Financial Markets

Highlights Evergrande has not only crossed regulatory gridlines but also regulators’ bottom lines; the government will use the example of Evergrande to impose discipline on real estate developers. The policy response will likely prioritize domestic homebuyers and suppliers to minimize systemic risks and damage to the real economy. However, a bigger risk stems from the possibility that policymakers overestimate the resilience of the economy and ignore signs of a significant spillover to other segments in the economy. The existing policy restrictions on China’s housing sector will not be reversed; the sector is on a structural downshift and will face risks of further consolidation and profit growth compression. Feature China Evergrande Group continues to stir up the global markets. Last Thursday the company missed a deadline to pay USD $83.5m in bond interest. The firm has now entered a 30-day grace period; it will default if that deadline also passes without payment. Chart 1Roller-Coaster Ride Continues... Evergrande has not remarked on the potential default nor have China’s authorities or state media offered any clues about a potential rescue package. Meanwhile, the PBoC injected large amounts of liquidity into the banking system of late, a clear sign of support for the markets. Evergrande share prices continued their roller-coaster ride (Chart 1). Evergrande’s tumult is indicative of an industry-wide problem.  Real estate developers have expanded their businesses and profits through high-debt growth models. China’s policymakers have been trying to crack down on this business practice since 2017 and their clampdown has significantly intensified since August 2020. In this report, we follow up on last week’s Special Alert and share our thoughts on the potential market implications and policy response to the evolving Evergrande situation. The “Three Red Lines” Versus The “Bottom Lines” Evergrande has not only crossed the “three red lines” – three debt metrics China’s authorities laid out a year ago to reduce the housing sector’s leverage – but it has also crossed the bottom lines of policymakers. Therefore, we do not expect the government to lend a financial hand to bail out the corporation and its shareholders. Meanwhile, as discussed in our Special Alert, we expect that there will be some kind of a rescue plan to help onshore homebuyers and suppliers recover their losses. The authorities’ silence in the past three months as investors’ concerns about Evergrande’s debt situation escalated speaks volumes about plans for the overleveraged company. The Evergrande episode is not idiosyncratic; it represents an industry-wide problem linked to the sector’s high-debt growth model.  However, Evergrande has become China’s and the world’s most indebted property developer; the “three red lines” policy last year has pushed the company into a severe liquidity crunch.  Evergrande not only borrowed heavily to pursue an aggressive expansion strategy (“disorderly expansion of capitals”), but did so as President Xi Jinping famously remarked “houses are for living, not for speculation” in late 2016. Between 2016 and 2020, Evergrande’s total liabilities almost doubled and its stock prices jumped by 460%. Evergrande’s founder was ranked the richest man in China in 2017, building his company’s fortune on excessive leverage. The way that the company accumulated wealth conflicts with the government’s new mantra of building “common prosperity”, a policy shift to reduce income and wealth inequality. Furthermore, Evergrande paid its offshore investors in June this year while it continued to borrow from onshore banks and offload its onshore assets. This move did not bode well for China’s domestic stake- and shareholders, along with policymakers. Chart 2Housing Price Inflation Has Been Subdued Outside Of Top-Tier Cities In contrast with policymakers’ silence about the future of Evergrande and its shareholders, the authorities have reportedly urged the company to finish and deliver its housing projects.  Evergrande’s projects are mostly in tier-three cities where post-pandemic home price inflation has been subdued compared with top-tier cities (Chart 2). As such, policymakers will be less concerned about fueling home prices in these cities and more willing to work out a plan to finish and deliver those housing projects. Bottom Line: Beijing may rescue the stakeholders of Evergrande rather than its shareholders. Contagion Risks We discussed our baseline scenario for Evergrande’s bankruptcy and restructuring in last week’s Special Alert. Our message has been that the well-telegraphed Evergrande default might not create an imminent systemic crisis or crash in China’s financial markets. However, it will likely reinforce the credit tightening that has been underway in China over the past 12 months.  This will delay and weaken the transmission of liquidity easing into the real economy. So far things are not bad enough for policymakers to reflate the economy in any meaningful way. Since the contagion risks from Evergrande’s debt crisis to China’s onshore financial markets seem to be contained, policy easing in the coming months will likely be gradual. Regulators have shown no sign of reversing the existing policy restrictions. Therefore, a bigger risk to China’s financial markets stems from the possibility that policymakers overestimate the resilience of the economy and ignore signs of a spillover to other segments in the economy. Real estate activity and investment in China are set to slow structurally (discussed in the section below). If policymakers allow a disruptive deceleration in the sector's growth while being reluctant to ramp up support in other industries, China’s economic growth could downshift much more than policymakers would like to see. A rapid deceleration in the real economic activity and jitters in the financial markets could reinforce each other and spiral out of control. The facts below explain why risks of an imminent systemic crisis in China’s and global financial markets are limited (Table 1): The exposure of China’s banks to real estate developers is small relative to the banks’ total lending.  Although about 40% of total bank loans are property-related, only 6% are in loans to real estate developers. The majority of the 40% is in mortgage loans, construction loans and other loans collateralized by land and property. Evergrande’s outstanding bank debt accounts for less than 0.1% of China’s total onshore loan balances. The company owes about 1% of China’s existing trust loans and 0.04% of domestic bonds. The company has quality assets, as we discussed in last week’s report, that could cover most of its onshore outstanding debt. Widespread mortgage loan defaults are unlikely to happen, even if Evergrande does not strike a debt restructuring deal with the government. Strict housing and home-sale regulations cap the upside and limit the downside in home prices. Moreover, conservative loan-to-value ratio requirements have contributed to China’s low default rates on mortgage loans.1 Evergrande’s overseas liabilities are more significant, with its USD $20 billion bonds accounting for about 10% of China's corporate USD bonds issued by real estate developers. On the other hand, major US financial institutions have minimal direct exposure to China and Hong Kong SAR. Table 1Evergrande Debt, An Overview* Despite limited systemic risks to the financial markets, a lack of government intervention could result in a disruptive bankruptcy of the company, risking substantial ripple effects on other parts of the economy. Evergrande’s accounts payable and bills amount to nearly RMB 700 billion, owed to companies in the upstream and downstream industry supply chains.  In addition, Evergrande’s contract liabilities are as high as RMB 170 billion and are associated with the pre-sold but unfinished residential units in more than 200 cities. We think policymakers and Evergrande will ultimately agree on a debt restructuring plan. Evergrande could transfer some of its hard assets to state-owned banks or enterprises and the banks could either extend or restructure Evergrande’s existing loans to help finish and deliver the company’s housing projects. Regardless of how the debt is restructured, a government-led rescue will likely prioritize domestic homebuyers and suppliers. Evergrande shareholders and investors in offshore, USD-denominated corporate bonds will suffer large losses. Bottom Line: Our base case scenario is that the government will restructure Evergrande’s debt to prevent the company’s crisis from evolving into a systemic financial risk. Will Policymakers Reverse Restrictive Housing Policies? Even though China’s monetary and fiscal policies have eased at margin, policy restrictions on the property market remain in place. The bar for regulators to significantly ease or to reverse policy tightening in the real estate industry is much higher than in past cycles. Furthermore, the government’s efforts to contain the sector’s leverage and home price inflation are structural rather than cyclical. Our view is based on the following observations: Chart 3China's Housing Demand Is On A Structural Downshift China’s housing demand is on a structural downshift due to China’s falling birthrate and working-age population.  The decline in demand will likely accelerate in the next four to five years (Chart 3). Therefore, it is unreasonable to expect that the growth in real estate investment in the coming years will continue growing at the same rate as in the past cycles.  The government is determined to improve housing affordability by capping home prices in the coming years while increasing lower-income household wage growth. Previous “big bang” stimulus and soaring home prices have widened rather than narrowed income and wealth inequality. Beijing’s current primary focus is “common prosperity,” which aims to reduce inequality. This overarching policy initiative will prevent policymakers from backtracking on reforms in the property sector. Things are not bad enough for a major shift in policy direction. Demand for housing is down, but from a very elevated level (Chart 4). The growth of home sales is now reverting to its pre-pandemic rate. In a previous report we pointed out that the current policy backdrop resembles that of 2H2018 and 2019, when the stimulus was very measured despite a slowing economy and an escalating trade war with the US. Demand for housing in the first eight months of this year is stronger than in 2018/19, thus policymakers may not feel pressure to loosen restrictions in the housing sector.  Chart 4Post-Pandemic Housing Demand Stronger Than 2018/19 Chart 5Real Estate Investment Relatively Steady Despite Contracting Housing Starts Growth in real estate investment has been steady despite contracting housing starts (Chart 5).  The government’s deleveraging pressure on the sector since August last year has forced developers to hurry and finish their existing projects (Chart 5, bottom panel). This has helped to reduce developers’ project inventories and discourage them from hoarding land reserves, and the policy intention is unlikely to change (Chart 6). Additionally, the government has prioritized home price stability by capping prices and fine-tuning the supply of land (Chart 7). In other words, housing starts have become less market-driven and weaker readings may reflect regulators’ policy intentions to rein in land supplies.2 Local governments may increase the supply of land when real estate investment softens too fast, but home sales and project completions will have to decelerate more significantly. Chart 6Developers Have Been Rushing To Finish Existing Projects Chart 7Government Prioritizes Home Price Stability By Capping Prices And Fine-Tuning Land Supply Funding constraints will not be removed soon and restrictive policies apply to both developers and banks. Banks need to meet the “two red lines” while developers must bring their leverage ratios below the “three red lines” by end-2023. The “two red lines”, which the PBoC unveiled in January this year, set the upper limit on the portion of household mortgages and real estate loans in banks’ total lending.  Despite aggressively scaling back lending to the housing sector, the lending ratio in many banks – including China’s six large banks and various medium-sized banks – still exceeded the upper limit. These banks will have to continue to reduce their property-related lending while the other banks will maintain a lower percentage of loans to the housing sector than in the past. Consequently, binding constraints on developers and banks will continue to weigh on the housing market in the coming years, suggesting that the property market downturn will last longer than in previous cycles. Chinese policymakers are unlikely to have much appetite for more robust construction activity in the current environment with supply-side constraints for both raw materials and energy. More than 10 provinces in China are currently under power rationing and have cut factory production amid electricity supply issues and a push to enforce environmental regulations. We expect supply shortages and production decreases to continue through the winter, limiting the upside potential of the country’s economic activity. Bottom Line: China’s reforms in the property sector are structural and the leadership is much less likely to use housing as counter-cyclical policy support to the economy than in previous cycles. Investment Implications China’s growth and its ever-important property market activity have slowed. Given the policymakers’ higher pain threshold for a slower economy and lower appetite for leverage, policy easing will likely be gradual and piecemeal in the near term. The current monetary, fiscal, and industry policy backdrops resemble China’s response in H2 2018 and early 2019. Chinese stock prices rose briefly in early 2019 on the expectation of a sizable stimulus, but the rally was short-lived (Chart 8). Furthermore, we do not rule out the possibility that policymakers will be overconfident in their capability to stabilize the economy as they balance structural reforms against growth volatility. They may choose to wait until there are signs of a significant spillover to other segments in the economy before backtracking the deleveraging campaign in the property sector and lending more support to the market/economy. In this scenario, the near-term response in the equity market will likely be very negative. China-related asset prices will not stabilize until policymakers decisively and significantly dial-up their reflationary response. Property sector stocks in China’s on- and offshore markets have been beaten down by policy tightening and lately the Evergrande saga (Chart 9). We maintain our view that these stocks have not reached their bottom. The property downturn in China is a structural change and authorities are unlikely to reverse current restrictions on the sector to support the economy. Chart 8Chinese Stock Price Rally In 2019 Was Short-Lived Chart 9Chinese Real Estate Stocks Have Not Reached Their Bottom The real estate sector’s contribution to China’s economic growth is expected to gradually decline in the medium to long term. The industry will be further reformed and consolidated, and more developers will be forced to abandon their high-leverage, high-growth business expansion model. The outlook for the real estate industry’s profit growth will become less certain.  Investors will require higher risk premiums for real estate sector stocks, which means that these stocks’ valuations will be further compressed.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 Chinese homeowners’ down payment ratios on a first property is 30% and 50% on a second property. 2Land auctions were delayed in July and August due to overwhelming demand from developers in the first half of the year. Market/Sector Recommendations Cyclical Investment Stance