By Shikeb Farooqui, Emso Asset Management – The Chinese property sector is currently in the grip of a policy-induced liquidity crunch which threatens to take down more than just Evergrande. In this article, we provide an update on policy motivations, recent developments, growth impact, and outlook as China convulses under the strain of credit and regulatory tightening of the property sector, and the market worries about the broader financial contagion.
The property sector has long been a countercyclical policy lever for Beijing, which we believe is coming to an end. The policy goal has firmly shifted towards taming the developers and property cycle, breaking the moral hazard, and providing affordable housing. In the past, Beijing’s tightening has been demand-side focused, tightening secondary market restrictions, mortgage lending standards, and credit.
This time we believe that Beijing’s approach is different and more focused on bringing the supply side in line, both property developers and local governments. Developers are being forced to clean up their balance sheets (The Three Red Lines), and bank lending to the sector is being restricted (Two Red Lines). In addition, Beijing has stepped up its crackdown on the misuse of commercial loans and consumer loans in the property sector and further tightened the use of shadow banking channels (such as trust loans, entrusted loans, and commercial paper) by developers. Local government borrowings are also currently heavily restricted and regulated.
Policy Tightening Visible in Data
The policy tightening, which started in the fourth quarter last year, is beginning to show in the macro data. Property indicators have been weakening since July, and high-frequency data indicates accelerating declines in September. Homebuyers and financial institutions are losing confidence in the property market, and while developers are still pushing pre-sales to raise cash, demand is ebbing, and growth rates are moderating. Primary sales are slumping and declining faster in low tier cities. New starts are declining at a similar pace seen back in 2014-15. The 30-city property sales indicator fell by more than 30% year-on-year in the first three weeks of September. These numbers are even starker as they coincide with peak sales season and major developers risk missing annual sales targets by up to 10%.
While state-owned developers are holding prices steady, private developers are being forced to slash prices. Slumping developer sales is exacerbating existing restrictions and feeding into local government revenues, making it harder from them to invest in infrastructure. Additional pressure from land auction reforms has broken the market for land sales, with land sales contracting 14% year-on-year in August and the first three weeks of September was tracking a contraction of 47% year-on-year. Land premiums are falling, and second-round land auctions are experiencing frequent failures in large cities. Completions, however, have been accelerating as the government pushes developers to ensure completion of pre-sold units to avoid potential social instability.
Real estate contributes approximately 29% of China’s GDP, although the direct impact of recent events according to International Monetary Fund estimates is likely around 10%.
Real estate contributes approximately 29% of China’s GDP, although the direct impact of recent events according to International Monetary Fund estimates is likely around 10%. Up to 40% of bank loans are backed by properties, although banks’ direct exposure to developers is limited to 6-7% of their balance sheet. According to varying estimates, 40-60% of household assets in wealth is made up from housing. In our view, negative sales and construction momentum are likely to create a significant drag on the broader economy in the fourth quarter of 2021 and the first quarter of 2022. Stress tests suggest that the growth impact could be between 1-2.5% of GDP as the direct and indirect effects kick in. We think that the pain threshold for a broader turnaround in policy is sequential momentum dipping below 5%.
We believe that China has reached peak tightening, but we shouldn’t expect a swift reversal of policy.
We believe that China has reached peak tightening, but we shouldn’t expect a swift reversal of policy. In aggregate, the system is beginning to move towards partial compliance, further tightening will be regressive and threaten to break the system. We are already beginning to see fine-tuning that is designed to protect the downside, allow the property sector to start clearing, and limit financial contagion but not to stimulate another cycle. The overarching consideration here is to protect homebuyers’ interests by making sure existing projects are completed, while ensuring longer-term stability for property market (implying continued financial clean-up and consolidation within the sector) and keeping housing affordable (not looking for another cyclically induced housing price bubble). While Beijing will want to limit financial and social contagion, we think that it will display a high tolerance for the growth hit as it works to also limit the moral hazard.
State-Sponsored Workout and Restructuring Plan for Evergrande
At this stage, we believe that a clear state-sponsored workout and restructuring plan for Evergrande is required to restore market confidence. While Evergrande, and a couple of other major infractors, may be a lost cause, we think that there is an implicit policy put for the property sector, and the authorities are paving the way for a plan that limits an industry-wide asset fire-sales. We expect to see more details on this later in October, and we think that the delay stems from the fact that the authorities will look to create a template out of Evergrande that can be used on other developers in other regions.
In the meantime, we believe that the main focus will be on completing construction while minimizing additional leverage. We believe that property developers will continue to be kept on a short leash to ensure the system moves towards compliance of the Three Red Lines, but banks will be instructed to work with the regulator to selectively provide liquidity to developers and homebuyers. Beijing will likely tolerate localized relaxations in mortgage lending to ensure stability, but a broad relaxation is unlikely before the biggest developers are at least amber. To this end, local governments have been instructed to stand ready to take on Evergrande projects. They will need authorization to utilize their borrowing quotas to secure the necessary liquidity. Part of this liquidity will be used to rollover maturing credit lines and ease the pressure on banks, and part of it will be used to take over projects.
We believe that property developers will continue to be kept on a short leash to ensure the system moves towards compliance of the Three Red Lines.
This model will likely be extended to other distressed developers. Ultimately, we think that banks will provide direct liquidity to the high-quality developers (function of degree of compliance on Three Red Lines, and project base) and indirectly (via propping up local government bond issuance) to the lower quality developers. Local governments will likely be instructed to act like a bad bank and work with the regulators to pick up vetted projects from failing developers to ensure completion. This, in theory, should create an environment in which the market can clear high quality assets and allow for state backed consolidation in the sector. We are not too concerned about the inventory overhang as we believe that structurally it can clear. There is roughly 12-18 months worth of oversupply, and a destocking cycle is already underway but we believe that it is likely to take longer than a normal cycle.
We expect a comprehensive macro policy framework to be tabled at the Central Economic Work Conference in December. With the seeds likely sown around the Chinese New Year, the new economic cycle is likely to start in earnest in late first quarter or early second quarter 2022. We think that fiscal with targeted monetary fits in better with the notion of ‘cross-cycle policy’ and ‘common prosperity’ and expect the focus to be on boosting the consumer and new economy investment via fiscal tools and providing liquidity to SMEs via monetary. The authorities will want to avoid liquidity tools that risk seeping into the property sector again. In this regard, a PSL directed to SMEs can prove to be a very powerful tool.
We do not rule out the possibility of reserve requirement ratio cut after the GDP print but seen in the context of all the maturing liquidity, only a cut of more than 100 basis points would signal broad easing. In the meantime, we expect credit to the broad economy will start stabilizing in the fourth quarter, but do not expect it to accelerate meaningfully before Chinese New Year 2022. To sum up we think of this more as a Volcker moment than a Lehman moment.