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02 May 2023

Chinese Property Developer Debt Leaves Markets Uneasy

As three years of COVID-19 restrictions were finally lifted, the people of China were able to celebrate the Lunar New Year once again with their friends and families. A common topic of conversation around the dinner table, as in the UK, was the state of the property market. A book published in 2021 entitled ‘Time of Negative Property Value’ has been an unlikely hit in China, becoming one of the top downloads on WeChat’s e-reader app over the new year holiday. While the title doesn’t exactly promise a thrilling read, the book offers a series of cautionary tales on the collapse of Japanese house prices taken from financial newspaper Nikkei. The book has tapped into the national mood regarding China’s property sector, with which the nation has a complex relationship.
 
As the world’s most populous country, its property sector is correspondingly gigantic. China has one of the world’s largest rates of home ownership, at around 90%. Owning one’s property is seen as a source of stability and a prerequisite for starting a family. Owning a second or third property has also come to be seen as a wise investment, given the demand for housing in China’s largest cities. Property prices have risen for years, and for a long time there were no taxes imposed on property. In 2020, direct investment in real estate contributed to 7.4% of GDP, with the construction industry adding a further 7.2%. That same year, employment in the construction sector peaked at 62m jobs.

As the two-decade property boom continued, property developers became some of the largest companies in China. Reflecting the trend for speculative investments, their main source of income was deposits and pre-sales for incomplete projects. Funded by credit, developers took RMB2.6tn, or US$419bn, in domestic loans in 2020. Over the years these loans have accumulated, reaching RMB33.5tn, or US$5.2tn, by the summer of 2021. The Chinese Communist Party has become increasingly wary of the vast pile of debt developers have been accruing and has made attempts to cool the overheating market. Following a meeting with 12 of the largest developers, the Chinese authorities introduced a policy of ‘three red lines’ in August 2020, requiring property developers to pass three tests before they can apply for refinancing. These are:
  • An asset-liability ratio of no greater than 70%
  • A net debt ratio of no more than 100%
  • A cash to short-term debt ratio of one or below
A year after the policy was introduced, all but two of the twelve developers in attendance at the meeting were able to remain within the red lines and could refinance their debt. The most notable exception was Evergrande, the second-largest developer in China. This would prove to be the beginning of a spiral into default, with deep ramifications for the sector.
 
In December 2021, Evergrande defaulted on US$1.2bn of overseas bonds. Other developers followed shortly. Kaisa defaulted on a US$400m payment, Shimao Group on a US$101m project loan, and Yuzhou Group asked for a deferral on the repayment worth US$582m. By August of 2022, two thirds of dollar-denominated bonds issued by Chinese developers were trading below 70 cents on the dollar, meeting the definition of distressed debt. Beijing authorities have been reluctant to take any significant steps to bail out the struggling developers, which has added to fears of a protracted crisis. Robin Xing, Chief China Economist at Morgan Stanley, said: “a more centralised bailout is probably the necessary solution here.”
 
Given that pre-sales - where homebuyers take out a mortgage to pay for a property that has not yet been completed – are common in China, the prospective buyers have become increasingly anxious about their liabilities on properties that do not yet exist. Mortgage holders have staged a national boycott of payments on unfinished properties, affecting over 300 projects by July 2022. This has sparked fears of defaults from lenders by the Chinese regulators, who asked banks to disclose any vulnerable mortgage exposure. Several local authorities in the worst-affected cities created bailout funds, seeking to ensure that pre-paid developments are completed.
 
As consumer confidence in the sector slumped last summer, developers and local authorities in China’s smaller and poorer tier-2 and 3 cities sought to reverse declining sales. Some developers have promised to accept harvests of garlic, watermelons, wheat and barley as deposits for houses from farmers, while local officials have offered households vouchers for future home purchases if they allow their existing dwellings to be demolished. According to Nomura, however, data showed that new home sales in tier-3 cities had fallen 40% from the previous year.
 
In recent months Beijing has begun to relax its ‘three red lines’ policy, and there are further signs that the sector is starting to stage a recovery. At the influential Central Economic Work Conference, attendees emphasised the importance of real estate to China’s economic growth, which sent the price of shares in developers soaring. Bonds issued by over-leveraged developers have recovered from distressed level to closer to their original value. Overseas investors, while still wary, have begun to return to the sector.
 
The Chinese government is faced with a difficult balancing act between bursting the bubble and unleashing chaos, and allowing the speculative frenzy to continue unchecked. Successive policies aimed at cooling the housing market have been implemented and then dropped - a repeated signal that Beijing considers the fast GDP growth the property market brings too valuable to legislate away.

This article was taken from the February 2023 issue of Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.
 
Chinese Property Developer Debt Leaves Markets Uneasy
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