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China’s Property Bubble: Who Will Pay?

China’s Property Bubble: Who Will Pay?
 Philippe Aguignier
Senior Fellow - Asia

Evergrande, a giant Chinese property developer, first grabbed the world’s attention in 2021 when it became the first major developer to default on its USD bonds. Two years later, it is in even deeper trouble, and is facing a liquidation challenge in the courts of Hong Kong. Country Garden, another giant developer, has also recently defaulted on some of its USD obligations. The country is going through a new bout of turbulence in the property sector

We had written in January of this year that the recurrence of financial crises in China has structural causes, and that "It is therefore highly likely that crises will keep on happening" (see China's Next Financial Crisis: A Matter of "When" Not "If", Institut Montaigne). We did not have to wait for long. This paper aims to assess the damage that the on-going crisis has already inflicted on the economy, the channels through which the crisis is spreading its poison, and how much could be still to come.

The property market: from bad to worse

China abandoned its "zero-Covid" strategy in late 2022. A rebound in the economy was expected to ensue, but although the economic activity did recover somewhat, sales have remained lackluster in the property sector and there has been no rebound. The sales of the top 100 largest developers dropped by more than 40% in 2022 over 2021, and by another 8% in the first half of 2023. More than half of the developers which were among the fifty largest ones in 2020 have by now defaulted on their debt. With the weight of property-related activities in Chinese GDP estimated at close to 30%, the impact of this debacle on growth and unemployment must be tangible, even though not directly quantifiable with available data.

Sales volumes have collapsed, but average prices have not dropped much: price indexes, which are calculated city by city, have generally fallen by around 10% on average since the crisis began: less in large cities such as Beijing, Shanghai or Guangzhou, and more in second or third-tier cities in the interior of the country. This is partly artificial: the government is worried about the impact of a severe drop in price on the public at large and on the health of the financial sector. Price control mechanisms in place (which had been created originally to prevent prices from rising too fast during the years of the boom) allow local authorities to prevent developers from putting properties on sale at a significant discount, something that many of them would be happy to do to raise cash. As a result, the adjustment between offer and supply has taken place through volumes rather than prices, and it is difficult to assess what would be the "clearing level" for prices. From anecdotal evidence, it seems that should controls be removed, current prices would not move much in big cities, but would decline substantially in smaller and more remote cities. This compounds the difficulties of Evergrande and Country Garden, two of the largest developers which are both heavily exposed to the smaller cities but relatively less so in the larger ones.

 The adjustment between offer and supply has taken place through volumes rather than prices.

The degradation of Evergrande illustrates the extent of the problems besetting the property market. Evergrande recently published financial statements for 2021, 2022 and the first half 2023. Its sales collapsed from more than 500 billion RMB in 2020 to 230 billion in 2022. It accumulated losses of more than 800 billion RMB (more than 100 Bio USD!). Many of its construction sites have remained idle for two years now, which means it cannot transform its assets (mostly projects under development and pieces of land) into cash. 

No comprehensive debt restructuring plan is in sight: a partial plan for offshore debt holders (the company has issued around 20 billion worth of USD bonds) has been circulated and then withdrawn. The company’s USD bonds are currently trading at less than 10% of their original value. As mentioned in the introduction, a request for litigation has been filed in Hong Kong, but the courts have not decided on it yet (the next hearing is scheduled for December 4th). The only bright spot is that thanks to very selective support from local authorities, some projects have been completed and apartments delivered to buyers who had already paid for them: the number of pre-sold but not completed apartments is estimated to have decreased by a third; they still amount to an overall value of around 600 Bio RMB.

Dozens of developers have defaulted on part of their debts after Evergrande did. The most recent one is Country Garden: as big as Evergrande, but less leveraged, it was considered to be one of the strongest and best managed of the privately-owned property developers, so the news that it had run into financial distress has been taken as a sign of the systemic nature of the crisis: if even Country Garden cannot survive the current downturn, who will?

Government’s reaction: let’s pump the air out of the bubble

The Chinese government has long been concerned about the dangers of an overleveraged and overheated property sector. Back in 2017, Xi Jinping famously proclaimed that "houses are made for living in, not for speculation", which has become something of a mantra for Chinese officials. Long before this banking authorities had started monitoring the property exposure of the banks very closely, and tried to curb some of the activities of both banks and non-banking institutions in the so-called "shadow-banking" sector. A specific concern was the situation of some of the largest privately-owned property developers, which were accumulating unsustainable levels of debts, to the extent that they might become "too big to fail" if nothing was done to force them to change their business model. By August 2020 they were worried enough so as to introduce a new set of regulations called the "three red lines", which aimed at preventing property developers which did not meet a set of financial criteria from renewing or seeking new credits from the banks. It is difficult to tell to what extent they had anticipated what would follow. In any case, if they had not acted at that point, they would later have had an even worse crisis to deal with, but very soon they had a full-blown crisis on their hands.

Confronted to a situation that threatens the whole economy as well as potentially its own legitimacy, the Chinese government has not stayed idle. Some targeted measures have been taken, such as canceling some previous restrictions on property purchases (put in place during the boom to prevent prices from rising too fast), or encouraging banks to lend selectively to developers which remained reasonably healthy; interest rates on mortgages were slightly lowered; emergency funding (550 Billion RMB in several tranches) to allow the completion of pre-sold apartments (a substantial amount, but not enough to clear the backlog), and the situation of some weak financial banks was treated swiftly (such as Shenjing, a bank linked to Evergrande, or a few rural cooperatives in Henan in 2022).

The Government’s options however were restricted as a full-blown rescue plan for the developers through a central Government intervention was a non-starter, since forcing the developers to deleverage had been one of their prime objectives in the first place. They also did not want, by any means, to reinforce the idea that the government would always come to the rescue when financial troubles erupted in the economy. Such an idea is prevalent in China, with huge economic costs in terms of misallocation of resources and is a major cause of the recurrence of financial crises.

In short, the strategy was therefore to stick to the mantra (the three red lines are still in place, although there may be more flexibility in the way they are applied), and let the property developers default. This meant in turns accepting costs and a large dose of pain in the form of economic losses and lower growth, while at the same time providing enough support (usually through the local governments) to avoid a complete economic meltdown and mitigate the disruptions to the social and political order that could arise.

The idea that the government would always come to the rescue when financial troubles erupted [...] is prevalent in China, with huge economic costs.

This strategy is rational from an economic standpoint, but it is also risky, as things may get worse or even out of control, at a time when the Chinese economy is facing other challenges as well. It also raises difficult questions, about which actors or segments of the Chinese society are going to foot a bill that is already enormous, and growing day by day.

The trillion RMB question: who will pay?

First in line to take losses are of course the owners of the property developers, as the equity value of their companies will be wiped out in a situation where debt holders cannot be fully repaid. The market capitalization of Evergrande has for instance declined from more than 50 billion USD at the peak to less than 1 billion today. For Country Garden, the decline has been from 47 billion to 2 billion. This is almost 100 billion USD for only two firms! The social impact of this value destruction may however be limited, as in many cases a small number of shareholders hold a majority of the shares (Xu Jianyan, Evergrande’s founder and chairman, owns 60% of the company; Yang Huiyan, Country Garden’s chairwoman, owns 54% of the company), so that the bulk of the losses are borne by a small number of people. In addition, these previously very rich and politically well-connected property owners may well become political targets, should the regime feel the need to have them bear the responsibility for the current mess (Evergrande’s chairman is currently under investigation).

Offshore bondholders (the main ones are so-called high-yield fixed income funds, placed by banks and fund managers with institutions or high networth private investors) will also suffer tremendous losses on their exposure. Offshore bonds (bonds issued mostly in USD and placed in international markets outside of China) have emerged as an alternative funding channel in the last ten years for cash-hungry Chinese property developers. They have also become an important asset class for bond fund managers looking for returns higher than usually offered by sovereign bonds. The aggregate principal value of bonds issued by Chinese developers is around 155 Bio USD: this is much less than the total of their onshore bonds, but the dynamics of each market are different: offshore investors will lose a far greater proportion of their exposure than onshore investors. As of today, the remaining market value of USD bonds issued by Chinese developers is only USD 20 Billion. The majority of issuers (54 of them) have already defaulted on their USD debt. The market value of the offshore bonds usually declines tremendously after default (very often to less than ten cent to a dollar), as the harsh reality is that offshore creditors have limited options at their disposal to get their money back: they can try to force a liquidation of the assets of the issuers, but this is a long and uncertain process; and even if they succeed it will be more difficult for them to get to access the proceeds of the asset sales than for onshore creditors (insert note on legal issues). 

There have also been defaults in the onshore bonds markets, but on a much smaller scale: the default rate for property-related domestic bonds in 2022 was "only" 9%. There are many cases of issuers having defaulted on their USD bonds but not on their RMB domestic bonds (Country Garden for instance). It seems that some developers facing financial difficulties have seen defaulting on their USD bonds as a low risk strategy, allowing them to save badly needed cash. They bet that eventually offshore holders will accept a restructuring in which they lose a large part of the principal value of their bonds ("haircut") rather than taking the risk of a long and uncertain liquidation in which they may get nothing or very little. At the same time, many issuers have been successful in negotiating a rescheduling or rollover of their debt with their domestic lenders or bondholders, simply pushing back repayment dates without a haircut on principal (in the end of course, the debt will probably not be repaid in full but this gives more time to the lenders to make provisions).

Foreign banks operating in China, it should be noted, may be affected but not materially.

Foreign banks operating in China, it should be noted, may be affected but not materially: lending to domestic property developers usually did not meet their risk criteria, due to their aggressive leveraging strategy and to the lack of transparency of the legal environment, so that they did not jump foolheartedly into the market.

Domestic banks and bondholders are obviously exposed, as they represent a major source of funds for the property sector.Total loans to the property sector amount to 53.7 trillion RMB or almost 30% of total banking loans, of which 38.6 trillion are mortgage loans to individuals to acquire residential property and 15.1 trillion are loans for property development, out of which 7 trillion are direct loans to developers. The amount of domestic bonds issued by the real estate firms is more modest, but still significant, at around 3 trillion RMB. 

Banks and bondholders (they are often the same: banks are the largest investors in the Chinese bond market) will therefore suffer from a downturn in property, but there are mitigating factors. First, mortgage loans, which account for the majority of the exposure, are much safer than loans to developers. The banking regulator has for a long time forced banks to respect strict rules such as minimum down payments, restrictions on financing the purchase for buyers owning already one house or apartment, or checks on capacity of borrowers to service their debt through their revenues rather than relying only on the value of the asset being financed. Cost of risk for such loans has historically been low in China (less than 0.5%), and has not risen recently (SCIO briefing on China's financial statistics in H1 2023). Loans to developers are of course much riskier, and Chinese banks have had to increase their provisions for such loans in recent years, but the regulator has prevented them from being too aggressive through rules such as the "three red lines". Finally, the banking sector in China is profitable (3 trillion RMB total profits in 2022) and well capitalized (total networth of 26 trillion RMB, with a buffer of 9 trillion RMB over the regulatory minimum amount). Even if banks were to lose a substantial part of their loan or bond exposure to developers, they would be able to absorb the shock, given time.

There have been and there will be accidents, of course, especially with some smaller and poorly managed banks, but such banks represent a small part of the overall banking system, and the regulators have proven their capacity in the past to intervene quickly to prevent such accidents from spreading. Overall, the costs of the property downturn for the banking sector are already material, they will probably rise, but they do not seem to present a systemic risk.

The public at large stands to lose a lot, through many channels, and will probably have to shoulder the bulk of the losses. The most immediate source of pain is the question of pre-sold properties. Developers, being restricted in their capacity to borrow from banks, have turned to this channel as a source of funding, which before the crisis came to represent up to one third of the funds they raised. The size of the problem was estimated at 700 billion RMB at the end of 2022, affecting millions of people (close to one million in the case of Evergrande).

This is a politically sensitive issue, and as mentioned above, a significant part of the government’s efforts have been directed at trying to clear the backlog of pre-sold. But in spite of some success (like in the case of Evergrande), the current numbers may have grown, as more developers have had to stop their operations due to lack of cash.

The public at large stands to lose a lot, through many channels, and will probably have to shoulder the bulk of the losses.

Private investors can also be financially hit through "shadow-banking" products, as developers have turned to non-banking actors such as trust companies to issue and place on their behalf debt instruments such as commercial paper, with the buyers being typically high networth individuals. The size of the problem is unquantifiable, but it is thought to be significant, as revealed by the difficulties of a large trust company called Zhongrong, which announced in August 2023 that several products it had sold to its clients could not be redeemed at maturity. Zhongrong has 629 billion RMB of products outstanding in the market, many of which are thought to comprise mostly property related assets. Zhongrong is part of a much larger asset-management group (Zhongzhi), which makes the situation even more worrying.

Homeowners have to deal with a decline in the value of their assets, which can have a material impact for them as housing assets constitute at least 60% of overall household assets in China (source PBOC). The immediate financial impact of such a drop is limited, as the value of mortgages is usually well below the value of the assets being financed, and banks anyway do not rely entirely on asset values to be repaid. Over time there could be a more serious impact on consumption levels, as citizens adjust their behavior to their perceived level of wealth, although there is no evidence at this time that this is a factor in the current gloomy condition of private consumption in the economy.

Thinking political consequences

At this point in the analysis, it is tempting to conclude that the property crisis is unlikely to bring down the financial system in the short term, but that a full recovery will take a long time, as secondary effects of the crisis will progressively work their way through the economy. The political impact of citizens realizing that a large part of their wealth has gone in smoke could however be devastating over time for the legitimacy of the regime, and this may be a reason why the government prefers to prevent official prices from dropping too much.

The political impact [...] could however be devastating over time for the legitimacy of the regime.

The economy may also be affected in the medium term in a different way: if a large number of people start coming to expect that property prices are likely to continue to decline (similarly to what happened in Japan in the 1990s), potential buyers will defer their purchases, and this will in turn delay the recovery of the market. This type of medium-term effects may over time be even more impactful than the immediate debt losses and other forms of value destruction. 

Before we get there, however, we need to take a look at another category of players which have been hit by the crisis: local governments are heavily reliant on land and land-related revenues to cover their expenses, which include the provision of basic social services as well as the funding of local investment projects. They benefited from buoyant property markets in the last three decades, but have now been hit by a major revenue shock: their land-related revenues are estimated to have declined by more than 2 trillion RMB in 2022 compared to 2021. They are also heavily in debt (at least 66 trillion RMB according to the IMF), and the government therefore has to deal with a second crisis, linked but yet distinct from the original property crisis, and potentially just as devastating.

This will be the topic of a forthcoming paper.

Image copyright:  STR / AFP

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