INSIGHT • 18 SEPTEMBER 2023
Chinese Property: the problem which will not disappear
Matthew Lee, Global Capital Markets Graduate
The Property Market
In November 2022 Chinese exports contracted 8.7% (YoY), falling well below expectations of a 3.5% contraction. Imports fared no better, falling 10.6%, with both figures the worst posted since the initial phases of the pandemic. While weak global demand contributed to the situation, China’s zero-covid policy was also a significant contributor to the weak economic performance – which is why towards the end of 2022, as the central government began to indicate a shift away (effectively bringing an end to mass quarantines and testing), the Chinese growth outlook suddenly looked much more positive. Since then, however, the recovery of the Chinese economy has stumbled. The Chinese consumer, simply put, is not spending as expected. To understand why, we have to turn to the largest asset class in the world – the Chinese property market.
Real estate constitutes a major part of total Chinese GDP. While estimates vary, some put the value at ~30% (including up and downstream industries). In 2020, the People’s Bank of China (PBOC) figures indicated a direct investment of US$1.18Tn in property markets, or 7.4% of GDP. The National Bureau of Statistics also showed the construction industry, which is unsurprisingly highly correlated with the health of the real estate market, accounted for US$1.115Tn of value, or 7.2% of GDP. In addition to its sheer scale, the property market also represents the largest investment asset class of the Chinese consumer: up to 70% of personal assets and household wealth is directly tied to property portfolios. From 2010 to 2020, this was a great bet, as average house prices more than doubled.
The Operations of Property Development
During this boom, a certain ‘modus operandi’ for many of the largest property developers emerged. The crux of this is two-fold: the first is to note that the vast majority of financing came from deposits and pre-sale proceeds, accounting for 34.5% of all sources of funds. It also represented an even larger proportion of total debt held by developers. The second is that while these proceeds were generated in exchange for development of a specific project, these funds were typically diverted into either completing existing projects or utilised to buy land for future projects. This operation was sustainable when demand was robust, and developers could continue to access more funding. However, over the course of their operations the majority of property developers, including some of the largest such as Evergrande and Country Garden, became highly levered. The central government was not blind to this fact and understood that trajectory was not sustainable in the long term.
The government’s response was to force companies into de-leveraging via their “Three Red Lines” policy. This policy was comprised of three criteria: (i) An asset-liability ratio of no greater than 70%, (ii) a net debt ratio of no more than 100%, (iii) A cash to short-term debt ratio of at least 100%. If property developers did not breach any lines, they would be allowed to grow their debt at a rate of 15% per year. For each subsequent line breached, that rate was decreased by 5%, down to 0% in the case all three regulations were breached. In Q4 21, over half of all developers would have re-financing limitations based on the new rules. Evergrande, in particular, failed to meet any of the new balance sheet requirements.
The introduction of the Three Red Lines policy was a catalyst for the first defaults from Evergrande. It is important to note here that it was not the reason – since 2015 Evergrande never had an asset liability ratio below 80%, and poor decisions by way of over expansion, over leveraging, and a significant mismatch between short term loans and long-term asset returns obviously plagued the company. Nonetheless, the new regulations appeared to be the straw that broke the camel’s back, as Evergrande could no longer grow its debt in an attempt to refinance and meet loan obligations.
An Interconnected Web
Following the defaults, market concerns mounted both internationally and domestically. As the second largest property developer at the time, Evergrande’s insolvency was already a significant concern. However, the greater fear came from the contagion risk. In addition to the secondary industries reliant on a healthy real estate market, financial markets and municipal governments have particularly large exposures to the property market. As with construction, the exposure of financial markets is fairly self-explanatory: domestic bank loans accounted for 13.8% of all sources of funds for property developers towards the peak of the boom in 2020. Perhaps the more interesting connection is with the local authorities, or the municipal governments who operate underneath the umbrella of the central government.
The exposures of the municipal governments came primarily via Local Government Financing Vehicles (LGFVs). LGFVs were borne out of central government rules that prevented municipalities from issuing their own bonds. These vehicles were used to circumvent the restrictions by creating separate legal entities that, in effect, allowed local authorities to raise funds via banks and individual investors for the purpose of real estate and infrastructure development. Despite being a legally distinct entity, LGFVs were understood to be ‘implicitly’ guaranteed by local governments, who would reimburse investors should the underlying vehicle default. However, in recent times, it seems more and more likely that this guarantee is faltering. Rhetoric from the central government has promoted “fiscal responsibility” on the local level, opening the door for the government to distance itself from payouts to insolvent LGFVs. This means that a decisive crash in the real estate market is likely to either harm investors, mainly comprised of Chinese consumers and banks, or create a debt crisis within regional governments.
As with the operations of property developers, the central government became increasingly concerned with LGFVs. Due to the off-balance sheet nature of these assets, they were described as creating “hidden debt,” and in many cases resulted in municipalities smashing past centrally imposed debt limits. Since 2015, the central government have allowed local authorities to issue Special Purpose Bonds (SPBs) in a bid to move away from the LGFV model. These SPBs are designed to be more transparent than LGFVs: At issuance, they must identify the specific project that the loans will be utilised for. This means that unlike the financing vehicles, the funds could not be diverted or re-purposed for other projects.
Government Response
In January 2022, following Evergrande’s liquidity crisis, the government announced some easing of regulatory measures. In particular, loans arising from M&A transactions would be exempt from calculating breaches of the Three Red Lines policy, affording some increased allowance for annualised debt increases. The rationale behind this appeared to be to support property developers with stronger liquidity to be better able to buyout struggling competitors. Ultimately, this and other mild changes to regulations were fairly restrained, and it appeared to show a Chinese government unwilling to seriously walk back their policies – likely because they could see the writing on the wall that the rolling back to the status quo was unsustainable anyway.
However, we are now almost two years from the start of 2022. Since then, the expected rebound of the Chinese economy has not played out, as the expectation of Chinese consumers with insatiable pent-up demand has not materialised. This will be of concern to the government, who have for some months now been indicating additional stimulus measures, with some analysts believing this will include a firm propping up of the real estate sector. Despite these statements and beliefs, relatively few material changes have been made. Some of the tangible changes that have been made include some rate cuts, and the raising of US$140bn via SPBs to pay off LGFV debt.
What comes next?
The latest macro data from China continues to be underwhelming. In addition to subdued growth, July saw a further drop in industrial output, with services output also contracting. On the property front, house prices continued to fall, and bank loans to developers shrank. The stress that has existed in the market for the past few years has not alleviated and appears to be getting worse.
All of this culminates in perhaps a fairly innocuous looking statistic: Chinese retail sales growth shrank to 2.5% in July from 3.1% in June. This is concerning because the growth trajectory of China was driven by local demand, especially amidst a global economic slowdown and increasing tensions between the US and China, and as US export demand from China fall. Unlike in the West, which did see pent-up demand arguments play out following easing of Covid rules, the property crisis appears to be weighing extremely heavily on the Chinese consumer. It appears there is a crisis in confidence. Despite the significant savings consumers amassed during the pandemic, they appear unwilling to spend as the property market (once the holy grail for domestic investment) continues to remain weak.
The path ahead is extremely uncertain. There are a large number of variables, many of which are volatile and difficult to predict. In addition, the opacity in various parts of Chinese markets and political workings only serve to exacerbate the issue. Nonetheless, we can look to likely, broad-based macroeconomic outcomes, and perhaps most importantly look to understand the key risk factors.
The most significant risk comes from what path the central government chooses to take with regards to policy and stimulus measures. Some analysts see strong government intervention (i.e. ensuring sufficient liquidity and walking back of de-leveraging policy) as likely – the rationale being that a collapse of the real estate market is simply far too economically devastating to simply accept. On the other hand, arguments for more modest policy amendments come from viewing the initial decision to implement the Three Red Lines policy as the government’s understanding of “pain now instead of later”, supporting the view that the central government understands that the market was unsustainable, and that it is better to bite the bullet and deal with the consequences now, rather than worsening the bubble with further credit binges. In either of these cases, the likely mechanism by which the economy improves/worsens will be via the Chinese consumer. If confidence is returned, then it is feasible that strong demand will help avert a full-scale collapse of housing prices and buoy real estate asset prices. In contrast, with fairly mild intervention, some analysts expect to see growth subdued below pre-pandemic levels, as the Chinese consumer fails to drive domestic demand and overall growth.
In the event of a Chinese significant and prolonged Chinese slowdown, there are some likely outcomes one might expect. With already weak global demand, subdued Chinese demand will likely further supress commodity prices, particularly copper and iron ore. Smaller Asian nations will likely face subdued growth, particularly due to developing Asian economies remaining highly exposed to both investment and import demand from China. Australian growth is likely to suffer off the back of this, unless they can find alternative export paths, particularly to the West and in the ASEAN region.
Another key risk for the Chinese growth outlook (and indeed the world) is in the rising tensions between the US and China. Recent relations have deteriorated, with more frequent clashes and worsening lines of communication. At the forefront of tensions is the contentious issue of Taiwanese sovereignty, and in the run up to the 2024 election, increasingly anti-Chinese / pro-Taiwanese rhetoric could cause the two nations to push each other closer to military red lines, raising the spectre for physical and economic conflict. As with policy growth, this is immensely difficult to predict, and is highly dynamic. What is certain is that should this tail risk materialise, not only will the world’s growth and inflation outlook drastically change, but millions of lives could be at risk.
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