Due to high indebtedness and the newly introduced "three red lines policy", developers in China have problems refinancing their current debts. What will be the impact of the current crisis?
The Chinese real estate sector is under pressure. The problem first appeared in the media at the end of September 2021, when China's second largest developer, Evergrande, failed to pay two interest rates on Eurobonds (offshore bonds) totaling $ 131 million in due time. And even though she finally paid both interest just before the end of the 30-day grace period, the big question remains how the development company will cope with future interest and principal payments in the coming months. In March and April 2022 alone, Evergrande has to pay $ 3.6 billion in principal. In addition to Evergrand, many other Chinese developers are also reporting liquidity problems. For example, Fantasia, a luxury housing developer, missed a $ 206 million debt repayment deadline in October. And a Hong Kong-registered development company, Sinic, failed to pay $ 246 million in interest and principal on time in October 2021.
Regulation of three red lines for real estate companies
The current development crisis is the result of long-term high indebtedness in the sector. At the end of the second quarter, Chinese developers owed 33.5 trillion yuan ($ 5 trillion), or a third of the country's GDP. For example, developer giant Evergrande reported a net debt-to-EBITDA ratio of 7.45 in 2020. In contrast, the recommended upper value of the credit burden is usually three times EBITDA. At the same time, the Chinese government's pressure on financial discipline and the related regulation of the three red lines began to manifest itself in the sector.
The "Three red lines policy" sets out three financial criteria for real estate companies:
liabilities of real estate companies should not exceed 70 percent of assets,
- net debt should not exceed equity and
- cash should be at least equal to short-term loans.
If all three criteria are met, the company can increase its debt by 15 percent. If one criterion is violated, it can increase its debt by 10 percent, violating two criteria means a maximum debt increase of only 5 percent, and if the company violates all three criteria, it cannot increase its debt at all. According to a Bloomberg study at the end of October, almost two-thirds of large Chinese developers did not meet at least one of these criteria. And Evergrande and China Railway Construction Corporation did not meet two criteria.
Due to high indebtedness and the newly introduced three red lines policy, developers have difficulty refinancing their current debts. Many of them try to raise cash by selling assets, but have difficulty closing deals. Many potential real estate buyers are backing away from purchases, forcing development companies to cut prices and potentially accelerating the downturn in the entire real estate sector. China's real estate price index also began to fall slightly for the first time in six years. Goldman Sachs estimated the month-on-month decline of the index in September 2021 to 0.5 percent. And sales among China's 100 largest developers fell 36 percent in September 2021 from the previous year.
Prices per square meter have tripled in large cities
The current real estate crisis was preceded by many years of speculation in the Chinese real estate market. The Chinese government's long-term strategy to maintain wealth in the country encourages individual investors to invest in housing. Investors face strict capital controls that limit their opportunities to invest abroad. At the same time, Chinese banks offer only low interest rates on household deposits. Therefore, real estate has become a popular investment for many Chinese. Housing wealth in 2017 accounted for 78 percent of all Chinese assets, while in the US, housing wealth is only 35 percent of assets. Most households in China own real estate. According to the Central Bank of China, 93.6 percent of urban households own their homes and many families also invest in second and third properties. A large part of these properties then remain unoccupied. China is known for its so-called ghost towns. There are approximately 65 million empty houses and flats in the country, which corresponds to the total number of households in France and the United Kingdom combined. Real estate investing has also caused housing prices to rise in recent years. Bloomberg reports that prices per square meter in major Chinese cities have tripled in the last few years: from 18,000 yuan in 2009 to 55,500 yuan this year.
There is no doubt that there is a need to monitor whether developers will pay further installments and how the Chinese government will continue to respond to the whole situation. So far, she has publicly rejected the idea of a state rescue program for developers. That's why some media have started to compare the development company Evergrande to Lehman Brothers. However, the Chinese government has become actively involved in the situation in recent weeks. For example, Chinese provincial governments are taking on unfinished construction projects.
The effects of the Chinese real estate crisis on the financial sector
The current real estate crisis could have far-reaching negative effects. Late payments by developers to their creditors could cause a contagion effect. Evergrande owes 171 Chinese banks and 121 other financial firms, according to the BBC. If the problems of developers spill over into the financial sector, the situation could lead to a credit crunch, forced consolidation of the sector, or the need for state assistance. As early as 2018, the China Central Bank emphasized in its report on financial instability that developers, including Evergrand, could pose a systemic risk to the national financial system. Chinese commercial banks have lent a lot of money to developers in recent years. Recent stress test of Chinese centers The banks' exposure to the real estate sector indicated that if an extreme scenario occurred and the amount of non-performing loans to developers increased by 15 percent, the capital adequacy ratio of commercial banks would decrease by 2.1 percent. Such a decline in banks' capital reserves, evenly distributed across the banking sector, would be an acceptable exhaustion of protection. But according to analysts at S&P Global, the crisis would not affect banks evenly, while weaker banks would suffer the biggest decline.
China's real estate crisis could threaten economic growth
At the same time, current real estate problems are likely to negatively affect economic growth. The real estate sector is the largest sector of the Chinese economy and accounts for about 29 percent of the country's GDP. Therefore, the analyst firm Oxford Economics has changed its forecast for Chinese GDP growth in Q4 2021 from 5 percent to 3.6 percent and also recently lowered its GDP forecast for 2022 from 5.8 to 5.4 percent. As China is the world's second largest economy, the slowdown in China's growth would hit neighboring East and Southeast Asia, as well as a number of European companies for which the Chinese market is increasingly important.
Construction material prices are falling due to the crisis
However, the Chinese real estate crisis also has positive effects. The problems of developers are beginning to manifest themselves in falling prices of building materials. China is the world's largest market for iron ore, and lower Chinese demand for this commodity is contributing to world iron ore prices falling in recent months.
Before the end of the 30-day grace period, the big question remains how the development company will cope with future interest and security payments in the coming months. In March and April 2022 alone, Evergrande has to pay $ 3.6 billion in principal. In addition to Evergrand, many other Chinese developers are also reporting liquidity problems. For example, developer Fantasia, which focuses on luxury housing in October, missed a $ 206 million debt repayment deadline in October. And a Hong Kong-registered development company, Sinic, failed to pay $ 246 million in interest and principal on time in October 2021.