As defaults escalate, another shock threatens to hit the global economy
This article was originally published by The Economist on 5 March, 2022
Not long ago prospective homebuyers in China would find large maps on the walls of property marketing offices. On display were not only the housing projects for sale. The maps also showed the parcels of government land surrounding the projects and their expected future prices, which were often higher than the home units for sale per square metre. The implication for the anxious buyer-to-be was clear: buy now, or regret it forever. Very soon land prices would be far higher next door.
The maps tell the story of China’s decades-long build-up in property debts. These seemingly endless increases in prices were made possible only because developers had access to almost unlimited credit. Ample loans, offshore-dollar bonds and deposits from buyers once fuelled bidding wars between them that pumped up land values. The winner was sure to turn a huge profit if they held onto the parcel and waited for the price to rise. Local governments, too, happily gorged; land sales contributed 43% of their revenues in 2021.
Homebuyers are seeing a very different picture now. Xi Jinping, China’s president, has been fearful of runaway unaffordability and untenable debt. He has turned off the tap of easy credit by capping developers’ ratios of liabilities to assets, net debt to equity, and cash to short-term debt (known as the “three red lines”). This has pushed China’s property sector to the edge. A dozen developers, including Evergrande, one of the world’s most indebted property groups, have defaulted on bonds since July 2021, or have come close. Companies recently deemed safe bets for investors have suddenly started looking wobbly. One of those, Shimao, missed trust payments on February 24th. Zhenro Properties stunned creditors on February 21st when it said it may not repay creditors in early March.
The implications go far beyond the offshore bond market. Construction has stalled in places. Some developers are now selling assets to patch up their cash flows. Many have stopped buying land, causing the value of parcels sold by local governments to crater by 72% in January year on year. Home prices are falling in many cities, turning off speculators looking for the guaranteed huge gains once advertised on sales-office maps. Families looking for flats wonder if they can even be built.
Whether the central government holds firmly to its red lines is unclear. If it does, the property market will be forced to make a monumental adjustment to better match supply with real household demand for homes. The annual supply of homes is now three times that of future urban-household formation, reckons Rhodium, a consultancy. Sales must fall from around 15m units per year to about 10m.
As the bubble deflates the effects are rippling through the Chinese economy. Senior leaders have yet to issue an economic growth target for 2022 but many economists expect them to draw a line at 5% (China’s gdp grew by nearly 6% in 2019). This will be a difficult rate to defend should the property sector, which makes up an estimated 25% of gdp, continue to crumble. A major slowdown, in turn, would hamper a global economy already hobbled by soaring inflation and geopolitical clashes.
Policymakers in Beijing must fulfil three major tasks if they are to avoid catastrophe. First they must make sure offshore defaults do not spiral out of control, closing out Chinese issuers from the dollar bond market. A second task is to ensure firms continue to build homes and families continue to buy them. This is crucial for economic growth this year. A third daunting challenge is to formulate a long-term plan that brings some stability to the market over the next decade.
Mr Xi probably did not anticipate such a rapid rise in offshore defaults. Altogether some $100bn in debts needs to be repaid this year. Evergrande, the group with $300bn in liabilities, has been the biggest worry. It defaulted in December and has become one of the largest restructuring cases in history. Investors are tracking the case for reasons to be optimistic. The group is now thought to be under a high degree of government control. It has promised to deliver a restructuring plan by July. State involvement is good because it will help avoid a total collapse, says one person involved in the restructuring. It also means that stability will be the main priority, not speed or efficiency.
Resources are running low. Legal expertise on such cross-border situations involving China is limited and, so far, many Chinese defaulters have been unwilling to cough up for high-quality advice. Accounting firms have abruptly resigned from auditing developers’ books. The early restructuring plans for a few Chinese developers have made little room for offshore creditors, says a lawyer working on a case. Evergrande’s offshore bonds currently trade at 15 cents on the dollar—a gloomy signal on what investors expect to get back. High-yield dollar bond issuance by Chinese companies—an important source of credit for them—has fallen substantially.
A second task for the Communist Party will be to keep developers building and buyers buying. Sales for the 100 biggest firms came down by close to half in February compared to the same month last year. Investment in property fell by 14% in December. Prices in many cities have declined. Domestic sales of excavators nearly halved in January year on year.
Policymakers are fidgety. Like global hedge funds, they want to avoid ugly incidents at companies such as Zhenro. The sudden shocks arise because developers have not been giving a clear picture of their total cash positions. They include billions of yuan held tightly in escrow accounts by local governments who want to ensure the money is used to build homes, not pay creditors. When payments come due, the companies cannot access all the cash they say they have. Fitch, a rating agency, downgraded Ronshine, another large developer, on February 22nd on concerns that it would fail to access such funds.
Trapped cash is also halting some construction. Many workers have laid down their shovels after going unpaid. Evergrande has claimed it can build 600,000 homes this year—music to officials’ ears. Yet on February 16th a court in mainland China froze 640m yuan ($101m) of the company’s cash after it could not pay a state-owned construction group.
The central government plans to standardise escrow accounts so that less of the developers’ cash is locked into them. But that will not be enough to rescue the sector. Investors hope that Beijing blinks and reverses some of its tough policies. Some local governments have already flinched. The city of Zhengzhou in central China on March 1st said it would make it easier for people to buy second homes. In the south, the city of Guangzhou cut mortgage-loan rates by 20 basis points on February 22nd. Banks in Shanghai have made similar cuts.
Things you should know
The articles may contain material provided by third parties derived from sources believed to be accurate at its issue date. While such material is published with necessary permission, the Westpac Group accepts no responsibility for the accuracy or completeness of, nor does it endorse any such third-party material. To the maximum extent permitted by law, we intend by this notice to exclude liability for third-party material. Further, the information provided does not take into account your personal objectives, financial situation or needs and so you should consider its appropriateness, having regard to your personal objectives, financial situation and needs before acting on it.