28 JUIN 2018
Official data shows that tighter credit conditions are beginning to act as a drag on the Chinese economy, but what impact is this having on real estate companies?
Since 2016, I have been highlighting risks surrounding the debt loads and land acquisition strategies of mainland Chinese residential property developers; based on Chinese regulatory policy and access to financing, these would begin to emerge around the middle of 2018 and be skewed towards smaller developers in tier-two cities. Now that we have arrived at this time, have these cracks started to emerge?
The short answer is that it is still too early to tell with any certainty. The financial statements for the first half of 2018, of developers listed on stock markets, won’t be publicly available until the end of August. This will be the first real chance to look at how the Chinese government’s ongoing policy of reducing corporate reliance on shadow financing has affected mainland developers.
At this point, economic data does not tell us much either. Credit impulses, both positive and negative, tend to have a lagged impact, meaning that their effects don’t appear in macroeconomic data until several months after they come into place. However, as a result of mainland Chinese developers’ financing structure – highly illiquid assets (land) combined with highly liquid liabilities (short-term financing tools with maturities of less than a year) – we can draw some inferences from the macro data.
Smaller developers tend to be more geographically isolated and have fewer financing options than their larger peers. As a result, they are more reliant on shadow financing and thus deeply imbedded into the financial system.
Developers make money by selling as many homes as they can for the highest price accepted, so revenues are a product of values and volumes. Chart one shows that house price inflation has come down significantly in tier-one cities. Although smaller developers tend to be locked out of these markets, the chart also shows that price inflation in smaller cities has begun to trend lower. Meanwhile, chart two shows that transaction volumes have fallen on a per square metre basis across all city tiers. Taken together, this equates to a significant headwind for developers’ revenues.
As shown in chart three, growth in land purchases by developers tend to lag that of home sales. That is, the peak in land transaction growth occurs approximately one year after the peak of home sales, with a similar dynamic exhibited for the trough. In the most recent cycle, this was stretched slightly with the peak in land transaction growth occuring 19 months after the peak in home sales. This is a result of a lack of investment opportunities for mainland Chinese developers, so revenues from home sales are put towards purchasing more land. CREIS estimates that developers spend 30-50% of revenues on land acquisition.
Similarly, once land is purchased, construction must commence fairly rapidly. Chart three also shows that construction starts track land purchases fairly closely, although it would appear that land purchases outpaced construction starts since mid-2017. This is indicative of a backlog of construction starts waiting in the pipeline, meaning that new construction could increase at a faster pace than land purchases for several months. Chart four seems to corroborate this, showing that construction has increased at a much slower pace than following previous spikes in home sales.
This adds a burden on construction firms. At a recent presentation, analysts at S&P Global Ratings said that one of the ways developers were offsetting the effects of a softer sales environment was to delay payment to downstream [construction] firms. The same presentation noted that certain developers were showing signs of funding gaps, and as seen in the next section, funding is becoming more difficult to come by.
In 2017, the Chinese government announced that it would embark on a deleveraging drive to tackle the risks posed by excessive corporate debt. Specifically, regulatory authorities began scrutinizing shadow banking activities (3). This had particular ramifications for smaller developers in lower-tier markets, where shadow banking could account for more than 50% of their total debt pile.
As a developing country, China’s financial system is not as deep as its counterparts in the US and EU, and thus corporates rely heavily on bank loans for financing. However, stringent regulations on banking and a fast growing economy has meant that the supply of funds have been unable to keep up with the demand for financing. This created an environment for the less regulated shadow banking sector to flourish.
The additional scrutiny on shadow financing appears to be having some effect. Chart five shows new issuance of the core products associated with shadow banking, trust and entrusted loans, as well as corporate bond issuance. From Q2 of 2017, there was a sharp reduction in issuance of entrusted loans – loans between two corporates facilitated by a non-bank financial intermidiary – and net issuance has turned negative in Q1.
Trust loans (loans to corporates from non-bank financial companies) have also declined to start 2018. Anecdotal evidence suggests that this could partially be due to a repricing of risk; where shadow lending was available to developers at or below the benchmark rate in 2016, developers are now paying a 30-40 basis point premium to borrow from the shadow banking sector. This spread is likely to go higher should the government continue with its policy of reducing shadow financing activities.
The cost of financing has also increased in 2018, as shown in Charts six and seven. Chart seven shows the risk premium being paid above government bonds to hold corporate bonds. Most developers would be rated AA or below, with the smaller developers that are more active in tier-two markets likely rated A or lower.
The spread between these and government bonds has widened above 750 basis points for only the second time since 2009, indicating that investors now need an additional 7.5% yield to take the risk of lending to these companies versus the government. It is also an indication of investors pricing in a higher probability of default. Meanwhile, Chart seven shows a similar dynamic is evident in the yield curve, where investors have increased the yield required to lend short-term (One Year) significantly more than they have for the longer term (10 Year) since 2016.
Some of this trend can be explained by Chart eight, which shows a sharp drop in wealth management products. These are structured finance products sold to retail customers, whose funds are then pooled and become a major source of demand for low-rated, high-yielding corporate bonds. Chart eight shows that the duration of these products has also been reduced, indicating that over the next 18 months a large share of these are scheduled to be paid out.
In addition to extra risk being priced in by investors, reports suggest that Chinese regulators have increased scrutiny over bond issuance, including longer approval periods. This has been extended outside of shadow banking and to the traditional banking sector, where banks are becoming more stringent in demanding collateral from developers seeking loans and extending loan approval periods.
This will have an outsized effect on smaller developers who do not have as strong relationships with the major banks compared to larger counterparts. Additionally, the China Banking Regulatory Commission has also stepped up its loan monitoring activities. If the borrowed funds are being found to go towards financing land purchases, then the parties involved could face penalties.
As highlighted at the beginning of this article, the release of banks’ financial statements at the end of August will provide a first look as to how developers have fared as a result of the Chinese government’s efforts to reduce leverage. However, based on the data available now we know that:
If the government continues to restrict credit, this will make for a difficult operating environment for Chinese real estate developers. Although defaults by developers are rare, there have been some (in various forms) since 2014, and there appear to be 1-2 priced in over the next year. This alone should not be a major disruptive force in the market. The risk will come if an unexpected default occurs, particularly if it is by a more highly rated developer. This would cause a sharp repricing of risk, significantly increasing borrowing costs for all developers and likely resulting in a liquidity squeeze as banks evaluate the risk to their loanbooks.
Technically, the government and regulators could pre-empt this by loosening restrictions on traditional and shadow banking practices. However, as I have written before, this would essentially just be "kicking the can" (as in 2013) or transferring the debt burden from developers to consumers via an increase in mortgage lending (as in 2016/17): neither of these would solve the fundamental issue of reducing systemic risk via deleveraging.
Rather, it would be optimal for the goverrnment to allow any defaults to occur, while at the same time standing ready to inject liquidity to keep short-term financing open. The People’s Bank of China, the central bank, took an important step towards this in 2016 when it took a more active role in open market operations.
Being able to ringfence short-term contagion and ensure market functionality by allowing risk to be repriced will be a key litmus test for the Chinese economy moving forward. Should China’s government and regulators succeed in doing this while accepting slower growth, the economy should succeed in gradually adjusting to a slower, albeit more sustainable, growth trajectory.