MP Econ Issue 7: China’s Property Sector Will Muddle Through Rest of Year
Given the intense focus on the Evergrande situation, this special issue of MP Econ provides a timely view of how I think the crisis will unfold. In the future, I will follow up with more detailed analysis of the policy dynamics that affect the property sector.
Evergrande may have averted a disaster this week by announcing that it will meet its interest payments to bond holders, but the saga is far from over. The lingering questions are how many other “Evergrandes” lurk in China’s property sector and whether the firm’s impending default will have a contagion effect.
We believe that Evergrande is an exceptional case that is unlikely to lead to a broader systemic crisis in the property sector. To be sure, there are other vulnerable firms, such as Sunac and R&F, whose stock prices have plummeted recently. But these larger property firms are all less than half the size of Evergrande, and it is unlikely that any of them will follow in the company’s footsteps.
This near-term baseline scenario is predicated on three key factors: 1) the central bank will further relax mortgage policy to alleviate the liquidity crunch for the property sector; 2) property sales will rebound as demand for housing remains healthy; 3) the more vulnerable firms will be able to sell their assets (e.g. land) to raise cash. These dynamics will be mutually reinforcing and will help to stabilize the property sector as it muddles through this year.
Why is Evergrande exceptional?
Among China’s top ten private property firms, Evergrande is one with the lowest return on assets (ROA) and with the worst management of its liquidity (see Figure 1). For instance, Evergande’s ROA is just 0.3% compared to 2% for the average of the top ten. If the firm cannot regain the confidence of its customers and creditors soon, it will likely default later this year and enter a lengthy restructuring process that could well involve the state buying some of its assets.
Figure 1. Evergrande is Significantly Weaker than Other Major Property Firms=
Note: Liquidity is measured by the ratio of liquid assets to short-term liabilities. The ROA is for 2020, and liquidity is for 1H2021
Source: Wind and MacroPolo.
The fact that Evergrande has been thrust in the spotlight is likely because it is the largest, yet the defaults of companies like Anbang, HNA, and Huarong have not caused lasting damage to the broader economy. In fact, this is the fourth time in five years that a major Chinese company with more than $150 billion on its balance sheet has defaulted.
If Evergrande does eventually default, the Chinese government will likely force it to go through a similar restructuring as the other firms above, possibly nationalizing some of its assets like land that will retain value. Beijing will likely also severely punish the executives of Evergrande to set an example for other firms to reduce their leverage and manage their finances better.
Why will the property sector survive?
Evergrande is exceptional in how it behaved and how it managed its business. But it’s unexceptional in the sense that it was facing liquidity constraints and weak sales that the entire sector has been weathering.
Indeed, the crux of the problem appears to be the People’s Bank of China’s (PBOC) overreach in tightening screws on the property sector, particularly that of mortgage lending. Preoccupied with stifling a property and land sales bubble, China’s financial regulators since late 2020 mandated banks to cut back on mortgage loans. So far in 2021, banks have lent out ~$60 billion less in mortgages than during the same period in 2020 (see Figure 2).
Figure 2. New Mortgage Lending Is Significantly Below 2020 Levels (billion yuan)
Note: The chart shows year-on-year change in total mortgage lending.
Source: Wind and MacroPolo.
The severity of the drying up of mortgage lending has been notable over the past two months, which likely explains the sharp contraction in property sales growth of -18% in August. The lack of sales puts even more stress on property firms that were already feeling the liquidity pinch. This is significant because property sales is the single largest source of cash flow for developers, as direct bank lending to developers is restricted. So without sales, property firms could no longer recycle cash, and if the situation persists long enough, even the soundest firms could face defaults.
As such, the PBOC was increasingly facing an impossible triangle: 1) persist in reducing developer leverage; 2) curtail mortgage growth; or 3) stabilize the property sector. Since Beijing, and Xi Jinping personally, have long emphasized a stable property sector as a precondition for any macro policy, the PBOC’s recent hawkishness will have to be moderated.
Demand remains strong
Therefore, the problems in the property sector aren’t a result of lack of demand. In fact, when it comes to the one million buyers who are going to be victims of Evergrande’s potential default, what they seem to really want is to get the units they were promised. Many of these buyers purchased presale units, and what’s remarkable is that despite the rising risks, Chinese households’ confidence appears resilient as they stick with presales. In fact, it accounts for about 90% of all property sales in China (see Figure 3).
Figure 3. Chinese Households Continue to Purchase Presale Property (% of total sales)
Source: National Bureau of Statistics and MacroPolo.
The fact that property demand appears to be holding up despite the recent turmoil further suggests that a reversal of the broader clampdown can go a long way toward assuaging concerns. The PBOC also seems to recognize that it may have overcorrected and will likely recalibrate in coming days by relaxing restrictions on mortgage lending. (The PBOC will likely wait and see the effectiveness of the mortgage policy before lifting restrictions on overall property borrowing.)
This should lead to a rebound of property sales toward the end of the year without triggering another property bubble. That’s because when Evergrande chooses to unload its massive existing assets onto other property firms, rather than go through default, these firms will not have much left to purchase additional land and inflate prices.
Finally, it is also incumbent on property developers, particularly the weaker ones, to find their own way out by selling assets at a discount. In fact, some of the smaller ones, such as R&F noted above, have already begun to do so. Evergrande, too, had plenty of opportunities earlier this year to sell land to raise cash and avoid a default. Its refusal to do so is partly responsible for the predicament it currently finds itself.
In contrast, when another troubled mega Chinese developer Dalian Wanda was caught in a liquidity crisis in 2017, the firm quickly sold 500 billion yuan (~$75 billion) of assets and survived. So long as property developers are willing to engage in a fire sale of their assets, their chances of survival are high because there will always be buyers for land in China.
Of course, there remains the possibility that this scenario doesn’t hold and the Evergrande crisis worsens. An indicator of a deteriorating situation is whether mortgage lending rebounds in coming months—a reflection of continued consumer confidence in the property sector. As noted above, since nearly 90% of all property sales are presales, a sustained drop in advance payments on property will significantly affect the cash flow of even the strongest developers. This risk is worth monitoring even if the probability remains low.