China’s economic growth over the last decade has been made possible by excessive debt growth. Debt to the private non-financial sector is equal to 218% as of 30 June, compared to 175% for advanced economies. Credit growth has outpaced GDP growth for many years now as many investments have been non-productive, especially in infrastructure and property (see, for example, also our blog “Addicted to Debt” from October 2016). Non-productive investments are included in GDP as and when they are made but contribute little to future growth. So, more and more debt is required to keep the growth rate at the promised level (6% in China’s case). This is not a sustainable growth model.

China’s leaders seem to recognize the issue and have been trying to steer the economy away from non-productive investments towards productive investments (e.g. in technology) and consumption. In August of last year, China imposed new guidelines (referred to as the three red lines) that were designed to rein in the unwieldy property sector. These red lines are: liabilities to assets should be less than 70%; net gearing ratio should be less than 100%; and the ratio of cash to short-term debt should be more than 1x. Debt growth is capped, depending on how many red lines are breached, going from 15% if no red lines are breached to 0% if all red lines are breached. The guidelines worked very well; property developers were starved from credit. But the consequences may have been underestimated. 

Home Sweet Home…

Now, Evergrande, one of the country’s largest property firms, is collapsing under a debt pile of USD 300 billion as they cannot fund themselves under the new guidelines. Many other property stalwarts, like China Fortune Land (which was ahead of the curve, already defaulting on bonds in February), Fantasia (what is in a name?) and Kaisa, are in a similar position. It happens to be that property is very important in China. The real estate sector, broadly defined, amounts to about 25% of GDP and property is seen as a store of value for households. Buying apartments, of which 20-25% is standing empty, serves as a nest egg. With Evergrande and other developers in financial distress, home owners, realizing their nest egg is not as safe as a house, are getting worried about their financial future and may save more as a consequence whereas the developers try to sell housing stock to reduce debt, resulting in house price declines. Many apartments are pre-sold but still need to be completed, which often requires some financing (Evergrande alone accounts for about 1.5 million of pre-sold unfinished units; pre-sale proceeds probably comprise about 50% of total funding to developers). Clearly, seeing housing prices under stress means automatically that fewer houses are sold and that higher discounts are required to pre-sell homes, creating a vicious credit crunch for weaker developers like Evergrande. It doesn’t stop there. Budgets of local governments are highly dependent on land sales, which surely will drop as developers don’t have money to spend.  Some local governments already have trouble repaying debt to off-balance sheet vehicles (LGFVs). The property crisis may also affect the banking sector, where especially smaller and mid-sized banks are at risk. Some property developers, including Evergrande, have or had stakes in banks and those banks happily loaned money to their shareholders. It is yet unclear how much exposure these banks have as financial reporting generally is murky (the same is true for financial reporting by property developers; clear cash flow statements are often missing). For example, Huarong, a state-run bad bank that went bad itself, was able to hide an USD 16 billion loss for months.

The government is taking steps to soften the blow from the property crisis. They understand that some companies may  have to default but at the same time they want to avoid investor panic. In part, this is done by resorting to the old recipe of easing credit (by lowering both the key 1-year lending rate and reserve requirements and urging banks to tide over “high-quality” real estate companies) and propping up infrastructure investments. Clearly, this doesn’t solve the problem but buys some time. The way how regulators want to go about solving the crisis is not entirely clear but seems to be focused on spreading the pain to healthy real estate companies (if there are any) and state-owned enterprises (SOEs). Home owners who have prepaid for houses will be saved as will many suppliers (especially construction workers). But at the same time, the government wants to address moral hazard by not bailing out every creditor. Under China’s bankruptcy laws this is quite easy to achieve as the courts simply can decide which creditors get preference and, as common in other Emerging Markets as well, locals will have an advantage. Foreign investors are likely to be short-changed and, in any case, are structurally subordinated as they often invest via variable-interest entities. The restructuring will not be left to the market but be controlled by the government. At Evergrande (and other developers), a risk committee, consisting of representatives of Party-loyal representatives of SOEs, has been formed to sort out the mess. In other cases, local governments have taken over projects to ensure that construction is completed. The restructuring most likely will be a lengthy process, taking at least 3 years.

Maybe not as solid as a house…?

The outcome of the restructuring, assuming it will be followed through, will be much lower economic growth (3-4% instead of 6-7%). Surely, the government will rebalance the economy towards more consumption and productive investments (going from fictional growth to genuine growth, as Mr. Xi, China’s thought leader, puts it), but this is unlikely to bridge the gap given the current outsized share of the real estate sector specifically and of non-productive investments in general which needs to be brought down. Given depressed house prices for some time to come, China’s households will need to find steadier investment opportunities to allocate their money to whilst developers are putting their house in order…