China Blinks: As Contagion From Property Sector Crash Spreads, Regulators Set To Ease Bond Rules

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by Tyler Durden
Thursday, Nov 11, 2021 - 12:45 AM

Two months ago Wall Street was quick to conveniently ignore China's property crisis, repeating that not only was the sudden hit to Chinese housing - the world's largest asset class according to Goldman...

... not a "Lehman moment", but that any contagion would be limited at best; at the same time central bankers - not just in China but around the globe - were quick to assure investors that a collapse by China Evergrande Group wouldn’t lead to a crash. As usual, Wall Street consensus (especially when coupled with soothing lies from central planners bankers) was dead wrong because now that the bond selloff has spread to China’s entire real estate sector and beyond, including healthy government-backstopped investment grade companies, concern is growing about the potential risk to the global financial system.

On Monday, the Federal Reserve made that link explicit in its semi-annual report on financial stability, warning that what happens in China’s property industry could impact financial markets and threaten world economic growth. Underscoring the risks of a potential spillover, the Hong Kong Monetary Authority asked banks to disclose their exposure to Chinese real estate, according to a local media report.

As Bloomberg reported, at the heart of the bond market rout is concern that developers may have far more debt than disclosed on their balance sheets. That emerged after companies suddenly struggling to pay public and hidden debt despite representing that they have sufficient capital. Making matters worse is developers’ inability to roll over maturing debt due to surging borrowing costs that effectively shut them out of the dollar bond market. China’s 10 largest developers by sales owe a combined $1.65 trillion in liabilities.

Commenting on the latest events in China, overnight Rabobank's Michael Every wrote that the “contained” Evergrande crisis - which even the Fed has noticed - is seeing contagion:

"Junk bond yields are soaring and the trend is spreading to better quality credits and large banks, with investment grade yields up 8-10bp yesterday. As developers who have not crossed any debt redlines ‘mysteriously’ see their bonds plunge, Bloomberg reports the 10 largest developers carry debts of $1.7 trillion…on book. Off book and contingent liabilities are likely *far* higher. Worse, Chinese cities are now tightening the use of proceeds from pre-sold properties, effectively forcing developers to use this cashflow to finish construction rather to repay debts. Can you guess what happens next?"

Yes we can, but for the sake of suspense let's assume it won't happen: instead let's give the mic to Larry Hu, head of China economics at Macquarie Group, who said that “China appears to be stress-testing its financial system,” adding that “only under stress do you know how much off-balance sheet debt there is and how much pressure the system is able to handle. But the danger is that China decides to ease off too late.”

Alas, one look at bond yields and it may already be too late as the cash crunch is worsening by the day. The yield on a Bloomberg index of Chinese junk dollar bonds - which is dominated by property firms - has surged to a record 24%. Kaisa Group Holdings Ltd., which said last week it missed payments on wealth products, was downgraded further into junk by Fitch Ratings on Tuesday.

In the latest flashing red light the selloff - which so far had been contained mostly to property names - spread to higher-grade issuers such as Country Garden Holdings while even an investment grade company controlled by China’s government, Sino Ocean Land (not to be confused with Sino Forest) has seen its bonds slump. Spreads on the nation’s investment-grade bonds over Treasuries widened the most since April on Tuesday.

And with bonds freefalling, it's hardly a surprise that shares are also plunging. A Bloomberg index of Chinese developers is at the lowest level in more than four years after losing 33% in 2021. Shareholders of companies such as Evergrande, China Fortune Land Development, China Aoyuan Group and Yuzhou Group Holdings are sitting on losses exceeding 70%. The gauge is valued at just 0.3 times book value, showing traders are assigning a significant discount to developers’ reported assets

Among the chief reasons behind the collapse in property assets has been the government's insistence on not intervening, and forcing companies to prioritize completion of existing projects over repayment of creditors while forcing companies to liquidate non-core assets. Cities including Beijing and Tianjin have tightened supervision over the use of proceeds from property pre-sales to ensure projects are completed, China Business News reported. That will worsen the cash shortage for developers, making it harder for them to repay their debts.

To be sure, the stakes are high. According to Bloomberg, Chinese banks had more than 51.4 trillion yuan ($8 trillion) of outstanding loans to the real estate sector as of September, an increase of 7.6% from a year earlier. The exposure was more than any other industry, and accounted for about 27% of the nation’s total lending, according to official data (for more statistics on China's property sector, please see "Catastrophic" Property Sales Mean China's Worst Case Scenario Is Now In Play").

About 41% of China’s banking system assets were either directly or indirectly associated with the property sector at the end of last year.

“We expect most of Beijing’s property curbs will remain in place for a while, with the worst likely yet to come for both China’s property sector and macro-economy,” Nomura International HK’s economists Ting Lu and Jing Wang wrote in a note published Monday. “Beijing’s policy makers may opt to ramp up support to prevent worsening defaults in coming months.”

And while banks like Goldman see the ongoing selloff the selloff as an opportunity, telling clients to add a “modest amount of risk” through high-yield dollar bonds issued by China property developers and claiming that the market is overestimating the contagion risk, as Goldman portfolio management team member Angus Bell said in an interview last week, even central bankers are starting to sound the alarm: Hong Kong banks will be required to disclose their loans and credit issued to mainland developers, treasury units’ securities holdings as well as the proportion of their exposed assets, the Hong Kong Economic Journal reported.

Meanwhile, in its twice-yearly Financial Stability Report released Monday, the Fed said that "financial stresses in China could strain global financial markets through a deterioration of risk sentiment, pose risks to global economic growth, and affect the United States."

For now, contagion in mainland financial markets remains limited giving Chinese authorities room to maintain their curbs on the property industry, meaning the likelihood of some of kind of Lehman moment remains remote. But that could very rapidly change as the entire world heads into a stagflationary episode in 2022 as a result of soaring inflation and shrinking growth.

As a result, how Beijing manages its crackdown on the nation’s real estate industry may have far-reaching consequences beyond its borders: “Even if systemic risk remains low for now, the contagion risk is very real,” Macquarie’s Hu said. “I would say China needs to act if onshore markets panic and the economic risk grows so big they can’t defend 5% growth next year.”

Perhaps it's the rising frequency of concerns such as this one that something must be done, or maybe it was the Fed's warning that finally shook Beijing out of its complacent stupor, but overnight China's Securities Times reported that rules for real estate developers to issue domestic bonds may be loosened.

Picking up on the story this afternoon, the WSJ reported that Chinese regulators, wary of financial risks spreading as a result of their crackdown on property lending, are considering easing the rules to let struggling developers sell off assets to avoid defaults and hits to the broader economy.

Currently, rules put in place late last year to restrict how much property firms can borrow, dubbed the “three red lines” on leverage ratios and which we previewed last year (in an Oct 2020 article which we correctly titled that "China Crackdown On Property Developer Debt Sparks Fears About Systemic Crisis") are so strict that they have hurt the ability of developers like China Evergrande Group to sell assets to repay debts.

Citing people with knowledge of the discussions, the WSJ reported that the PBOC is considering opening a pathway for financially strained property firms to unload projects by allowing the buyers, likely state-owned firms, to take over the assets without having the projects’ associated debt affect their own debt ratios.

The potential easing of the borrowing rules highlights a deepening dilemma for Beijing as it tackles the oversize real-estate sector, which, together with related industries such as construction, accounts for nearly a third of China’s economic output. Rising default risks in the country’s real-estate sector have rattled global markets and threatened a sharp slowdown in the Chinese economy.

According to the WSJ, the potential move would represent a calibration - rather than a capitulation - of the broader policy aimed at reining in real estate speculation and reducing the economy’s reliance on the sector, the people said, adding that the property lending restrictions likely would be in place for up to four years.

For the central bank, which has publicly called risks from developer defaults controllable, the challenge is to stand firm on its goal of breaking the vicious cycle of builders’ binge borrowing leading to rising property prices, while preventing any kind of widespread defaults that could destabilize the entire financial system—its other major mandate. In the end, this will be an epic failure as we have said many times previously, as China simply can not grow at its current breakneck pace without the debt-fueled ponzi scheme that is its housing sector. 

Sure enough, as pains from the clampdown spill over from private developers to their state-owned peers as well as to investors and local governments, calls for easing are coming from many corners of Chinese society.

As the WSJ reports, on Monday, when senior officials affiliated with China’s State Council, the top government decision-making body, held a discussion with a dozen or so real estate and banking executives in the southern boomtown of Shenzhen to size up their concerns, many spoke up about the dire conditions of the industry and its knock-on effects on other parts of the economy, according to a summary of the gathering reviewed by The Wall Street Journal.

Li Haiming, executive director of Kaisa Group Holdings Ltd. , a private builder that missed a payment to investors last week, said at the meeting that developers like his are facing a severe liquidity crunch and could be saddled with unfinished so-called zombie projects.

Li's suggestion to the officials present, who are from the Development Research Center—the State Council’s think tank which compiles recommendations to policy makers—was simple: undo the restrictive deleveraging policies that China has ushered in over the past year and let things go back to normal, or as he put it, allow banks to continue to lend and extend loans. He also said state-owned firms should be encouraged to acquire projects from troubled developers to help them replenish their cash flow and build market confidence, according to the meeting summary.

But right now, state firms are unwilling to pounce mainly because such acquisitions would add any acquired projects’ associated debts to their balance sheets, potentially hurting their ability to borrow. That has hampered the attempts by many strained developers to unload assets and repay their creditors.

So in response, the People’s Bank of China is considering loosening the borrowing limits by enabling such acquisitions, WSJ sources said. To that end, the central bank might choose not to take into account the amount of debts the acquirers assume upon taking over the assets when measuring their ability to borrow based on their leverage ratios. That would then open up a channel for some developers to survive the current cash squeeze. In effect the "three red lines" framework would be quietly undone.

“It would be a way to let you live,” one of the people said. “Not just die.”

Already, financial regulators have started easing some rules on the margin to try to stabilize the market, including measures to allow some developers to sell medium-term bonds in China and steps to make it easier for them to repay dollar debt owed to foreign investors. The country’s top securities regulator is also considering renewing the application process for developers who plan to sell asset-backed securities to raise money, according to the people.

In response to the news that Beijing may be about to blink, the market was euphoria, and shares of Chinese real estate developers soared after the Securities Times report hit: Shimao Group surged by 17% in Hong Kong, China Aoyuan +16%, Sunac China Holdings +15%, CIFI Holdings +12%, Agile Group +11%, KWG Group +11%, Seazen Group +10%, Greentown China +9%, Logan Group +8.7%, Guangzhou R&F Properties +7.7%; in mainland trading, Poly Developments jumped +7.6%, Gemdale +6.4%, China Merchants Shekou +4.9%, China Vanke +4.2% and so on.

There is another reason why Beijing may have decided to fold: according to an article published by the China Finance 40 Forum, a Beijing-based think tank, titled “How to Prevent Hard-Landing Risks of the Real Estate Market,” a 15% plunge in property investment and sales could reduce the country’s economic growth rate by 1.5 percentage points. This is hardly a tradeoff that China's leaders, always terrified of rising social unrest in case of an economic crisis, are willing to take.

And if indeed Beijing has agreed to once again backstop the sector, expect this meltup to be one for the history books.