Chinese credit is slowing and the property development segment is diving into a hard landing. The signals are everywhere. Goldman has more:
Evergrande developments the main driver for near term risks. With Evergrande bonds pricing in elevated risks of default, investors are questioning how “fat” the tail risk is for China property bonds. More specifically, could we see defaults pick up for a sizeable number of HY bond issuers? In the near term, we believe much will depend on the developments surrounding Evergrande, and how the company will resolve its credit issues. Given Evergrande’s large amounts of trade and other payables (RMB 951.1bn) and contract liabilities (RMB 215.8bn) outstanding at the end of June 2021, any default that were to disrupt the company’s property development business onshore (e.g., if construction is halted and the delivery of pre-sold properties is interrupted) would likely be negative, affecting homebuyers’ sentiment. Under such a scenario, tail risk concerns may increase. On the other hand, if the company can stabilize their onshore property development business (for example, by bringing in third party investors to assist in a potential debt restructuring), and that the outcome from a potential debt restructuring is not too dissimilar to current market levels, the impact on the China property HY market may be limited.
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Policy focus on deleveraging the property sector unlikely to change. Beyond the near term focus on Evergrande issues, the key factor likely to affect tail risk in the China property sector is government policies. We have already seen the implementation of the “Three Red Lines” policy that aims to curb leverage growth for individual developers, and the imposition of curbs on the amount of lending each bank can extend towards the property sector. More recently, stringent rules were implemented that aim to stamp out irregularities within the property sector, as well as the banning of private equity investments into residential real estate. As such, there appears to be no letting up on policymakers’ focus to deliver the property sector, and ensure that “property is for living, and not for speculation”. Therefore, we believe tail risk is here to stay, as regulatory tightening exacerbates credit differentiation, and weaker, higher levered developers will continue to face challenges.
Policy implementation has room to ease. We do not expect overall policy direction to change, even in the face of slowing activity levels. We believe the focus on removing potential financial risks from rising leverage in the property sector is unlikely to alter. Furthermore, ensuring housing remains affordable is a key policy objective, as highlighted by the rising importance of affordable rental housing, as detailed in the 14thFive-Year Plan earlier this year, and recent news suggests concurrence with that. That said, we retain the view that policymakers have zero tolerance for systemic risk concerns to emerge. Should there be broader contagion across the financial sector, we do see room for policy implementation to ease. For example, it is worth noting that the “Three Red Lines” have an implementation period of 3 years, and the cap on property sector lending have an implementation period of between 2 to 4 years. As such, although we expect tail risk is here to stay, we also think that it will be prolonged, and credit cleanup across the sector is likely to last beyond the coming months.
For companies in the tail, progress on asset sales and deleveraging will be key. To assess tail risk in China property HY, we identify the issuers that have over USD 1bn of bonds outstanding, and who have bonds that are yielding in excess of15%. The list is shown in Exhibit 3&Exhibit 4, and they have an aggregate USD 35.8bn of bonds outstanding, accounting for21.4% of China Property HY bonds outstanding. We note that, amongst this list, one issuer breached three red lines as at June 2021 (Guangzhou R&F), one breached two red lines (Greenland), one was in compliance with all three red lines (Kaisa), with the remaining companies in breach of one red line (Exhibit 1). Furthermore, the red line that most issuers have breached is maintaining the ratio between total liabilities (excluding presales deposits) and total assets (excluding presales deposits)below 70%, whilst most have cash exceeding short term debt by over 1x. To us, this means that for the majority of the higher yielding credits, near term cash positions are relatively sound, but there is a need to reduce liabilities relative to their asset bases, and that may necessitate asset disposals.
Idiosyncratic stories to dominate, but tail risk stay concentrated. Given the need to delever, how each issuer will progress on strengthening their balance sheets will determine whether their levels of credit stresses will rise or fall. Therefore, idiosyncratic factors will likely dominate, and will react to news flow, particularly given that the next set of earnings are due in around six months’ time. In addition, as shown in Exhibit 2, margins are compressing. This will create added pressures for developers, and may pose additional challenges to deleveraging. This is why we remain cautious on theriskiest credits within China property HY. However, we donot believe that investors should adopt an overall negative stance towards China property HY. In addition to the high yields available, overall the sector continues on a gradual deleveraging trend, and therefore we expect tail risk to remain concentrated and not broad based across the sector.
Idiosyncratic, eh. It is true that policymakers will keep hosing off their own policies to prevent a disastrous freeze in the segment. Evergrande being numero uno:
“China’s property developers — and their creditors — appear to be approaching a reckoning,” said analysts at Capital Economics in a note.
They warned Evergrande is “close to collapse” with large losses looming for banks, bondholders and home buyers.
But idiosyncratic in China still means two things. First, owing to the magnitude of the property segment, spotty distress still equals immense downwards pressure on growth and commodity demand.
Second, the risk of a bowel-shaking crash on policy error is very real. To wit:
It’s “almost unavoidable,” said Nomura International Hong Kong Ltd. credit analyst Iris Chen. Her base case is a government-supervised deal that ensures Evergrande delivers homes and pays suppliers, where dollar debt investors would get 25% of their money back. Luther Chai, a senior research analyst at CreditSights Singapore LLC, also says Evergrande will default and enter restructuring. That risk is being priced in, with many of Evergrande’s dollar bonds trading near 30 cents.
Liquidation is a scenario where bondholders may get close to nothing. This is unlikely, says CreditSights’s Chai, because it would “wreak havoc across China’s property and banking sectors, as well as related companies such as Evergrande’s suppliers.” Morgan Stanley analysts say “all parties are incentivized to avoid a liquidation scenario” in the restructuring of any Chinese property developer. Chairman Hui Ka Yan, who controls more than 70% of Evergrande’s equity — would lose a significant portion of his wealth.
Obviously, the scope for something to go wrong is large. JLG Research surveys the landscape for fallout:
In short, we find it (very) interesting that the big risk to Chinese property markets many skeptics expected years ago (us included) is playing out nearly precisely as the biggest bears feared, yet the level of global media interest/attention remains virtually mute.
More specifically, first compliments of Capital Economics, when looking at the absolute collapse in the average price (in RMBth/sqm) for contracted sales for Evergrande (Ex. 1), we see a budding risk that unbuilt Chinese property starts begin trading like distressed emerging debt, which, at risk of stating the obvious, would have very negative implications for bulk metal prices globally (see iron ore prices today – Ex. 21).
Exhibit 1: Evergrande Property Statistics
Source: Capital Economics.
Furthermore, when thinking about buyer confidence in China, it’s important to remember that it matters a lot. Why? Simply put, based on our discussions with contacts in China, deposits and advances are now among the largest funding sources for the property sector. Why? Well, the Chinese government has made it hard to fund via the bond market (Ex. 2), thus developers are more prone than ever to derive funding via pre-sales (i.e., the role of pre-sales is much more important today vs. the past several years).
Exhibit 2: Two of the Largest Sources of Chinese RE Developer Funding; YoY % growth
Source: National Bureau of Statistics China, Bloomberg Intelligence, and GLJ Research LLC.
And, if that wasn’t enough to scare the “China monetary hawks”, it’s important to remember that contract liabilities (i.e., unbuilt pre-sales) of major RE developers in China essentially tripled between 2016 and 2020 (Ex. 3 below excludes Evergrande).
Exhibit 3: Current Contract Liabilities of 70 Real Estate Companies w/ Assets >$1bn USD
Source: Company filings, Bloomberg, and GLJ Research LLC.
CONCLUSION? Summarily, there are (very) few large, and more importantly clean, balance sheets in China’s real estate sector. And, finding white knights for genuinely large players will be very hard (in our view), with a lot of “real resources” (i.e., cash) still needed to finish these often-speculative developments off. Thus, with China’s bulk metals-driven economy clearly slowing (Ex. 5-10), as well as comments (just this week) from the PBOC saying they are o.k. with the current pace of monetary stimulus (link) – specifically, on Tuesday of this week, Sun Guofeng, head of the monetary policy department at the PBOC, said there is no big shortfall of base money, and liquidity supply and demand will remain basically balanced in coming months – we see China’s -17.4% YoY fall in aggregate credit growth in Aug. 2021 (Ex. 4) as a major red flag for any bulk commodity bull (to include the iron ore bulls out there).
Exhibit 4: China Aggregate Financing Outstanding (y/y% change)
Source: PBOC, Bloomberg, and GLJ Research LLC.
IS CONTAGION SPREADING THROUGHOUT CHINA? While, clearly, Evergrande is the 800lb Gorilla behind recent concerns of contagion spreading in China, it is not unique nor is it the first. That is, in Ex. 11-20 below, we highlight the debt and equity trading range for the large (currently stressed) Chinese developers, in chronological order form when their debt began to fall (these are USD bond – admittedly, onshore debt would be better, but the data is less accessible). More specifically, we note:
- China Fortune Land Development ($61bn of liabilities): Defaulted in January – the first major default of this tightening cycle. Ping An – largest insurer in China – reported a $5.5bn loss relating to China Fortune in its 1H21 results;
- China South City Holdings ($10bn of liabilities): Bonds trading at 100 as of Jan 21, but has consistently traded down since February with a big step down in the past two weeks. Current price: 69. Current yield: 42%;
- Yuzhou ($21bn of liabilities): Massive debt selloff in late March. Since then, its debt has remained surprisingly sturdy although its equity continues to fall;
- Sichuan Languang ($31bn of liabilities): Initial weakness showed up in February but legged down in April before settling at just 25c on the dollar in July. Pricing now solely on recovery;
- Evergrande ($304bn of liabilities): The Gorilla. You know the story. After surviving a big scare in Sept 2020, its debt stabilized for 9 months, until it began to sink in June. Three months later the most indebted developer in the world is functionally insolvent; we believe yesterday’s agreement with the PBOC is a defacto “surreptitious bankruptcy”;
- Central China Real Estate ($23bn of liabilities): 2024 USD bond prices; January: 100; July: 87; Sept: 68;
- RiseSun ($36bn of liabilities): Issued a new USD bonds on January 11th at 100; Price on July 5: 87; Price on Sept 6: 59;
- Sunshine City ($7bn of liabilities): Smaller fish, same story. Selloff has accelerated in the past 6 weeks. Clearly illiquid but the trend is one-way;
- Fantasia ($12bn of liabilities): Post Evergrande – things are falling faster. Bonds traded at par in June. By September, banks stopped accepting it as collateral (link); and
- Guangzhao R&F ($51bn of liabilities): This is “wet your pants” territory. R&F is a major developer that did not even show stress even as Evergrande began to fall. The chart below speaks for itself (Ex. 20).
WHAT DOES IT ALL MEAN? What does the above tell us? Well: (1) Evergrande is not unique, rather it’s one of many, (2) collateral has been getting squeezed for months as defaults mount, and (3) the most recent selloffs have been more abrupt and violent in issuers whose stress emerged just weeks ago.
In brief, and why we are perplexed this isn’t getting more media coverage, this is not coincidental – it’s a chain reaction. That is, if a developer defaults, lenders cut lending to its peers. As lending dries, it makes those peers much more likely to fail. Each default also decreases the expected recovery as fire sales crush the market of the underlying. Combined, the names above – each in default or significant stress – represent over half a trillion dollars of total liabilities. Liabilities are not just debt, but payments to suppliers, employees, remaining construction costs etc. The whole ecosystem is on the brink, which is a massive risk to the bulk metals complex, yet everyone is acting as if all is well.
As we have stressed, on the above, as well as the break down in iron ore prices overnight (last night, we broke below the $128.64/mt level hit 8/19/21 during the “great Aug. 2021 iron ore price scare” – Ex. 21), we would be adding to short positions in FMG and RIO; VALE is also clearly at risk as it has a major shipping disadvantage vs. its Australian peers; we also see sizeable risk to EAF.
Exhibit 5: China Automobile Sales
Sales continue to drop in August, down -17% YoY after falling -6.8%/-11.0% YoY in Jun/July, respectively
Source: China Passenger Car Association (“CPCA”), GLJ Research LLC.
Exhibit 6: China’s Tier One Cities
New home sales of Beijing, Shanghai, Guangzhou, and Shenzhen
Source: China Passenger Car Association (“CPCA”), GLJ Research LLC.
Exhibit 7: An Unsustainable Divergence: Beware of Risks to Commodity Prices
Source: Bloomberg, GLJ Research LLC.
Exhibit 8: Slowdown to Excavator Sales Confirms Cyclical Peak to New Property Starts
Source: Bloomberg, GLJ Research LLC.
Exhibit 9: Land Sales Coincident to New Starts
Source: Bloomberg, GLJ Research LLC.
Exhibit 10: China Construction Vehicle Sales – YoY % growth
Source: Hong Kong Teng Yuan Co. Ltd., GLJ Research.
Exhibit 11: China Fortune Land Development
Exhibit 12: China South City Holdings
Exhibit 13: Yuzhou Group Holdings Company Limited
Exhibit 14: Sichuan Languang Development Co., Ltd.
Exhibit 15: China Evergrande Group
Exhibit 16: Central China Real Estate Limited
Exhibit 17: RiseSun Real Estate Development
Exhibit 18: Sunshine City Group LTD
Exhibit 19: Fantasia Holdings Group Co. Ltd.
Exhibit 20: Guangzhou R&F Properties Co., Ltd.
Stay short iron ore.