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UNCORKED

The Chinese property bubble

by | Apr 21, 2022

The Fund Manager

The Chinese property bubble

by | Apr 21, 2022

Bust or buying opportunity?

In the new territories north of Hong Kong, a vast and lavish property development was planned: a wetlands restoration, hundreds of luxury townhouses, all surrounding the jewel in this property crown – a Palace of Versailles-themed villa of truly palatial size and ostentation.

If you want to know when you’ve reached the very pinnacle of a property market and bad things are about to happen, look out for the word ‘Versailles’. 

The original, monumentally lavish Palace of Versailles sparked revolution and saw King Louis VI and Queen Marie Antoinette go from gilded halls to the guillotine. Then, at the very peak of the 2008 US property boom, construction stalled on the biggest house in Florida, modelled on the world-famous Parisian palace. 

Now, this Chinese Versailles has been seized from the huge, debt-ridden property developers Evergrande by LA-based lenders Oaktree Capital. It has been obvious for some time that all is not well in the Chinese property market. 

For years, property development has been a significant driver of the country’s economy. Apartment blocks were built across China, funded by large deposits or even full pre-payment, plus loans to the developers. They were constructed by the rapidly expanding Chinese, super-sized property companies. In 2019, property prices were enjoying double-digit growth and buying housing amounted to a national obsession, fuelled in part by strong underlying trends including urbanisation and rising wealth. Critically, property ownership was also seen as the primary means of wealth creation and preservation.

 “Fuelling the fire were government policies which occasionally looked to stimulate real estate as a key counter-cyclical move”

Growth has been the mantra for Chinese real estate developers. The industry remains highly fragmented and developers learned in prior downturns that access to financing was often linked to their size and league-table ranking. Further fuelling the fire were government policies which occasionally looked to stimulate real estate as a key counter-cyclical move. Local governments were also benefitting as they generate 30% of their annual revenues from land sales to developers. 

And so the scene was set for over-heating. Developers borrowed more to grow faster to keep up with their peers. Like many things in China, the statistics of the property sector are staggering. Property development and related activities represent 25-30% of the country’s GDP. An astonishing 90% of Chinese people are now property owners – the current UK figure is 63% – and property is thought to make up 70% of the wealth of urban China. With mortgage rates at around 5% and rental rates of only 2%, an estimated fifth of China’s apartments are thought to be unoccupied. The cost of buying an apartment in ‘silicon valley’ Shenzhen in 2020 was estimated at 44 times the average salary. 

Policy-making in China is not a transparent process, so in many respects we are left to guess at what triggered the moves against the rampant property sector growth. Several key factors are relevant: the philosophy of Common Prosperity, a framework of policies intended to benefit China’s middle class over its oligarchs, has risen to the forefront; Chinese regulators have tried for years to stamp out excesses in the sector, without success; in addition, relations between China and the outside world deteriorated and triggered China’s determination to become more self-reliant and resilient. 

“President Xi Jinping has long held the opinion that: ‘Housing is for living in, not for speculating’”

With the property market running red hot in 2020, the government attempted to apply the brakes. A series of measures were implemented to tame demand for property and supply. The most notable measure was the Three Red Lines policy, announced in August 2020. This was a traffic-light system of three financial ratios designed to restrict developers from having too much debt. President Xi Jinping has long held the opinion that: ‘Housing is for living in, not for speculating’ and his government aims to dampen the economic dependence on property and focus on clean energy and high-tech. 

The Three Red Lines were meant to be applied over several years, giving developers time to manage their finances and conform to requirements. However, many developers began to circumvent the rules by relying on short-term borrowings and joint-ventures to conceal debt within their balance sheets. During 2021, it became increasingly clear that Beijing’s patience with financial excesses had run out. In October 2021, massive Evergrande, now $300bn in debt, defaulted on its loan payments, the largest ever emerging-market debt default. 

The contagion spread as prices for bonds issued by developers Fantasia, Guangzhou R&F and Central China Real Estate moved sharply lower. The default rate in the sector reached 30% for 2021 and has continued to climb in early 2022. 

Chinese policymakers stress that maintaining stability is key and alarm bells appear to have finally sounded in Beijing. Property sales have collapsed and real estate prices are decreasing. But even more troubling is evidence that land sales and new starts have similarly collapsed. Why? Local bankers and regulators have reacted to the rising stress by trying to lock down developers’ local bank accounts. This has triggered a liquidity crisis as developers are unable to meet their obligations. And developers without cash cannot buy more land or start new projects. 

As the situation has deteriorated, policymakers have changed their tone. The People’s Bank of China issued comments about misunderstandings in how its policies were applied. Access to first-time-buyer mortgages has now eased and many cities have enacted local easing measures. The Three Red Lines policy has been relaxed, encouraging banks to lend more and instructing state-owned asset managers to get involved. The central government is taking over policy-setting for management of developers’ project-level escrow accounts. State-owned asset managers, the institutions that have historically helped resolve distressed investments in China, have been ordered to get involved. And most recently, we have seen several cities pull the ultimate stimulus lever by reducing down-payment requirements. 

Despite this positive policy trajectory, the market continues to trade at severe distress because, to date, policymakers have not managed to answer the fundamental question: can these companies remain going concerns? Given the degree of distress and uncertainty, investors are looking for a clear signal that it is safe to re-enter. 

It is rare to see markets price in so much downside as can now be seen in the China high-yield market. The level of risk aversion from Chinese investors is extreme and, of course, this may mean there are substantial opportunities for investors. With the market pricing in default rates in excess of 40%, investors have a unique opportunity to add to risk if they can see past the short-term volatility. As the direction of policymaking is clearly turning positive, the stage appears to be set for a recovery later in 2022. 

About Paul Lukaszewski

About Paul Lukaszewski

Paul Lukaszewski is Head of Corporate Debt, Asia Pacific, at abrdn.

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