There’s not much point repeating a couple of good posts from ZH on the China property situation given they capture my thoughts so here they are. First up, the Chinese property crash is getting worse fast:
Having already suffered the fastest drop on record, Chinese junk bond markets – where property developer issuers dominate – were routed once again as fears about fast-spreading contagion in the $5 trillion sector, which drives a sizable chunk of the Chinese economy, continued to savage sentiment. Meanwhile, China Evergrande Group’s offshore bondholders still had not received interest payment by a Monday deadline Asia time, Reuters reported citing sources.
But while Evergrande’s default is now just semantics, and one week after Fantasia shocked bondholders with a surprise announcement it too would stuff creditors just weeks after it had said its liquidity was fine, which sent its bond plunging from par to 74 cents in seconds…
There are 3813 words left in this subscriber-only article.
Get your first month for $1
… other signs of stress included smaller rival Modern Land asking investors to push back by three months a $250 million bond payment due on Oct. 25 in part “to avoid any potential payment default.” This was not expected, and Modern Land’s April 2023 bond plunged more than 50% to 30 cents on the day.
Elsewhere, Xinyuan Real Estate proposed paying just 5% of principal on a note due Oct. 15 and swapping that debt for bonds due 2023. Fitch Ratings called the move a distressed debt exchange while downgrading the firm to C. At least the two companies are relatively small: Modern Land and Xinyuan have $1.35 billion and $760 million of dollar bonds outstanding, respectively, according to data compiled by Bloomberg. In comparison, Evergrande has $19.2 billion.
Among the declines for high-yield issuers, China Aoyuan Group’s 6.35% note due 2024 dropped 13.2 cents on the dollar to 57.5 cents; Sunac’s 6.5% dollar bond due 2026 declined 9.4 cents to 57.9 cents, leaving both poised to close at the lowest-ever levels.
Kaisa Group, which was the first Chinese property developer to default back in 2015, also saw some of its bonds slump to less than half their face value while supposedly “safe” names such as R&F Properties, and Greenland Holdings, which both have prestige projects in global cities like London, were also widely sold.
Yields on Chinese junk-rated dollar bonds surged 291 basis points to 17.54% last week, the highest level in about a decade, according to a Bloomberg index.
And just to add insult to injury, China’s 10-year government bond futures declined to a three-month low as the central bank’s latest liquidity draining weakened expectations of fresh monetary policy easing. Futures contracts on 10-year notes fall 0.4% to 99.14, the lowest level since July 12. 10-year sovereign bond yields rose 5bps, the biggest gains in two months, to 2.96%.
“It’s a disastrous day,” Clarence Tam, fixed income PM at Avenue Asset Management in Hong Kong, told Reuters, highlighting how even some supposedly safer “investment grade” firms had now seen 20% wiped off their bonds. “We think it’s driven by global fund outflow …. Fundamentally, we are worried the mortgage management onshore hits the developers’ cash flow hard,” he added, referring to concerns people could stop putting deposits down on new homes.
In other words, the dynamic is spreading from the biggest rotten apples – i.e., Evergrande, Fantasia – to collapsing confidence in the property sector, to credits that until now were seen as healthy and immune from a property implosion. In short, the bursting of the US housing bubble has moved to China, and yes – that culminated with the original Lehman moment.
Meanwhile, JPMorgan analysts highlighted how international investors were now demanding the highest ever premium to buy or hold ‘junk’-rated Chinese debt. There is now a whopping 1,200 basis point difference between the bank’s closely-followed JACI China high yield index and a similar index of investment grade AA-rated local Chinese market bonds, known as “onshore” bonds. The option-adjusted spread on the ICE BofA Asian Dollar High Yield Corporate China Issuers Index (.MERACYC) is also at its widest ever.
“Evergrande’s contagion risk is now spreading across other issuers and sectors,” JPMorgan’s analysts said, demonstrating a rare talent for observing the obvious.
And while today may have been “disastrous” it could get far, far worse if the market loses faith that Beijing will bail out the bond market.
“We believe policymakers have zero tolerance for systemic risk to emerge and are aiming to maintain a stable property market, and policy support could be forthcoming if the deterioration in property activity levels worsen,” said Goldman head of Asia Credit Kenneth Ho.
Overnight we saw the first sign of such an implicit support in Harbin, the capital of northeastern Heilongjiang province, which became one of the first cities in China to announce measures to support property developers and their projects. According to a report on a website run by Harbin Daily, the city will offer as much as 100,000 yuan home-purchase subsidy to “talents” that meet certain requirements. The city would also make more existing homes eligible for housing provident fund loans to buyers; the moves are aimed at promoting stable and healthy development of the city’s property market, according to the document.
The cash-strapped property developer’s troubles and contagion worries have sent shockwaves across global markets and the firm has already missed payments on dollar bonds, worth a combined $131 million, that were due on Sept. 23 and Sept. 29.
While China’s property sector turmoil has so far been contained to the bond market, tensions amid offshore bonds could soon create headaches for the country’s equity traders, according to Gilbert Wong, head of Asia quantitative research at Morgan Stanley. High-yield credit spreads over comparable Treasuries are the widest on record — at about 1,866 basis points on an option-adjusted basis, data compiled by Bloomberg as of Friday show. But a measure of stock volatility has actually fallen so far this month.
Still, the pair has shown a close relationship in recent years, which suggests their divergence may not last. In the end, a crash in the stock market, where hundreds of millions of Chinese residents are invested, may be just the kick Beijing needs to wake it out of its no bailout stupor.
More localised support can be expected. But this is not going to be enough to turn around what is now clearly a systemic crisis for property developer funding. Only ending the “three red lines” policy will do that now. Will China do it?
I don’t think so. Why? It can’t. Another ZH post:
Back on Sept 30, China stunned markets when reeling from soaring energy prices, widespread blackouts, mass factory closures and a shortage of coal – it’s most popular source of power – Beijing ordered energy firms to “secure supplies at all costs.” Local producers did not need a second invitation to do just that, and in less than two weeks, the Chinese thermal coal futures have soared by over 16% to an all time high, spiking above 1,500 yuan per ton overnight, where the jump triggered even more stops ensuring that the move higher would continue.
The move in Chinese coal prices, seen in its long-term context, has been nothing short of staggering.
But while we can certainly admire the view from up there, that doubling in coal prices in just the past month is terrible news for Beijing which is under increasing pressure to cut rates or ortherwise ease financial conditions to contain – or “ringfence” in the parlance of our times – the “disaster” taking place in the Chinese bond market, the commodity price inflation means Xi’s hands may be tied for one simple reason.
Historically, Chinese coal prices – due to their core role as the anchor of China’s energy-intensive economy – have been the asset the most closely has correlated with Chinese wholesale, or factory gate inflation, also known as Producer Prices. And while we wait to get the latest Chinese CPI and PPI print this week, we can already predict what it will be either next month or the month after.
While coal prices were relatively contained one month ago, they have since then exploded. And if the historical correlation between Coal prices and PPI holds, were may be soon looking at a tripling of China’s PPI, which from 9.5% Y/Y in August, is about to soar to 30% or more.
Needless to say, if Chinese PPI does hit 30%+, even if CPI somehow stay in the single digits, the results would be catastrophic: profit margins would collapse, the plunge in already thin cash flows would lead to even more defaults and supply chain bottlenecks, even as the scramble to obtain commodities “at any price” keeps pushing costs – and PPI – even higher. Meanwhile, if producers do try to pass on some of the costs and CPI spikes (the gap between CPI and PPI was already record wide before the recent surge in coal prices).
… then Beijing will have social unrest on its hands. And all this is happening as China’s property sector desperately needs a massive liquidity infusion which is – you guessed it – inflationary.
And while China may be facing its first “galloping inflation” PPI print, it’s only downhill from there, because as Citigroup wrote over the weekend, power cuts (with over 20 provinces, making up >2/3 of China’s GDP, have rolled out electricity-rationing measures since August) and contractionary PMI “seem to suggest China could enter into at least a short period of stagflation.”
Some more details from Citi on the recent blackouts:
The three NE provinces were hardest hit, with power cuts from factories to homes. Costal manufacturing and export hubs like Guangdong, Jiangsu and Zhejiang were also seriously impacted. The outages are attributable to:
- 1. Electricity supply shortage. Thermal power (73% of total power production in 21H1) was limited by the low supply and surging prices of coal. China’s coal industry just emerged out of a prolonged de-capacity and is subject to tighter safety regulations. The geopolitical tensions (e.g., between China-Australia) and the COVID disruptions (e.g., in Mongolia) affected coal imports. Coal inventories in key coal-handling ports like Qinhuangdao are now around the new lows since the supply-side reform.
- 2. Export-led industrial boom. China’s uneven recovery, with electricity-consuming industrials (67% of total power consumption in 2020) outpacing services (16%), pushed up the power demand.
- 3. “Dual energy control”. To peak carbon emissions by 2030, the NDRC added more effective incentive measures for the “dual control of energy consumption and intensity” – for example, missing the targets may lead to delays or suspensions in the NDRC’s approvals of new energy-intensive projects for localities. Such measurable KPIs appear even more important amid the ongoing reshuffle of local officials ahead of the 20th Party Congress (in 22H2). China aimed to cut energy intensity by 13.5% during 2021-25 and by 3% in 2021. Total energy consumption growth is capped at 2.9% for 2021, which would require a more aggressive intensity reduction by 5.3%. The barometer released by the NDRC on August 17, showing 19 provinces lagging behind, further served as a wake-up call for local governments in achieving their “dual control” targets.
This led to a series of factory shutdowns and production cuts in energy-intensive and high-emissions sectors. Other than executive orders and window guidance, the cut of electricity supply has been used by some as a policy tool. It’s exerting material impacts on sectors like steel, non-ferrous metals, cement, glass, coking, chemicals, industrial silicon, paper making and electroplating, among others.
What are the implications?
As noted above, Citi believes that “China seems to be entering into at least a short period of “stagflation”:
- 1. PPI inflation to remain elevated. The supply disruptions in the peak season should outweigh the demand weakness induced by the property down-cycle in the near term, keeping energy and industrial prices up. Citi expects PPI inflation to stay above 9% toward the year-end; we expect it to more than double from 9% in coming months, leading to catastrophic results for profit margins.
- 2. Inflation divergence to deepen. Power rationing and production cuts may drive up consumer prices more directly than the market-based pass-through from PPI shocks. However, lingering public health risks still hold back the recovery of services. Recent regulatory actions may also reduce household expenses on education, healthcare and other services. The room for pork price declines has narrowed, but the down-cycle hasn’t bottomed yet. These would help keep CPI muted. The enduring PPI-CPI divergence would squeeze the profit margin of mid/downstream sectors, especially SMEs.
- 3. China as an exporter of inflation. China’s environmental initiatives can be inflationary for the world over the medium term. The tight supply of industrial products would prompt the government to prioritize domestic demand over exports by, for example, cutting export tax rebates (already done for steel). The impact of disruptions with manufacturers/suppliers/assemblers would ripple through global supply chains (think electroplating for electronics as an example).
As a result of the above, Citi warns that China’s growth risks tilted toward downside; the bank recently downgraded its growth forecasts to 4.9% (vs 6% previously) for 21 Q3 and 4.5% (vs 5.1%) for 21 Q4 earlier, but it did not anticipate the abrupt widespread power-related production cuts. Some high-frequency activity indicators (e.g., daily crude steel outputs) have weakened quickly since.
And the pièce de résistance, Beijing is now trapped: if it eases, inflation – already at nosebleed levels – will soar further crushing margins and sparking a deep stagflationary recession; if it does not ease, the property market – already imploding – will crater.
There is the rub. China is trapped. But look through the ZH hysteria. It is only trapped for the next few months while it sorts out more energy supply and allows property deflation to hit demand.
The question is, how will China not waste this crisis? Will it buckle and stimulate property and risk an even larger energy bubble that cascades through households as higher utility bills? Or, will it allow the property crisis to run on and deflate prices for a while culminating in an almighty energy crash?
We know China wants to structurally get off the property and commodity teat, and it is now operating under the rubric of “common prosperity”, so I think it will choose the latter and take more short-term pain.
The point at which it might break is if the financial system is dragged into the developer shakeout. A 10% correction in property prices won’t do that. Losing a few small regional banks to developers bad loans won’t, either.
So, I still think China presses ahead with property reform, endures a hard landing in the short-term and pops the Wall Street commodity mania.
We will see more incremental supports but the trajectory will remain down for construction.