Recent regulatory measures on China’s property sector exposed a variety of property developers as vulnerable. Several meaningful players have defaulted and/or remain in distress. Lending to the sector is curtailed and therefore liquid assets and liquidation of assets have proven important.
Ongoing distress and defaults
A turning point for the sector has not yet been reached; however, regulators and the central government have recently implemented targeted measures to limit collateral damage on companies that are well run and regulatorily well behaved. For those companies that failed to comply with existing regulations or have been exposed with undisclosed liabilities—we do not expect the government to provide salvation. Distress and strain in the sector is expected to endure for several quarters at least.
We believe the Chinese government has extensive resources to ensure defaults and acute pain in the property sector is reasonably contained. The government desires financial stability and the current, planned, “blood-letting” was to forestall a true nationally systemic crisis when problems in the property sector exceeded the government’s resources. Importantly, the government desires a proper reallocation of resources away from property development to more productive resources—any regulatory/stimulatory response is likely to bear this strategy in mind. Therefore, the sector is likely to shrink along with supporting industries and trading partners.
Given a policy priority to assure properties are finished and delivered, local governments have suddenly increased the amount of cash required to be held at project escrow accounts, which most developers report as unrestricted cash. Moreover, commercial banks have also increased the cash collateral required for its construction loans. These measures have exacerbated the liquidity squeeze faced by property developers and reduced the transparency of their cash position. The balance sheet transparency has also recently deteriorated after some developers swiftly reduced their reported debt to comply with the government’s debt leverage guidelines or “three red lines” that were released in early 2020. The most common practices to reduce their reported debt have been disguising it as payables, moving it to unconsolidated joint ventures, and issuing unconsolidated private bonds that contain a company guarantee.
Although the early moments of property market stress in 2020 weighed on emerging markets sentiment and caused bouts of volatility, we continue to discount this as a source for major negative contagion risk to global markets (please refer to an earlier discussion). Closed economies with capital controls and a managed currency tend to absorb economic volatility domestically—without “leakage” to the global financial system—until the central bank expires its resources.
In China’s case, record balance or payments surpluses in 2021 have enhanced the Chinese central bank’s ability to absorb any transitory duress from the property sector that may have otherwise caused otherwise self-reinforcing currency and interest rate volatility. The possibility remains that contagion will spread to some highly indebted local governments and its state-owned enterprises, especially those that are highly reliant on land sales to fund their budgets. While the central government might tolerate some distress for these bond issuers, some of which have offshore bonds, it will ultimately provide financial support if risk aversion threatens the broad financial stability.
We expect to see China’s GDP growth to decelerate this year and to continue to slow for the foreseeable future. The desired rebalancing of the economy is the driving force of this expected decline, the current property sector duress has simply hastened and accelerated the slope of the decline because that was the traditional vector of large-scale economy-wide stimulus—policy makers will want to avoid stimulating via the property sector as this would enhance/enlarge property’s role in the overall economy when the strategy is to shrink it relative to other sectors (consumer primarily).
China’s economy is one of the largest and most important for many trading partners. China should slow and the pivot from property-led fixed asset investment will affect countries such as Chile and Australia who extensively supply to this sector. Chile and Australia are not alone, and we expect several primary trading partners to see concomitant structural growth declines of between 20-50 basis points per annum.
Opportunities amid the rubble?
Prior to 2021, we largely avoided the Chinese property market given lack of compelling value amidst a now validated view of structural decline. Bond prices have declined materially since the current acute episode began last fall. However, we continue to struggle to find a plethora for compelling investment ideas—for want of balance sheet transparency. These situations often present attractive absolute return opportunities for nimble managers however, we believe discipline and patience is key. In the current environment, we are looking for compelling opportunity and being very selective.
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