China hasn’t bailed out its over-indebted property developers yet, to the shock of foreign investors who’d bought their dollar bonds. Could the forced deleveraging trigger a financial crisis?
By Wolf Richter. This is the transcript of my podcast of last Sunday, THE WOLF STREET REPORT.
Property development has been a huge factor in China’s economic growth. It accounts for 28% of GDP. And much of it has been funded by debt, including dollar-debt, and much of it is now blowing up.
Foreign investors piled into the property sector over the years, buying hundreds of billions of dollars in bonds, including dollar bonds issued by China’s property developers. They bought those bonds because they liked those yields, in some cases over 10%, thinking that the Chinese government wouldn’t let those companies default, that it would bail out the bondholders as it bailed out so many bondholders before, and surely it would do it again, given how crucial the funding of the property sector is to the Chinese economy.
And now just about everything has gone wrong for these foreign investors. For months, there has been a massive crackdown by Chinese authorities on liquidity-driven inflows into the housing sector.
Authorities cracked down on overleveraged property developers. They targeted mortgage approvals and interest rates for first-time buyers. They tamped down on rental growth. They pushed banks to reduce their lending to homebuyers. A national property tax has been put on the table.
And this was topped off with an increasingly strained relationship between the Chinese government and the United States government, that includes major steps by the US government to crack down on speculation by Chinese entities in the US stock markets.
China’s crackdown on property speculation is guided by the official mantra that “housing is for living, not for speculation.”
That massive amount of speculation and leverage has for years posed enormous risks to financial stability. And the government is now trying to defuse those risks – and it looks like at the expense of foreign investors that have bought those hundreds of billions of dollars in bonds.
Those foreign investors are suddenly realizing that they’re no longer sacred and that the government may not bail them out.
Bailouts had been taken for granted, given how important the property sector is to China’s economy, and foreign investors whose money was needed to fuel that property speculation, had felt secure in their thinking that China would bail out those bonds if push came to shove.
Now push is coming to shove.
Evergrande Group, the second largest property developer in China, and the property developer with the most debt in the world, owes banks, shadow banks, other companies, investors, its suppliers, contractors, and home buyers $305 billion, according to Bloomberg.
It hasn’t been able to sell a single dollar bond since January 2020, and has no prospects of doing so as foreign investors have gotten the message.
On August 31, it said that work was suspended on a number of real-estate projects after it delayed payments to its suppliers and contractors. It warned that it may default on its debts if it can’t raise new money.
If it was difficult to raise new money before, it became impossible after that announcement – unless the government steps in, and that hasn’t happened yet.
On September 7, Moody’s and Fitch downgraded Evergrande Group and a number of its entities deeper into deep-junk, to ratings that indicate that a default is imminent with little recovery for investors in those bonds.
Moody’s said that the downgrade reflects the company’s heightened liquidity and default risks given its large amount of debt that will mature over the next 6-12 months.
Since Evergrande does not have enough cash to pay off the debt that matures over the next 12 months, it has to raise new money to pay off those old investors. If it cannot raise new money, either by issuing new bonds, or by borrowing from banks, or by selling assets that are not already leveraged to the hilt, it will default on those maturing bonds.
Fitch, when it downgraded Evergrande on September 7, said that “a default of some kind appears probable.” It based this on tight liquidity, declining sales, pressure to address delayed payments to suppliers and contractors, and little progress on asset sales.
On September 8, Evergrande told two banks that it would suspend interest payments on bank loans, according to financial intelligence provider REDD, which cited four sources briefed by bankers.
Evergrande has already suspended interest payments to several trust firms, and may suspend all payments to its wealth management products, according to REDD. This would rile up retail investors that put their money into those products.
On Friday, so September 10, Evergrande said that its contracted sales of properties in August, including sales to suppliers and contractors in exchange for money it owed them, dropped 26% compared to a year ago.
In Shanghai, trading of its bonds that mature in 2022 and 2023 was suspended last week after they collapsed. Evergrande’s bonds have been blacklisted and can no longer be used as collateral.
Evergrande’s shares, which trade on the Hong Kong Stock Exchange, have spiraled down since late 2017, and on Friday closed at the equivalent of about 45 US cents.
Evergrande’s dollar bonds have collapsed. On Friday in Hong Kong, its dollar bond due in 2025 traded at 29 cents on the dollar. In May, those bonds still traded at 80 cents on the dollar.
But it’s a whole industry. Evergrande just has the most debt.
Four other major Chinese property developers are now teetering. The dollar bonds have collapsed, on fears by international investors that those bonds cannot be refinanced when they mature, which would mean a default. These fears further limited the ability of those property developers to issue new debt to raise new money to refinance those maturing bonds and pay off existing investors.
This is the vicious circle that overleveraged companies find themselves in when investors belatedly get cold feet after having eagerly swallowed all the hype and hoopla for years. And then suddenly, the endgame starts, with everyone wondering what might be left for them when it’s time to poke through the debris.
The four property developers are Fantasia, China South City Holdings, Guangzhou R&F, Xinyuan Real Estate Co. Their bonds have fallen below 60 cents on the dollar, and in some cases below 50 cents on the dollar, indicating a high probability of default.
Other property developers have already defaulted. So far this year, property developers have defaulted on $6 billion in debt, about five times as much as over the prior 12 months combined, according to Morgan Stanley, cited by Bloomberg.
This includes China Fortune Land Development Co., which has nearly $10 billion in bonds outstanding, including $4.6 billion in dollar-bonds. In March, it defaulted on $550 million in dollar bonds. Last month, Ping An Insurance Co. disclosed that it wrote down its investment in the developer by $5.5 billion.
For now, developers that are less leveraged and have credit ratings that are less deep into junk, are faring better.
So will the collapse of these overleveraged property developers cause a financial crisis in China?
It could. But some of the biggest losers are foreign investors that bought those bonds, and not Chinese banks; and for a financial crisis to happen it would have to sink China’s banking system.
And then, China has some unique tools to ward off a classic financial crisis.
The government controls nearly everything, including the central bank, the big four state-owned commercial banks which are the largest banks in the world, the bad-banks which absorb the bad loans, big asset managers, and most of the largest companies, and much of the media, including the social media, specifically with regards to financial stories.
In other words, the government controls the money, the lenders, the borrowers, the buyers, the markets, and the message.
The government can order the big four banks to exchange defaulted loans for equity stakes and forget them. It can tell the central bank, the People’s Bank of China, to do whatever it takes. It can tell state-owned asset managers and pension funds to buy shares and bonds to prop up prices and to fund companies. It can tell the bad banks to buy bad debt from commercial banks.
The government has a long history of bailing out bondholders. And it has a history of bailing out investors in risky schemes that have blown up – including regular folks chasing after the latest bet, such as Evergrande’s wealth management products and apartments in unfinished buildings.
When enough of these folks start protesting in Beijing because they lost oodles of money on some mass-scam they’d fallen for, including property investments, the government, fearing social unrest, steps in and takes care of it. That’s how it has done it in the past.
And the holders of dollar bonds have been counting on it.
This property debt that is now blowing up has funded years of economic expansion and huge projects and millions of jobs. And foreign investors were fairly sure they’d get bailed out when push comes to shove.
So far, these special tools have helped the government to avoid a financial crisis.
But now it looks like the government is forcing a brutal deleveraging on the property sector to bring down risks and tamp down on rampant speculation and price increases. It looks like an effort to rebalance the economy away from property development.
It looks like investors are invited to eat the costs of this forced deleveraging. It looks like the government is teaching them a lesson, namely that they might not get bailed out, and that the flood of liquidity into the property sector was misguided and needs to end.
And it looks like the government is willing to take the risks of spillover effects into the broader economy and credit markets. And if, in fact, the government refuses to bail out bondholders, and allows a large-scale bloodbath among investors, particularly foreign investors, to occur in order to deleverage the economy, that would be a sea change for investors in China.
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