Reasons for China property to avoid systemic fallout
If the Coliseum falls, will Rome? Asia credit markets have been spooked by the impending default of China Evergrande (3333 HK), one of China’s most indebted property companies with more than USD300b in liabilities. Indeed, the EVERRE/TIANHL USD complex of bonds are trading at c.25%/15% of face value – pricing near recovery rates amid a restructuring scenario. Spreads in the China property space responded in sympathy, with broad widening to reflect the immense regulatory uncertainty in the onshore markets (Figure 1).
Renouncing capitalism. Indeed, China’s regulatory tightening across large segments of the economy including the Technology, Education, Gaming, Financials, and Property sectors have approached such perceived extremes that the markets are convinced that China is pursuing a more egalitarian form of socialism – renouncing in part some of the capitalist ideals that had supercharged their growth over the last decade. The severity of the regulatory tightening on the Property sector in particular, sees the following justifications:
§ Inequality. According to Wan et al (please refer to “What Drove Housing Wealth Inequality in China?”, China & World Economy / 32–60, Vol. 29, No. 1, 2021), housing is the largest contributor to wealth inequality – responsible for c.70% of the total – with its contribution increasing over time. This exacerbates societal disenchantment, namely with some of the youth, who have embraced the “lying flat” (躺平) movement and rejected the pursuit of hard work due to the unattainability of aspirational wealth.
§ Declining birth rates. High property prices have been touted as one of the contributors for lower birth rates in China, a statistic that was alarming enough for authorities to lift caps on births this year in a major policy shift.
§ Capital allocation. China’s pursuit of technological self-sufficiency on hard tech (e.g. semiconductor chips) requires the channelling of financial resources/national savings away from more “speculative” sectors such as property.
Stay with BBB/BBs. Certainly, these policy agenda warrant a more cautious view on China property. However, we reiterate that safety remains within the BBB/BB segments of the market, as we believe that a systemic default encompassing these higher-rated companies would amplify risks of social and financial instability – the very risks that the policymakers were trying to avoid with such curbs in the first place.
Figure 1: China property BBB/BBs see limited widening compared to single Bs
How “unaffordable” is housing in China? While there are several measures of housing affordability, we will adopt the “rule of thumb” ratio of 5x the annual household income as a dividing line between what is deemed affordable and what is not. By this measure, it does appear that average multiples for both private (7.2x) and public (5.6x) housing do warrant some concern from policymakers, according to research from the Lincoln Institute of Land Policy.
Figure 2: China housing price-to-income ratio by city state
Source: Li Sun (2020). Housing Affordability in Chinese Cities. Lincoln Institute of Land Policy, DBS
The question is, how far would policymakers have to see prices decline on aggregate before it is “affordable” enough? We outline a few scenarios below:
1. Benign (0%) – Policymakers keep prices stagnant while allowing wages to catch up with property inflation. After all, nominal wages have seen increases of 7-8% per annum over the last five years on average.
2. Moderate (-10%) – Policymakers allow for pricing differential across localities (a global truism is that major cities command a premium). A 10% decline of property prices on aggregate would achieve average price-to-income ratios below 5x for private/public housing in 80%/100% of the above sample of city states.
3. Extreme (-31%) – Policymakers require nationwide private housing price-to-income ratios to average below 5x, which requires an aggregate decline of 31% or more.
Factoring a measure of pragmatism. We believe that the outcome would lie somewhere between the benign and moderate scenarios, as the authorities would need to strike a balance between managing social objectives and systemic stability. Yet in either case, the longer-term outlook for the property sector would be dampened by this base case of stagnant/declining prices. However, from a purely credit perspective, comfort is derived from the fact that (a) average developer margins of c.20% (Figure 3) allow a buffer for price declines before the sector becomes loss-making, and (b) developers are continuing to fall in line with the “Three Red Lines” directive of deleveraging – with a large majority expected to fall into the “green” category by 2023 (Figure 4).
Figure 3: China developer margins have some buffer
Source: Bloomberg, DBS
Figure 4: Estimated compliance with the “Three Red Lines” by 2023
Source: Bloomberg, DBS
The three “red lines” are Liabilities/Assets (excl. contract liabilities) < 70%,
Net debt to equity < 100%, cash to short-term debt >1x. Red/Orange/Yellow/Green classifications represent a breach of 3/2/1/0 of the “red lines”.
China’s “Lehman” moment? Even if the property prices see a more benign decline, commentators have still likened China Evergrande’s default to the collapse of Lehman Brothers and its systemic impact on the US and the rest of the world in 2008. However, we believe that there are important differences one should consider:
1. Absence of a complex derivatives portfolio. Unlike leveraged derivative positions that can be reduced to nothing at the collapse of the underlying (the trigger for Lehman’s insolvency), Evergrande has an extensive land bank, development projects, and finished properties that command real world residual value.
2. China’s property market is fragmented. Despite being one of the largest developers by sales volume, Evergrande accounted for only c.4% of the country’s property sales in 2020. The company’s total liabilities of USD300b also represents only c.1% of China banks’ total loan portfolio – which does not pose significant systemic risk.
3. China’s financial system is state-controlled. Lehman’s failure resulted in amplification of counterparty risk as global financial institutions withheld credit from each other in the thick of uncertainty. The state oversight of China’s financial system allows for greater counterparty coordination in assessing broader Evergrande risk exposure.
Figure 5: BBs lie in the better quality half of China Property USD credit
Focusing on quality. As much as contagion risks are not our base case expectation, we are mindful that the China property market still sees more than half of issuances rated single B and below. Our premise remains to stay with the better quality half in the BBB/BB bucket, as highly leveraged developers will be at greater risks of insolvency under a prolonged period of price stagnation/decline with limited access to capital.
Understandably, some investors remain concerned that there may be risks even to the BBB/BB segment, for which we believe it helpful to consider the following implications:
§ Real estate accounts for c.25% of China’s economy, with intricate links to the building and construction industries, commodity-related sectors, and financial institutions, all of which provide employment to a sizeable portion of the population.
§ Mortgage loans account for c.20% of outstanding bank loans, according to the PBOC. Should LTVs be substantially compromised, risks in the property sector would quickly translate to the financial sector, for which policymakers would find does not have a quick-and-easy fix.
§ Real estate is estimated to account for c.40% of household net worth. Any significant longer run decline in property prices would dampen the wealth effect, and further hinder China’s progress towards a consumption-driven economy.
§ Tough measures threaten to create the kind of financial instability that they are trying to avoid. The directive of deleveraging was to prevent a build-up of systemic risk, which becomes obsolete should the directives themselves result in financial collapse.
§ China’s 20th party congress will be held in October 2022. As President Xi heads for a third term in office, social and economic stability would remain a key priority leading up to the re-elections – objectives that would be difficult to conceive with a country-wide property crisis in the next 12 months.
Where are the opportunities? We continue to see value in Asia credit, given that the risks appear more than adequately priced in by the markets. However, we believe clearer communications on policy implementation from China would be necessary before the markets can crystallise any potential valuation upside. While such regulatory noise is momentarily amplified, investors can look to Asia ex-China credit markets in Indonesia/India/Thailand which have also widened in sympathy and offer value. For bargain-hunters in China property names, we believe that there may be an interesting play in BBB/BB names with larger Tier 3 land banks, given that housing is not acutely unaffordable in such localities, which most importantly, falls in line with the authorities’ social objectives.
Figure 6: Price-to-income ratio by city tier
Source: Li Sun (2020). Housing Affordability in Chinese Cities. Lincoln Institute of Land Policy, DBS
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