/short investment manager. This article contains information that is general in nature and does not constitute investment or any other form of advice. This article does not take into account the objectives, financial situation or needs of any particular person nor does it constitute a recommendation to be relied upon when making an investment or any other decision. You need to consider your financial needs before making any decision based on the information in this article and a person should obtain and consider the relevant disclosure document before deciding whether to invest in an Auscap fund. The Auscap Long Short Australian Equity Fund’s disclosure document, the Product Disclosure Statement, and the Auscap Global Equity Fund’s disclosure document, the Information Memorandum, are available from Auscap upon request. A copy of the Target Market Determination for the Auscap Long Short Australian Equity Fund, prepared in connection with the Design and Distribution Obligations, is available at www.auscapam.com/ddo. No part of this article is to be reproduced or disclosed without the prior written consent of Auscap. In relation to any MSCI data in this article, the MSCI data is comprised of a custom index calculated by MSCI for, and as requested by, Auscap. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)

Principal and Portfolio Manager
Auscap Asset Management

Auscap manages the Auscap Long Short Australian Equities Fund and the Auscap Global Equities Fund which target solid absolute risk-adjusted returns, looking to invest in companies that generate strong cash flows and are trading at attractive prices.

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