Not A Lehman Moment
Evergrande & China Real Estate Sector
Not A Lehman Moment
With Chinese Characteristics
Evergrande's troubles have moved from an event risk with global ramifications to being a manageable crisis. In contrast, the onshore consumer seems growing more cautious.
Evergrande has an eye-popping level of debt on its balance sheet and hence the attention. But there are nearly 100,000 Real estate companies in China, and the top ten companies account for almost 26% of the real estate development market share. The debt of the larger companies has grown faster than completion as they used pre-sales cash and debt to increase their land banks.
The virtuous cycle started to break in late 2019.
What can be so important that the government is willing to risk nearly 30% of the country’s GDP?
Is it a short-term measure, or can we go back to what has worked in the last 30 years?
What would be the costs and the end game?
What are market interpreting and likely signs of things to come?
Why focus on real estate now?
Property has been a big part of China’s economy and leverage growth. The three red lines were introduced in August 2020 as the first concrete attempt to control leverage in the system.
Still, there are other overriding objectives such as
2) diversifying savings
3) addressing falling marriage & declining birth rates
4) Most importantly, avoid the liquidation cliff that comes with a fall in the working-age population and used to pay for retirement in a few years.
There have been questions on birth rate and population and if official figures overstate the data. The Dependency ratio bottomed in 2010 at 36.49% and has risen to 42.21% in 2020. China’s workforce will fall by 40 million over five years, creating an unsustainable dependency ratio.
What the market assumed
Evergrande will turn into a big bang default and trigger cross-default on all debt with eventual restructuring to ensure it did not have a lasting impact on the economy. This scenario is unlikely to happen if previous significant corporate defaults are any guide.
Real estate is just too important to continue with policy tightening
The sector accounts for nearly 26-29% of GDP, and the central & local governments will not want to see a slowing economy. They will take the foot off the brakes when they see FAI (Fixed Asset Investment) slow down and revenues from land sales fall, causing unwelcome fiscal deficits.
PBOC will ease by cutting RRR & adding excess liquidity. PBOC withdrew the added liquidity related to the Golden week holidays.
A state-led bailout
A local government would lead a bailout, and SOEs would buy parts or all of Evergrande. There were numerous instances of SOE & private companies reviewing investment in Evergrande Vehicles and Services arms, but none have come to fruition.
Evergrande failed to sell its Hong Kong headquarters to a Guangzhou local government-related entity in an outcome suggesting potential fallout whether Evergrande sold “too cheap” or “too expensively.”
Only projects level investment has attracted interest.
Evergrande has recently repaid its suppliers in kind by giving them unfinished projects but remained responsible for completion, which leaves a different sort of risk at the suppliers' end.
The HNA & Dalian Wanda unwind template is what the government seems to be pursuing, a painfully slow breaking apart of the company. USD debt holders should hope the Founders Group restructuring and treatment of offshore debt is not on the table as holders Founders USD debt were in for a rude shock with a difficult choice of low payouts or an onshore debt for equity swap.
The smoke signals
Everyone knew the level of property sector debt was unsustainable, yet the timing of the unwinding was tricky.
The real-estate developers have had difficulties meeting supplier payments since mid-2020 that became obvious early this year.
The challenges in dealing with real estate debt come from opaque earnings and balance sheet disclosures. The information gaps are complex relating to corporate & project level SPV's, consolidation of debt & reporting of contingent and off-balance-sheet debt.
The real estate borrowings using WMP issued by related parties, off-balance-sheet lending, and borrowing by Hong Kong entities under keep well & guarantees make getting a complete picture of total liabilities complex. The treatment of pre-sale advances creates a contingent liability that regulators don’t consider as a financial liability.
The use of supplier IOUs instead of scheduled payment was reported in 2020. Their reports of discounting some of IOUs by up to 25% signaled trouble has been brewing. This year, companies sought help from local governments for help or bailout.
The Hang Seng Mainland Property Index contains mostly high-yield & offshore debt borrowers. The Index peaked on 2nd January 2021, signaling the onset of stress early on. It broke down on 24th March, falling nearly 36% from the peak.
After the March steep fall, Index recovery was weak, making lower highs; the Index conclusively broke down in late June when Evergrande stock broke support. Evergrande USD bonds followed the Equity a few weeks later.
Hang Seng Mainland Properties Index
The Stock peaked in October 2017 and fell 65% by March 2020. As prices recovered, each rally made lower highs. The biggest giveaway of stress was the Island Gap between September – October 2020.
The 13th May break of October 2020 to April 2021 consolidation to the downside was a point of no return.
The end game had begun.
The first significant drop in its USD bonds came in March 2020, two months after the stock dropped 21% between January to March.
The stock finally broke down in May. Bonds followed ten days later, and the fall accelerated in June 2021.
RMB bonds were slower to react than USD bonds.
While the price of RMB 6.98% July 2022 (15恒大03) peaked on a similar timeline to the USD 2025 bond, it was not until 8th July that the RMB bond started to respond to what was happening in offshore debt.
The late August recovery was much sharper than the USD debt. In a way, the market was saying RMB debt is first among equals.
USD credit market divergence
(What if) It makes sense for onshore equities and bonds to outperform USD Credit and Hong Kong listed equities.
The government has given a directive to prioritize project completion, meet Wealth Management Product (WMP) & local debt obligations. It will also be challenging to use any onshore cashflows for meeting offshore debt obligations.
Evergrande has made onshore WMP repayments, and local debt maturity was extensions in a timely fashion.
In comparison, recent USD coupon payments have been on the last day of the 30-day grace period.
The final maturity of Jumbo Fortune Enterprises USD private debt was extended by at least three months upon posting additional collateral and consent fee. The principal repayment has no grace period. The agreement to extend was reached after the maturity date, but the holders did not serve the event of the default notice.
The group has failed to sell its Evergrande Property Services business worth $2.6 billion and its headquarters in Hong Kong for $1.7 billion.
The chairman has sold personal assets to meet future obligations, which may be enough to pay December & January public debt obligations.
The public USD debt due until April is as follows. Details of private, structured, off-balance-sheet & contingent debt are not available.
Crisis in offshore debt paused but far from over
The government has taken steps to ensure onshore cashflows & assets are not used to repay offshore debt. With the offshore market effectively shut for China high yield issuers, meeting public & private debt repayment will be challenging.
Easing of project-level loan growth directive from PBOC addresses some of the supply-side risks. The risk to demand-side recovery remains.
Sinic Holdings, Fantasia Properties & Modern Land have missed USD Bond payments so far (Restricted Default as of Oct.).
USD Funding Challenges
The Modern Land case is interesting. It solicited holders for maturity extensions, to which they agreed to terms on the $250 million 16th October 2021 bond upon receiving a consent fee (assumed to be ~$3 million). The issuer decided not to proceed with the extension and did not announce its reasons. Either way, it has created a question mark on ability, willingness, or view on future access to USD funding markets.
These actions by Modern Land management are not good news for confidence in the sector and its medium-term funding prospects.
Contingent liability conundrum
Kaisa Group Holding:
On 27th April, the company launched a $500 million 11.70% 2025 bond new issue and a simultaneous tender and exchange for up to $500 million of 9.375% 2014 outstanding bond. The issue was fully subscribed.
According to REDD, in late October, it told investors it did not issue any WMP products, but in November, in a meeting with investors management, WMP issued by a third party but guaranteed by Kaisa would not be repaid (~$50 million). At which point, debt consolidation of total WMP amounting to $2 billion was triggered (Source: SCMP).
Despite the large amount of WMP outstanding issued by an affiliate with Kaisa, guarantee management was able to structure this as "Contingent Liability" and not consolidate it into Kaisa's balance sheet.
The new bond started to fall in August, partly due to the Evergrande contagion. The price fall accelerated in early October, well before any WMP repayment issues were flagged or rating action announcement.
Moody's downgraded Issuer to B3 on 18th October, Caa1/Caa2 on 29th October, and Ca/C on 10th November.
The stock peaked in 2015 ahead of its chairman's prison sentence. Its defaulted bonds were exchanged twice in 2016 & finally in 2018.
The stock broke down in July, almost right after the bond issuance. Finally, in August it started to fall rapidly. It seems the market missed a few things, or the due diligence did not go far enough.
A BB-rated firm with a sketchy past, a breakdown in stock price should get at least a red flag up for debt holders.
Other types of Contingent Liability Real Estate companies carry but don’t always fully disclose quality guarantees, sales advances & structured offshore lending via collateral or letter of credit.
S&P estimates contingent liability is ~$75 billion for the sector, but this is not verifiable.
The contagion continues amongst B & BB issuers of USD debt and those listed in Hong Kong
What are good indicators of stress?
A significant shareholder of a Mainland firm listed in Hong Kong can alter the price action of the underlying stock. The significant shareholder tends to use shareholder loan facilities to get leverage and will do everything to maintain a low Loan to Value (LTV). These stocks also tend to have high dividends even with high debt-to-equity ratios. When it does go through certain levels, it triggers meaningful declines.
USD credit has been a good indicator even though it lags. The Asian private banks have been aggressive in providing HNW clients with LTV of up to 80% on purchases of USD developer bonds. Prime Brokerages have been very aggressive in offering leverage. A lot got unwound in September / October correction due to margin calls and changes in LTV. Changes in LTV for real estate bonds can drive quick significant moves.
The onshore debt trading can be technical & limited, while WMP products are held to maturity and have little value in signaling.
A more complicated way to follow in real-time is the difficulty accessing bank funding loans or the impaired ability to issue new obligations.
China USD bond market
Net result Bloomberg China High Yield Index OAS (option-adjusted spread) widened to above 25% but is now below 20%). Even further tightening to 15% would still leave the sector in a precarious position.
The first step to Contagion is credit stress moves from high yield to the Investment grade universe within the sector, followed by banks & the financial sector.
Longfor, China Vanke & Country Garden saw their bonds drop 7-8 points from October to early November and then saw a strong bounce of 4-4.5 points. The Contagion risk is paused for now.
If Investment-grade spreads start to widen, that will not bode well for banks & Insurance companies.
China Investment Grade & higher-rated High Yield Debt
XS2293918285 – Guangzhou R&F 11.75% August 2023
XS1627599654 – Evergrande 8.75% June 2025
USG52132BW96 – Kaisa 11.95% October 2022
XS2382274376 - Agile Group Holdings Ltd. 4,85% October 2022
XS1750118462 - Country Garden Holdings 5,125% January 2025
XS2033262895 - Longfor Group Holdings Ltd. 3,95% September 2029
Onshore real estate Indices
They did not follow the Hong Kong listed index and were signaling limited contagion.
CSI 300 Real Estate
A topping process and testing its long-term support is visible, but there is no breakdown.
Shanghai Real Estate Index
Although making lower highs, support and trend are intact.
Round two is still out there
We saw a sharp rally in real estate stocks and bonds last ten days: driven by
1) Short covering
2) Evergrande coupon payments just before the end of the grace period
3) Country Garden, Sunac, Kaisa & Shimao making asset sales and capital raise.
4) Government measures in giving access to some issuers to the interbank market, reiterating growth targets for project-level loans, and loosening ABS issuance.
5) China Communist Party 6th Plenum was a significant schedule on the calendar. There was no way a negative headline of a substantial default was going to be allowed. If that meant personal assets were needed to be sold, it was going to be done
6) Almost all offshore high yield issuance is in Reg S, which excludes the US buyer’s ability to replace local HNW & Asia-focused credit funds to drive price recovery. The locals are likely sellers on upticks. Asia distressed funds are a small universe to make a meaningful impact.
None of the measures will be of much help to USD debt recovery. Except perhaps if it helps onshore debt servicing allows asset sales to flow through extra cash to pay off debt.
The interbank & ABS access is limited to state-owned and high-grade issuers and is likely only for acquiring land, acquiring distressed projects, and project completion.
Offshore Maturity Cliff
$3.6 billion maturities come due in December. January sees $5 billion in maturities re due; we should start to see stress levels rise again as public and possibly off-balance-sheet debt repayments come due.
Onshore maturity Cliff
Source: China Property Watch: Strains In The Key Of 'B'
China’s real estate leverage
The gap between projects under construction vs. completed is a good indicator of excess still in the system. Even without new land sales, there is enough forward supply.
Residential sales slowing down
The land and floor space sales peaked in Q4 2020.
Measures taken by the government, will likely hit sales and consumer confidence.
1) Some local governments have started to put a floor on prices. It could lead to a fall in volumes as it is likely to deter bargain hunters.
2) Buyers are cautious in committing to new developments as they are uncertain of completion dates. Buyers remain liable for mortgage payments irrespective of the completion status.
3) The introduction of property taxes and how they are implemented adds to the uncertainty. Even if the tax rate is low, it will likely force registration under a real name vs. a shell company or a nominee.
4) The new rules of segregating future sales proceeds will likely be more draconian than three red lines and affect leverage & land bank acquisition dynamics.
Prices of new residential seeing a steady slowdown
The number of cities where prices were going up peaked in 2019, well before the Q4 peak in land sales.
There is an incentive for holders of multiple properties under a cloud of property tax to sell.
With low rental yields and many properties kept empty, there is a need for constant appreciation to service debt. Any fall in price over the medium term can increase the supply of investment properties to meet loan repayments.
Residential mortgage & credit card payables
Both balances are at all-time highs, but a fall in mortgage loan growth rate indicates a fall in real estate demand, while the rise in credit card balance suggests an increase in stress in household debt servicing (figures are as of the end of June).
Right question: Why the policy won't be reversed
According to the latest survey, the Total Fertility Rate (TFR) is 0.85 (China Statistical Yearbook 2020 compiled by the National Bureau of Statistics).
The birth rate has been in a long-term downtrend, especially in the first child's births; the uptick in second and third childbirth is not enough to take the slack. The loosening of the two-child policy has not had the desired effect.
The housing and childcare costs are a significant obstacle.
The national average of house price to income is 13.6x. But in urban areas, the cost is amongst the highest globally as a percentage of personal income.
To increase birth rates, the government needs to bring housing costs meaningfully lower and make it cheaper and less stressful to raise a child. Hence the after-school education crackdown, we should see more measures taken to address childcare costs.
Marriages and Divorces
Marriages fell to -17.5% YoY (China's Ministry of Civil Affairs). In still a largely conservative society, marriage remains essential to the birth rate.
A subsidy for buying a house for recently or newly married couples who don’t own property while addressing the cost of childcare would be the right incentive to fix falling marriages and birth rates. A district in Beijing allows couples with two or more children to avoid waitlist for public/ subsidized housing. Some local authorities are offering subsidies for medical and childcare.
The government needs to address Dependency Ratio
The aging population can help support childcare. But the sharp drop in the working-age population alone will result in a fall in consumer spending and consumption. A rising birth rate can rapidly replace the consumption lost to an aging population.
Addressing housing inequality
In the first decade of the 21st century, the number of housing units built in China was roughly twice the total Stock of housing units currently in Spain or the UK, or about the same as Japan's current entire Stock (Economist Intelligence Unit, 2011).
Since then, China has been building a London every year.
Yet millions do not have affordable housing, especially in Urban and high-growth regions.
Link: Housing Affordability in Chinese Cities
The Hukou (household registration) System (Appendix 1) in most regions leads to millions of migrants continuing to be denied access to subsidized housing in most cities. In many cities, Hukou is necessary for property ownership. This system has meant most wealth is concentrated with multiple home buyers with Hukou registration in the prosperous regions.
GDP and defaults
Making a sudden reversal to a sector that accounts for nearly 30% of GDP will undoubtedly cause rising defaults and cause a banking crisis, high unemployment, and a severe drop in consumer spending. It is unlikely that government will knowingly accelerate defaults.
Need for space means moving people and jobs to less expensive regions and creating a more even growth.
The government could justify a GDP drop to mid 4% over a few years in exchange for a higher quality of growth and “Common Prosperity.” The economy does not need to create as many new jobs as it did a decade back.
Persons seeking first job or graduates seeking employment peaked in Q3, 2010
China’s property is the most significant asset class globally. It is one of an unequal distribution of housing wealth.
China's middle class is ~700 million, and the Hukou system means the household wealth is concentrated in a tinypercentage of the predominantly urban population.
The country Gini Coefficient, a measure of inequality, is 46.5. A Gini coefficient below 0.2 indicates equitable income distribution, 0.2-0.3 is relatively equitable, 0.4 is inequality threshold alert line, 0.4-0.5 fairly inequitable, and above 0.5 considerable disparity. With no social safety net addressing housing inequality is the most effective policy option.
The government policy of “Common Prosperity” is a bedrock for Xi's third term. It would be challenging to reverse a standing committee-driven policy change. Reducing housing inequality will have more support than the number of people who will lose out. It is unlikely the local government's push to loosen policy will win in the face of dividendsthe central government reaps in widespread support by bringing prices down.
Managing a change in the direction of the most significant economic sector while reducing leverage, maintainingsteady growth expectations, and social stability is the holy trinity and won’t be without accidents.
The Gini index or Gini coefficient is a statistical measure of distribution was developed by the Italian statistician Corrado Gini in 1912. It is used as a gauge of economic inequality, measuring income distribution among a population.
The coefficient ranges from 0 (or 0%) to 1 (or 100%), with 0 representing perfect equality and 1 representing perfect inequality. Values over 1 are not practically possible as we don't take into account the negative incomes. (Income can be 0 at its lowest but not negative)
Thus, a country where every resident has the same income would have an income Gini coefficient of 0. A country where one resident earned all the income, while everyone else earned nothing, would have an income Gini coefficient of 1.
Gini should not be mistaken for the absolute measurement of income or wealth.