China is preparing for Evergrande’s downfall. As expected, the real estate giant defaulted on its financial obligations to its creditors after momentarily saving itself from defaulting last October by managing to meet a coupon payment to local creditors.
“Evergrande is the beginning of the end for the real estate sector in China,” predicts Edgar Fernandez, who is a stock analyst at an investment bank.
“China has had an export model in the last decades. It has been the factory of the world. That model fell due to the 2007-2008 crisis and the State saw it had to motivate domestic demand to continue growing at high rates,” Fernandez said.
Over a ten-year period, household debt in China has gone from 18% of gross domestic product (GDP) to just over 60%. Property builders and developers in China have also taken on substantial liabilities totaling $5.2 billion, debt that exceeds the size of an economy like Japan.
China then had to advance towards a growth model that targeted the domestic market driven by the real estate sector. “This led to an increase in private indebtedness in real estate investment to the point that ghost cities were built,” Fernandez explained. In 2017, China had 65 million empty homes, which is equivalent to saying that one in 5 was uninhabited.
For Fernandez, “Real estate companies are highly leveraged operationally and financially, that is, when they build, they put the homes on pre-sale, which finances new constructions and new pre-sales for them.”
The Chinese government is facing the reality that population growth and the economy will not be able to sustain the massive leverage of its real estate companies. At present, investment in this sector constitutes 30% of the country’s GDP. The lifting of the one-child policy was not recognition to a right for its population, but a cold accounting calculation.
Like Evergrande, other property developers have begun to default on their debts. Modern Land, a Beijing developer, defaulted on a $250 million interest payment. Fantasia Holdings, in Shenzhen, defaulted on its debt service for more than $206 million in interest.
For some property developers such as Aoyuan Group, FITCH lowered their risk rating for possible insolvency. Others, such as Kaisa Group Holdings, are already in restructuring plans to meet their debts.
According to Bloomberg, since the Evergrande drama began, Chinese real estate companies have defaulted on more than $10.2 billion in payments to foreign bondholders.
Although Chinese real estate developers have a stock of homes that, in theory, serve as collateral to respond to their massive debts, a good part of these buildings are unfinished or in almost uninhabited ghost towns.
China prepares to avoid a real estate crisis
China’s banking sector has approximately $50 billion in assets, double the size of the U.S. banking sector itself. In 13 years the size of Chinese bank assets quintupled, but this growth was done through the receipt of pledges from real estate companies, which is why up to 40% of the bank assets are directly or indirectly related to real estate.
Since the Evergrande scandal began, at least ten companies have defaulted, and although Xi Jinping’s government has tightened credit conditions for real estate companies, the question that keeps analysts awake at night is whether it will let a large part of the real estate sector go bankrupt or not, despite the risk this represents for the Chinese economy.
Chinese authorities are taking action to partially reduce the liquidity problem facing real estate companies. In November, the China Banking and Insurance Regulatory Commission announced that commercial banks would grant “reasonable” loans for the real estate sector.
The bailout of property developers was not enough, so on December 8, the Chinese Central Bank decided to lower reserve requirements for commercial banks in an attempt to inject liquidity into the financial system in view of a possible collapse of the real estate sector debt.
This measure allows banks to issue more credit to the public, so in a single day the Chinese Central Bank put more than $1.2 billion yuan into circulation in the market. Now we have to wait and see if China will be able to contain the fall of its real estate sector.
China’s real estate crisis could spread to the U.S.
A recent Federal Reserve (FED) report warns that a collapse in the Chinese real estate sector could compromise the stability of the U.S. financial system. The Chinese housing sector accounts for up to half of the world’s dollar-denominated debt.
Among the main creditors of the Chinese real estate sector are American investment funds and banks, which today have to deal with the possibility of losing much of the money lent to construction companies in exchange for junk bonds, which were accepted in the expectation that the demand for housing would continue growing indefinitely.
Investment funds such as BlackRock and HSBC are among Evergrande’s main lenders. Other companies such as Fidelity, Pimco and Allianz had also lent to the real estate giant.
The dollar bonds of Chinese real estate companies are now trading as junk on the stock markets, pointing out that China’s housing sector does not have the money to service its debts, and most likely repayment of foreign creditors will not be a priority in view of a financial restructuring of these companies by the Chinese Central Bank.