Feature Stories | Oct 27 2021
The risk of China’s largest property developer going into liquidation remains real, but even if Evergrande doesn’t, there are clear risks ahead for the Australian economy.
-Evergrande’s debt systemically significant
-Beijing orchestrating a property market slowdown
-Financial risk considered contained
-Risk to commodity demand is substantial
By Greg Peel
The collapse of Evergrande would not, analysts agree, spark a “Lehman moment”, referring to the collapse of one of America’s largest investment banks in 2008, which shifted the global “credit crunch” to that point into a Global Financial Crisis.
On the day it appeared Evergrande might well collapse, the Dow fell over -600 points and global markets followed suit. But analyst confidence that another GFC was not upon us swiftly relieved markets, at least until the Fed started to send more hawkish signals, exacerbating the September sell-down already in train.
Subsequently, Evergrande faded from the minds of investors, with news out of China not always overly forthcoming. However, the issue of Evergrande’s future, if it has one, has by no means yet been resolved. To that end, while analysts may not foresee another GFC, they still believe the risk is substantial for the world’s second largest economy, and that those risks flow on to the global economy.
And in particular, the Australian economy.
How did we get here?
Evergrande is a very significant Chinese property developer, notes Auscap Asset Management, with some 1.5 million dwellings under development, spread across 778 projects in 223 cities, in a country that produces approximately 15 million new dwellings a year. Property development is an enormous driver of economic growth within China.
Evergrande employs 200,000 people directly and reportedly creates 3.8 million jobs per annum indirectly in its construction and other businesses. The problem is that it has approximately US$300bn of liabilities, US$170bn of which is due within twelve months, and has 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 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 is at risk of defaulting on its obligations. Evergrande has missed bond payments, is late in paying employees and has not paid due invoices from suppliers and other creditors.
One of those bond payments, an amount of US$83m, was due to be paid on October 23 and at the last minute, Evergrande made good. But the company is by no means out of the woods.
Ironically, one might suggest, Evergrande’s problems have their roots in the GFC.
China’s response to the GFC was one of massive fiscal stimulus, supporting the country’s rapid urbanisation, and driving strong economic growth. This resulted in a property boom as demand for housing in the cities ran wild. Like with all booms, a stumble followed, in this case in 2014-15, leading to a sharp pullback. Beijing’s response was to ease property policies, and to support the market by investing in “shanty town” renovation.
The growth in China’s property market was a major element of strong economic growth, and substantial growth in debt. But economies cannot grow at such a rapid pace forever. Eventually they mature.
Housing demand in China, notes JPMorgan, is sourced from new family formation (marriages), urbanisation, public housing (renovated shanty towns) and investor demand. By 2017, China was experiencing lower birth rates, a decline in new marriages, the end of shanty town investment subsides from the government, a slowing in the pace of urbanisation, and a crackdown on speculative property development. This is when housing demand peaked.
JPMorgan estimates that demand fell from 20.2 million units in 2017 to 16.4 million in 2020, and will fall to 12.7 million by 2030. Note that immigration is another driver of housing demand, and that came to a halt in the pandemic, which in China is not over yet.
Beijing’s response to the 2014-15 pullback was to support property development. By 2017, President Xi had changed his mind. “Housing is for living,” he said, “not for speculation”. This represented a fundamental shift in housing policy, JPMorgan notes.
Xi perceived a rapid increase in housing activity as undesirable because it can crowd out investment in desirable areas for the new Chinese economy, such as manufacturing upgrades, “green” sectors, small and medium enterprises and rural development. Rapid property development also increases financial vulnerabilities, given the high indebtedness of developers and the risk of a house price correction, and increases social dissatisfaction among the haves and have-nots.
The importance of a more equal distribution of wealth, as one might expect from a communist government, has come strikingly to the fore in 2021, as Beijing has been prepared to suffer a sharp share market pullback with clampdowns on carbon emissions, tech companies, education companies and, most importantly, property developers.
Concerned about the level of ever-growing property developer indebtedness, Beijing last year introduced a “three red lines” policy, creating three measures to be used to assess the rate of allowable growth in developer debt. The lines 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 one, two or all three measures, the regulator can cap their debt growth at 10%, 5% and 0% respectively. If all measures are achieved, growth is capped at 15%. Beijing has given developers until mid-2023 to comply.
Evergrande failed all three tests in August 2020.
The Spiral
Evergrande responded to this failure by immediately implementing a clearance sale, offering -30% off all properties. Despite this, China’s property sector performed strongly in the first half of 2021, with value of sales increasing year on year across all months, UBS notes. But data in July and August were weak.
In June, regulators reportedly instructed major lenders to conduct fresh stress tests on their Evergrande exposures, Auscap notes. Later that month, several large banks started restricting credit to the developer. In July, both Standard Chartered and HSBC began declining loans to buyers of Evergrande properties. In August, the chairman of Evergrande’s onshore real estate business resigned.
Two days later, the regulator summoned Evergrande executives and told them to reduce debt levels. By end-August, Evergrande’s debt had hit US$300bn. Claiming lack of payments from the developer, many suppliers stopped deliveries. In September, Evergrande announced its sales in August had fallen -26%.
In September, Evergrande missed two interest payments to bondholders, bringing the company into the global spotlight and setting off stock market plunges. Earlier this month it missed a third.
But while Evergrande was an early driver of September stock market weakness, concerns over inflation and monetary policy pushed Evergrande aside, and now markets have recovered. The S&P500 has since regained its all-time high. Markets believe Evergrande will not spark a new GFC, and assume it is a problem Beijing will solve one way or the other, with little impact outside China.
But such an impact may not necessarily be contained.
Evergrande has made good on one September bond payment, after a one-month period of grace, but another is due on October 29.
Contagion?
According to UBS, in 2019 the largest 50 developers in China accounted for 60% of development activity. Of the country’s 66 major developers, almost half passed the “three red lines” test in August 2020, up from just 14 six months earlier. Only four failed all three tests, Evergrande being one.
Evergrande and one other were the only two developers not to show any improvement between June and December 2020.
UBS estimates China’s property sector could represent, directly and indirectly, 25% of China’s GDP growth. Land sales account for around one third of local government budget revenue, which funds 15-20% of total funding of infrastructure investment.
Housing market value is the biggest contributor to Chinese household wealth at more than half, and as is the case in any country, perceived wealth through property ownership has a major impact on consumer spending. Property debt at the household level has picked up, notes UBS, but remains manageable given the high level of down-payment required for purchases.
UBS estimates China’s banks have a total exposure to the property sector of 28-32% of total bank loans. The analysts see this, too, as largely manageable in the case of an Evergrande spillover.
JPMorgan puts that figure at 40%, but only 6% of that is loans to property developers. Mortgage loans, construction loans and loans collateralised by land account for 20-25%. On that basis, JPMorgan suggests that given small bank exposure to developers, even severe credit quality deterioration for property developers is unlikely to trigger systemic stress in the banking sector.
Mortgage loans represent a big chunk of Australian bank lending, but compared to Australia, China has stricter macro-prudential controls and more conservative loan-to-value ratio requirements. JPMorgan notes that over 1997-2004, Hong Kong house prices collapsed by -70%, but mortgage delinquencies peaked at only 1.43% of loans.
What will Beijing do?
It is widely assumed the Chinese government will not sit idly by and watch Evergrande go under, setting off a property market crash. It is also assumed Beijing did not walk blindly into implementing the “three red lines” policy without knowing full well what the ramifications could be.
There is a question as to whether the government will act now, and control the restructure of the company, or whether it will allow Evergrande to fail before stepping in to pick up the pieces thereafter.
While a restructure was the popular assumption back in September when Evergrande missed bond interest payments, subsequent attempts by the company to offload assets to other Chinese developers to raise cash have failed. At least two potential buyers have assessed the situation so far and both have withdrawn, likely deciding they’d rather pick up assets at little cost in a liquidation.
Simon Hunt Strategic Services, writing in late September, believed it was likely Beijing would allow Evergrande to fail. But the government would then step in, the analysts suggest, to support households which have part or wholly paid for apartments off the plan, and provide credit to supply chain companies out of pocket.
The assumption thus is that equity and bond holders would be left to take the hit. But there have since been some developments.
There was news out of China on October 20 that Evergrande had made some sort of payment, amount unclear, to domestic bondholders. On September 23, the company missed interest payments due on two bond issuances – one domestic (renminbi) and one foreign (US dollars). Under the rules, Evergrande had one month to make those payments or default would follow.
The company avoided default on October 22 by making good on the US dollar bond payment, but that’s just one obligation. A default on any payment means secured creditors can place Evergrande into liquidation.
However, on October 20, the Chinese central bank said it will “fully respect and protect the legal rights of Evergrande Group's creditors and asset owners in line with repayment priorities laid out by the law”. The spokesman also said “regulators should do their best to avoid risks from cash-strapped Evergrande spilling over into other property developers and the broader financial sector”.
Several of Evergrande’s property developer rivals have in recent weeks already defaulted on debts and have seen their credit ratings downgraded. Evergrande said it would continue to implement measures to ease its liquidity issues, cautioning that "there is no guarantee that the group will be able to meet its financial obligations,” while applying for a resumption of trading after it was halted on the Hong Kong stock exchange.
The Fallout?
Evergrande resumed trading on the Hong Kong exchange on October 21 and closed down -10%, to a level equivalent with that of late September of around HK$2.67, where it has hovered since. The shares traded at HK$30.00 in 2017.
The signs are that Beijing will do its best to contain the situation, while allowing the heat to come out of the property market in a controlled manner.
UBS analysts’ baseline forecast assumed Chinese property sales declining by -8% year on year and new starts falling by -8-10% in the second half 2021, with real estate fixed asset investment falling by -2-3%.
In a worst-case scenario, in which Evergrande’s outcome leads to major spillover effects, UBS sees new property starts falling by as much as -20% or more in the next few months and real estate fixed asset investment falling by -10%, potentially dragging down China’s GDP growth by -1-2 percentage points.
However, UBS is not alone in assuming the macro impact of a worst-case scenario would not be as significant as that experienced in 2014-15 (remember images of China’s “ghost cities”?) given inventories remain low and excess capacity in upstream construction materials sectors has declined.
If things really get bad, it is assumed Beijing would step in with further fiscal and monetary support, and perhaps extend the deadline on property developers satisfying the “three red lines”.
However, Auscap believes the Evergrande fallout could lead to a “very significant impact” on GDP.
Chinese property developers fund themselves through also offering retail investors “wealth management products”. More than 80,000 Chinese bought Evergrande WMPs over the last five years, raising US$15.4bn. Some US$6.1bn of these investments remain outstanding (as at September).
Non-repayment, or even just the risk of non-repayment, of WMPs by a developer as large as Evergrande could have repercussions for future developers trying to raise funds this way. Then there’s the likelihood potential property market bond investors will be scared off, materially increasing the cost of capital, and furthermore, materials suppliers to the sector may well be once bitten, twice shy.
Then there’s the so-called “wealth effect”. JPMorgan notes housing is the largest asset making up Chinese household wealth, accounting for 60% of household assets according to a 2019 PBoC survey, compared to 30% in the US. Home ownership is also very high at 90%. When house prices are strong, property-owners feel wealthy, and are more prepared to spend money.
JPMorgan’s research suggests every -1 percentage point decline in house prices tends to drag consumption down by -0.2ppt. More importantly, the analysts suggest, given the high level of home ownership, a housing price collapse would create a much bigger socio-political problem than a house price spike.
Impact on Australia
The large negative side-effects associated with China’s traditional growth model, attempts to reduce moral hazard in the financial system, and President Xi’s focus on achieving “Common Prosperity” have conspired to see China more comfortable with lower growth, particularly in the real estate sector, observes Shaw & Partners.
Strong growth since the GFC has come at the expense of rising debt levels, and sharply higher house prices have exacerbated inequality.
China’s average house price to disposable 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, notes Auscap.
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
In a worst-case impact of the “three red lines” property developer policy, property investment could fall -10% in the second half of 2021, Shaw suggests, and mark an annual contraction in 2022. But the peak-to-trough change will likely be smaller than that in 2014-15. Residential inventories versus sales are relatively low compared to 2014, especially in lower-tier cities.
The spillover effect to upstream industries such as coal and steel would also likely be smaller given excess capacity has reduced significantly since 2015, as has industry leverage.
And it is expected by all observers that in the case of a dramatic downturn, the government will respond with monetary/fiscal support to ease down the market rather than watch it collapse.
On a longer term horizon, Oxford Economics believes urban housing sales and property investment will continue to grow at a reasonable pace, but a much slower pace than in the past. Ongoing urbanisation and a still-high savings rate (albeit declining due to an ageing population) will continue to support future real estate investment, Oxford suggests.
There are already signs of a slowdown in the Chinese property sector, with new construction starts contracting, and a sharp weakening would have significant effects on growth in overseas suppliers, given the vast quantity of inputs this sector “sucks in”, Oxford warns.
The impact would also spread more widely due to negative effects on global commodity prices. So far, the broader commodity indices are holding up well, Oxford notes, but there have been visible effects on some China-sensitive commodities, most notably iron ore. There are also indications of a weakening trend in copper prices. These commodities are probably the most important global channel for Evergrande contagion in the near term and should be watched closely.
However, there are two conflicting forces in China currently impacting on copper and other metal prices. One is lower demand as property construction slows, while the other is lower supply due to government enforced power cuts for producers and subsequently falling inventories.
Beijing has been attempting to limit production anyway, so as to reduce carbon emissions generally but also to ensure clean air for the Winter Olympics in February which no one is allowed to attend, unless you’re an athlete, official or Chinese.
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, Auscap notes. There are also potential flow-on implications for employment and consumption to consider.
Auscap remains 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, Auscap suggests 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 Auscap remains positively disposed to domestic and global economic growth as the world emerges from covid, an awareness of the potential implications of any fallout from a significant slowdown in the property sector in China is informing Auscap’s approach to investing while these risks are present.
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, the analysts warn. 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.
Evergrande’s next bond payment is due on October 29.
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