The Real Challenges for China Real Estate
China’s property market has been under pressure since early 2021, with incidents of defaults amid an increasingly challenging liquidity environment. Head of Fixed Income and Portfolio Manager Teresa Kong, CFA, explains the key risks in Chinese real estate businesses and the steps the government could consider to address them.
What do you think is the biggest risk in China’s property market at the moment?
From the perspective of international bondholders, the single biggest risk is the inability of high-yield property developers to borrow in the U.S. dollar (USD) bond markets. Many Chinese developers have strong operations and management teams but can’t issue new bonds because market participants are not discriminating and are demanding a high credit premium. This means that their bonds are trading at 50, 60 or 70 cents on the dollar with high implied probabilities of default. The contagion from other defaulted developers may cause a vicious cycle which could be self-fulfilling unless market sentiment turns around.
What will turn sentiment around?
We see three key factors to improving confidence:
- More targeted policies from the Chinese government to ease the property funding channels
- Increasing merger and acquisition (M&A) activity that shows property developers are able to realize value on their balance sheets by selling assets like land, joint ventures and projects
- Willingness of property developers to bite the bullet and issue equity, even at depressed valuations, in order to meet liabilities fully and on a timely basis
What kind of targeted policies will help?
These fall into both micro and macro policies. On a micro basis, real estate-specific policies like a relaxation of down payment requirements for first or second homes and relaxation of the use of escrow (restricted) cash accounts are steps in the right direction. Some type of real estate-specific funding (from China’s central bank perhaps, or another source) based on certain credit quality standards (such as the Three Red Lines-framework relating to the ratio of debt to cash, equity and assets) could also be a big help.
On a macro basis, policies like a further lowering of key benchmark interest rates, like the recent loan prime rate (LPR) and medium-term lending facility (MLF) rate cuts, and further easing of the required reserve requirement (RRR) ratio, could all lower the cost of capital.
Are things getting better or worse?
In terms of contracted sales, it has stabilized at low levels. By our estimation, we are looking at a year-over-year (YoY) decrease of around 30%. Due to the high base of the first half of 2021, the negative YoY print will likely persist until July or August, when the base effects become favorable. In terms of market conditions, we have seen some improvement in M&A activity from certain developers, so this is an encouraging sign that companies are finding some source of liquidity. There has also been equity raising. Overall, the situation is improving on the margin, but not sufficient for a broad restoration of confidence.
Should we expect more defaults within China real estate?
Yes, in our view, smaller developers that are over leveraged are at highest risk of default this year. We would also expect to see more debt extension and distressed debt exchange to happen this year. While the total defaulted may not exceed last year’s US$44.7 billion, we may see more smaller developers defaulting. But the sector as a whole remains crucial to the Chinese economy, and we believe there will be strong players who will survive the current default wave. It’s important to distinguish these stronger players from the rest, as these will have the potential to benefit from industry consolidation.
How important is real estate for China’s 2022 economic growth target of 5%?
Real estate drives around 25% of China’s GDP growth via its direct and indirect channels such as steel, cement, furniture, appliances, among others. The traditional growth drivers of the Chinese economy are consumption, investment and exports. Of these, consumption at the moment is hampered by COVID policies. Exports are largely dependent on global markets rather than policy. That leaves investments, which includes real estate and infrastructure investments among others. While the Chinese government has already said it will increase infrastructure investments, it will be difficult to reach the growth target with just increases in infrastructure. Thus, real estate is a key leg of the economic stool and needs to recover in order for China to hit its 5% target rate.
Are you concerned about other risks in the credit markets?
We have seen that episodes of Federal Reserve rate hikes typically spell volatile times for the credit market. We have talked a lot about high-yield debt but investment grade debt has more interest rate duration and is therefore more exposed to an upward shift in rates.
The clock is also ticking on the U.S.- China accounting dispute that may lead to the SEC delisting Chinese American Depositary Receipts (ADRs) from U.S. exchanges. While a delisting event constitutes a change of control whereby bondholders can put the bonds back at 100, it does require the companies to have sufficient USD liquidity.
What is your outlook for the Chinese renminbi?
The Chinese renminbi (RMB) was remarkably resilient against the appreciating USD in 2021. It caused the currency to appreciate against a basket of China’s trading partners, which its central bank is currently using as a guide to manage the RMB. Given the growing divergence between U.S. and China monetary policy, we would expect the RMB to experience a mild depreciation against the USD over the next couple of quarters. A weaker RMB would also incrementally help with exports in light of the downward pressures on growth.