An Update on Chinese Property Developers

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Evergrande’s missed bond payment a few weeks ago raised alarm amongst many of the financial commentators we follow. Since then it has missed a couple more and given few indications it plans on paying international bondholders.^[i] A few other Chinese property developers—mostly small, distressed ones—have followed suit, to varying degrees.^[ii] Yet the spreading chaos commentators we follow expected and warned could spill globally seems absent, in our view. This doesn’t shock us—as we wrote recently, our analysis shows China’s financial system is largely still isolated from the world’s. But also, the latest reports suggest to us China’s government is acting to mitigate the local effect, and the process appears to be playing out in an orderly fashion. This underscores why we didn’t and don’t think Evergrande is a financial crisis catalyst—neither locally in China nor globally.

Evergrande has now missed a combined $279 million (£202 million) in offshore coupon payments since late September, which will officially constitute a default if they remain unpaid after a 30-day grace period expires on Saturday.^[iii] Meanwhile, more credit events are popping up. To date, seven small, distressed developers including Fantasia Holdings, China Properties Group and Xinyuan Real Estate have either missed payments to offshore creditors or compromised with them, replacing existing debt with new bonds.^[iv] Yet all these transactions are in the millions of pounds—far too small to cause fundamental troubles in China’s economy, much less the world’s, in our view.^[v]

Some analysts estimate China’s real estate market has amassed $5 trillion (£3.6 trillion) in debt, which has doubled since 2016.^[vi] This debt, however, doesn’t all come due at once—it is staged over a sequence of years. About half of it, the plurality, is bank loans—not bonds, which amount to about 10% of developers’ outstanding debt.^[vii] With China’s financial system largely still closed off from the world’s, we think the chances of this hitting Western banks is minimal. Furthermore, our research shows China’s government has a lengthy history of recapitalising banks when it really needed to. In our view, there is little reason to think that is necessary now, but it is worth noting past trends, given the government’s emphasis on social stability.

Already, it appears to us China’s government is acting in other, more limited ways to prevent major domestic fallout. Reports we follow indicate authorities are adopting measures to isolate Evergrande and other problem areas, whilst providing liquidity backstops to ensure credit keeps flowing to the property sector generally.

First, for property developers with the ability to pay, the People’s Bank of China (PBOC) is firmly hinting that not doing so isn’t a great option and encouraging them to meet their financial obligations.^[viii] In our view, by not bailing out problem institutions, the PBOC is seemingly signalling it is serious about reform and seeking to establish more market discipline in the sector and requiring companies to take actions in the market to try and stay afloat.^[ix] So, for example, a Chinese state-owned asset manager recently bought out Evergrande’s stake in a struggling bank to limit the potential for contagion, but authorities have thus far given no indication they will help property developers directly.^[x]

Second, the PBOC and other Chinese banking regulators are taking steps to support the property market’s current soft patch.^[xi] This includes relaxing mortgage restrictions and injecting more than $100 billion (£72.4 billion) into the financial system, which has helped cut overnight borrowing rates and head off broader market hiccups.^[xii]

Third, local authorities are introducing support measures to ease credit. Some local governments including Harbin, northeastern Heilongjiang’s provincial capital, have allowed property developers to access presale funds held in government escrow accounts to pay suppliers and complete unfinished, pre-sold projects.^[xiii] It is also subsidising new home purchases for qualified residents.^[xiv] Then too, just as the developed world typically handles defaults, we think China is taking a more market-orientated approach. Property developers have begun discussing solutions for their outstanding debt.^[xv] Reports indicate Evergrande’s CEO has met with creditors and investment banks over possible asset sales and debt restructuring.

We don’t think this means everything is grand, but a calamity doesn’t seem likely. To us, it looks more like China is letting the air out of a frothy pocket of its economy where speculation has reigned in recent years. With the slowdown in the sector and overall focus on deleveraging, China’s total social financing growth rate—its broadest measure of credit—is hitting new lows. (Exhibit 1) Yet the PBOC’s shifting focus to “promoting healthy property markets” suggests a more sanguine outlook, in our view.

Exhibit 1: China’s Total Social Financing

Source: FactSet, as of 14/10/2021. Aggregate Social Financing, January 2013 – September 2021.

All this looks engineered and intentional to us, not uncontrolled and uncontainable as many now think—and all appears to be in line with the Chinese government’s stated aim to maintain social stability above all else. In our view, if Evergrande’s default process is orderly and encourages more market-orientated discipline, it would be a better outcome than most commentators currently expect—a pretty positive surprise for Chinese markets.