China not letting up on property

Pantheon Economics with an excellent note:

Chinese Property Sector Update: Keep a Cool Head on Easing

2021 was a terrible year for China’s property sector. Activity and price growth were well below the norms of recent years, as our first chart shows. Bad as the data look, the full-year performance was flattered by a reasonable start, which partially compensated for the disastrous second half of 2021. Even so, new starts collapsed, in a clear sign of the pressures facing property developers.

These pressures have scarcely eased in early 2022. Evergrande is still begging creditors for more time, missing another dollar payment on January 24. Shimao Group, which held an investment grade rating in December, has embarked on a fire sale of assets, joining Evergrande, Kaisa, and Sunac, among others, which will weigh further on prices.

China’s property sector plummeted over the course of 2021, and nosedives are hard to escape. Policy easing looks modest compared to previous cycles, in line with government messaging.

The impact of easing on growth will also be weaker than markets expect, based on past cycles.

Markets are understandably eager to latch on to any sign of easing, resulting in some overly optimistic readings of policy announcements. A change allowing developers to utilise a greater share of presale proceeds was heralded as a decisive step, for example. But this only helps if there are pre-sale revenues to access, which is tough when sales are plummeting. Developers also face multiple demands on these revenues; if used to service debts, they cannot be used to fund construction. In short, this policy addressed liquidity, not solvency. Both must be fixed to stem the sector’s bleeding.

Nonetheless, an overall shift in the direction of policy is tangible. Monetary policy is still primarily a quantitative game in China, so we need to look past the recent 10bp rate cuts, and focus on liquidity injections. Liquidity provision reached a nadir in mid2021, and has embarked on a modest recovery since, as shown in our chart above. Note, however, that support still remains muted compared to past cycles at present, implying a similarly modest upswing to come in the credit impulse. For now, policymakers are holding to the “no floodlike stimulus” line, and we think worries over excessive leverage mean further large net injections will wait until Q2.

The cost of credit is also falling, for some borrowers. Policy rates have been lowered only marginally, but government bond yields have seen a substantial drop, particularly against the backdrop of rising yields globally. This will aid fiscal stimulus efforts, but it is not clear that it helps developers; coming back to our earlier observation, does this fix solvency, or just liquidity?

The impact of credit on growth is weakening

Our view so far has been that whatever happens to the credit impulse, property will benefit far less than in the past. In part this is because of strong signals that new credit aims to support M&A activity, and infrastructure; in part because resources will be needed for balance sheet repair on the developer and local government side this year; and in part because developer borrowing remains constrained.

Credit growth has improved, but this is not a case of banks shovelling cash into the pockets of desperate developers. Instead, the change in momentum comes from increased bond issuance, by the state but also by state-owned enterprises. Most developers do not have the luxury of borrowing at the same rate as the government, unsurprisingly, but SOEs—with implicit government backing—come closer.

The plunge in government bond yields then, primarily tilts the field even further in favour of SOEs, who have been tasked with limiting the fallout from the failure of Evergrande and others, by acquiring their assets. SOEs have already bought assets from Shimao Group, for example. This ensures that construction work on existing developments can continue, but does not create new property investment. Credit may increase, but it is not creating growth.

Meanwhile, under the “Three Red Lines”, even well-behaved developers may only increase their borrowing at 15% per year. M&A-related debt has now been excluded from this cap, facilitating the purchase of distressed assets, but the underlying constraint is still in place. Policymakers are very deliberately seeking to limit the flow of credit into the sector, not expand it. With all sources of funding under pressure—as our chart above shows—the outlook for property investment remains grim.

The other source of funds—the Chinese homebuyer—has received only modest support, so far. The cut to interest rates included the five-year loan prime rate, the best guide to overall mortgage pricing. A 10bp cut is better than nothing, but it seems unlikely to drive a surge in demand. Mortgage lending has also been “encouraged” by the authorities, and restrictions eased in some provinces. Again, however, this is unlikely to move the needle much; more meaningful obstacles must be overcome.

Buying a new home—typically prior to completion— requires conviction that the developer will be around to finish construction. Buyers also need to feel confident in their ability to meet mortgage payments, or, better yet, make a profit on the purchase. All of this is in doubt, thanks to the overall state of the market, the state of developers, and China’s slowing economy, itself partially a function of the property implosion.

Confidence is a nebulous concept, but arguably it won’t be restored until developer failures cease.

Given the wall of debt maturities to come in the year ahead, that looks like a 2023 goalpost. This provides a clear incentive to accelerate the process of mergers in the sector. The sooner weaker developers can be acquired by stronger counterparts, the sooner worries can fade. Success here will see a big surge of credit, but again without concomitant increases in real activity, as the funds are directed toward consolidation in the sector.

The key takeaway is that the inflection in the liquidity and credit cycle is good news for the economy, but it will not bring a rebound in property investment or sales in 2022. The immediate liquidity problem for the sector has been contained, but it remains acute for a number of individual firms. The overall solvency picture will improve only gradually, and will involve increased SOE dominance of the sector. A lot of credit is about to be used for very little immediate return on growth.

We see one more reason to expect a weaker link between liquidity and growth this year. Beyond its use in supporting the property sector, greater bond issuance is also needed because land sales revenue has also collapsed, leaving local governments in a perilous position. Worse, land sale revenues in 2021— low as they were—likely overstated the strength of local government finances, as they were primarily financed by LGFVs. In short, governments bought their own land using debt.

Local government expenditure is therefore almost entirely debt-financed at the moment, which probably explains why local bond quotas reportedly will be unadjusted this year. This also implies a chunk of the credit impulse has been swallowed up in financing land purchases, rather than productive economic activity.

Just as importantly, banks have become even more exposed to the property sector, and will need to position for a greater risk of non-performing assets. Expect greater caution in lending—already apparent in declining loan growth—which will disproportionately affect the riskier private sector, and further propel the less-productive SOEs to dominance.

Houses and Holes

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