No matter how the Evergrande drama plays out, whether it culminates with an uncontrolled, chaotic default and/or liquidation which sparks a crash in real estate values, or with Beijing blinking and bailing out the core pillar of China's housing market, remember that Evergrande is just a symptom of the trends that have whipsawed China's property market in the past year, which has seen significant contraction as a result of Beijing policies seeking to tighten financial conditions as part of Xi's new "common prosperity" drive which among other things, seeks to make housing much more affordable to everyone, not just the richest.
So before we go further, a quick reminder of the sharp deterioration observed in the past few months which has been a direct (if reflexive) contributor to Evergrande's downfall and which we touched on last week in "Chinese Data Dump Confirms Hard Landing Imminent" in which we noted something stunning: according to WIND, growth in land sales in value terms in the 100-city sample, a proxy for land purchases by property developers, slumped to -90.4% Y/Y during 1-12 September form -65.0% in August. In volume (floor space) terms, it also dropped sharply to -38.3% y-o-y from -21.9%.
Picking up on this weakness in the property market, Goldman notes that after housing activity turned significantly more negative from June to July, August registered another sequential declines in housing starts and property sales. And although idiosyncratic factors such as floods, typhoons, and virus related mobility restrictions likely played a role, the unrelenting policy tightening over the past year probably was the key driver, from the “3 Red Lines” to property loan caps, from land auction reforms to local home purchase restrictions.
Indeed, the fact that property developers’ bond issuance has plunged suggests policy tightening has been a more significant driver than those idiosyncratic factors. It is here that Evergrande, whose ponzi-like business was reliant on ever greater access to debt to perpetuate its growth, fell smack in the crosshairs of Beijing's tightening campaign.
And with policymakers (still) showing no signs of wavering on property market deleveraging, Goldman warns that latest development regarding Evergrande which may default as soon as today on a bank loan, "likely suggest that housing activity may deteriorate further in the absence of the government providing a clear path toward an eventual resolution for Evergrande." The bank adds:
As our credit strategy team points out, Evergrande is large (total assets of RMB2tn, or 2% of China’s GDP) and complex (with over 200 offshore and nearly 2000 onshore wholly and non-wholly owned subsidiaries). But it accounts for only 4% of China’s total property sales and its 123,000 employees and 3.8 million contractors make up a fraction of China’s over 400 million urban labor force. In the event of an orderly default of Evergrande and limited spillovers to both the financial market and broader property sector, the macro impact should be manageable.
Of course, as we discussed extensively over the weekend, and as markets are realizing rapidly this morning, the danger is precisely the contagion effect, should a default occur without clear “ring-fencing” of spillovers to other parts of the real economy or financial sector.
Ominously, Goldman warns that "events over the past week suggest risks of inching toward that direction" with equities and bonds issued by other developers with high leverage have sold off, while protests at Evergrande offices across China may cause reluctance among potential homebuyers more broadly.
Meanwhile, a surge in yields and rising financing pressure faced by property developers has contributed to failed land auctions in a number of cities.
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So now that we know where we are, the question is where we go from here, and it is here that Goldman has a rather dire forecast about the future of the Chinese property market. As the bank's China analysts write in a Sunday note titled "Rising risks from the property markets", they examine the implications for the economy in three different scenarios, given the property market’s connection with both upstream and downstream sectors, its dominance on Chinese households’ balance sheet (40% of household assets), and its important linkages to the banking system (40% of bank loans are backed by properties).
- In the first and base case, Goldman uses its property team’s forecasts for 2022 (land sales and housing starts down 15% and property sales and house prices down 5%) combined with a moderate tightening in financial conditions as equity market sells off and credit spreads widen. Goldman analysts expect completions to increase 10% as completions should follow previous presales. This scenario effectively assumes that the property market deleveraging would continue but at a gradual pace, and Evergrande related risks would not generate significant negative spillover effects on the financial system and other developers.
- In the second and more severe scenario, land sales and housing starts fall 23%, property sales and house prices decline 8%, and completions stay flat from 2021 to 2022. The tightening in financial conditions is similar to the credit tightening in 2014H2.
- In the third and most bearish scenario, land sales and housing starts fall 30% and property sales, house prices and completions drop 10% from 2021 to 2022. The tightening in financial conditions doubles that in the second scenario. Note that in this scenario, the tightening is of the same magnitude as the tightening in Goldman's China Financial Conditions Index (FCI) from November 2017 to June 2018 when domestic credit tightening and the US-China trade war rattled the financial market significantly.
To link these three scenarios to economic growth, Goldman considers both financial (e.g., through financial conditions) and real impact, and within real impact, both direction (e.g., lower construction activity and less local fiscal revenue from land sales) and indirect effects (e.g., lower demand for upstream products such as cement and steel and downstream products such as furniture and home appliances). The table below outlines the mechanisms the bank considers in its calculation, to estimate the impact on GDP.
Next, Goldman quantifies the impacts of these three scenarios (this is a partial equilibrium exercise which does not take into consideration potential monetary and fiscal policy easing in response to the property market declines):
- In the first scenario, the total negative impact would depress the level of output by 1.4% of GDP, with the direct impact playing the most important role.
- In the second scenario, the total negative impact increases to 2.5% of GDP.
- In the third scenario, the total negative impact is as large as 4.1% of GDP, with the financial conditions channel contributing the most to the total impact, highlighting the importance of the financial spillover effect on the economy in this most bearish scenario.
It goes without saying that a 4.1%,or even 2.5% hit to China's GDP, would have catastrophic consequences not only on China's economy which could then rapidly spiral into a recession, but the deflationary shockwave which quickly spreads across the globe, would devastate risk assets in most developed nations.
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That said, what is the bigger picture impact of these adverse impacts to China's GDP? Here we take a step back again to evaluate why China has been aggressively implementing its regulatory tightening and structural shifts in the post-Covid era.
As Goldman notes, the past year offered policymakers a rare “window of opportunity” to implement regulatory tightening and structural shifts without worrying too much about missing the growth target. A rebound in domestic activity as lockdowns eased, and strong demand for Chinese exports from other countries, both provided considerable economic momentum without the need for large policy stimulus. In August, Chinese exports increased 25.6% yoy (Exhibit 1), significantly higher than the Bloomberg consensus expectation of 17.3%. The strong exports data seem to suggest the tailwind from robust external demand continues to blow, extending the runway for the Chinese government to tighten domestic policy.
At the same time, this year’s GDP growth is unlikely to miss the low bar of the “above 6%” target (Exhibit 2). Goldman's base case is a weak Q3 (1.3% qoq ar) followed by a sequential, not year-on-year, rebound in Q4 (8.5% qoq ar), which implies 8.2% full-year growth. Even in the bear case where an exceedingly weak Q3 (-2% qoq ar) is followed by no sequential recovery in Q4 (0% qoq ar), a rather extreme assumption given the strict lockdowns implemented in August had been mostly lifted by September, 2021 full-year growth would still reach 7%. The combination of exports continuing to surprise to the upside and a non-binding growth target this year would seem to suggest that the window for policymakers to focus on structural issues remains open.
However, in light of recent events, Goldman warns that this “window of opportunity” has closed. First, the recent strength is exports is primarily driven by higher prices rather than stronger volumes. Although we expect the level of external demand to stay strong, the room for further increases is limited. Second, with the more contagious Delta variant and the “zero tolerance” COVID policy, consumption recovery is likely to feature a “start and stop” pattern, capping the upside as well. Third, continued semiconductor shortages may persist for months to come, if not quarters, and weigh on auto production and sales. These three forces are mostly beyond the government’s control.
So putting together the exogenous slowdown in China's economy due to forces beyond Beijing's control, coupled with the endogenous shock emanating from the property sector in general (due to policy tightening) and Evergrande in particular (whose implosion has accelerated due to Beijing's insistence not to bail out the company), Goldman's conclusion is simple: an aggressive policy response is needed, and here's why:
After the cleanup of the shadow banking sector, the Chinese banking system is in a stronger position to withstand shocks than a few years ago, the bank's analysts contend. Regulators have gained experience with Anbang, the Tomorrow Group and Huarong previously, although Evergrande is arguably a much bigger and more complicated case. On the other hand, the importance of the property sector to the economy is certainty not lost on Chinese policymakers. Therefore, Goldman's baseline remains that the authorities will not allow a situation where a disorderly default of Evergrande spirals into a crisis as they head into the Sixth Plenum in November, although a potential restructuring of Evergrande would probably take a while and negative headlines and operational hiccups are likely along the way.
Yet even Goldman's optimism is suddenly far more muted than it was just a few weeks ago (when the bank anticipated virtually no adverse consequences from Evergrande) and cautions that as financial markets begin to worry about the contagion effect and financing challenges begin to emerge for other developers, it is imperative for the government to provide clear communication on the plan regarding Evergrande and to shore up confidence among homebuyers, suppliers and contractors, banks and other non-bank financial institutions. "Without such communication, particularly if market tensions worsens significantly in the coming days and weeks, the hit to economic growth in Q4 and next year from the property market would look more like scenarios 2 or 3 than our current base case."
Looking beyond the immediate risks and uncertainties around Evergrande, Goldman adds that two other policy adjustments are also needed.
- First is the overall macro policy stance. Despite the recent increases in on-budget and off-budget fiscal spending and more MLF/OMO liquidity operations than market expected in September, the overall domestic policy stance still appears too tight. Additional easing on both fiscal and monetary fronts is needed in Q4 to ensure sufficient growth momentum as we head into 2022 (we agree with this, as it is imperative for China to force its credit impulse out of contraction territory and that can only happen with a substantial monetary and fiscal stimulus).
- Second is the pace of structural changes. When it comes to long-term goals such as de-carbonization and property market deleveraging, the pace of policy implementation is as important as the ultimate policy objectives. In the case of deleveraging, both the 2018 experience and the recent turn of events in the property market illustrate that, if the push to lower debt is compressed into too short a timeframe, growth may slow significantly and we may end up with a higher, not a lower, macro leverage.
Goldman's bottom line:
Housing activity fell sharply in July and weakened further in August. At the same time, concerns over Evergrande are rising and signs of financing difficulties spreading to other developers are emerging. We estimate the potential impact on growth under different scenarios. For now, our baseline remains that any potential default or restructuring of Evergrande would be carefully managed by the government with limited contagion effect in both financial and property markets.This would require a clear message from the government soon to shore up confidence and to stop the spillover effect, the absence of which we think poses notable downside risk to growth in Q4 and next year.
In short, and as we concluded last night, being's dilemma is simple: do nothing and watch as the economy crumbles, potentially with dire socio-economic consequences, or step in and stabilize markets at the expense of once again losing all credibility in its (failed) ongoing attempts to delever... which is to be expected for an economy which has 350% debt/GDP according to the IIF, a number which is too big to shrink on its own.