investment viewpoints

Steering through China’s property sector

Steering through China’s property sector
Dhiraj Bajaj - Head of Asia Fixed Income

Dhiraj Bajaj

Head of Asia Fixed Income
Nivedita Sunil - Portfolio Manager

Nivedita Sunil

Portfolio Manager
Tracy Wang - Senior Credit Analyst

Tracy Wang

Senior Credit Analyst

As defaults escalate among China’s high yield property developers, our Asia fixed income specialists break down the key factors driving debt markets including the sector’s fundamental problems and potential future government policy response. After presenting several prospective scenarios for the future – including the higher risk of a hard landing - we map the investment implications for investors.

 

Need to know

  • A raft of defaults in high yield (HY) real estate has caused seismic shifts in China’s property sector during the second half of 2021 and continues to strongly disrupt the market. 
  • Policy easing so far in response to this funding crunch has been very slow
  • There is higher risk of a hard landing for China’s property sector and higher systemic risk to China’s economy in the next 3-6 months should the policy stance have no material change.

 

Real estate defaults mount

A raft of defaults in high yield (HY) real estate has caused seismic shifts in China’s property sector during the second half of 2021 and continues to strongly disrupt the market. Eight developers have defaulted on USD17.5bn worth of debt in the period so far. Including the likely defaults of Evergrande and potentially Kaisa1, we believe total defaults this year could rise to USD50bn, or approximately 30% of China’s high yield property universe.

Such spectacular dislocations have prompted a 41% decline in the Iboxx China HY Real Estate index since 1 June 2021. The average cash price of Chinese HY property bonds is now well below USD60 (compared to USD96 on 1 June 2021). More than 60% of property developer bonds are trading at yields greater than 30%, signalling that debt restructuring is now more than priced into debt instruments.

Local government regulators tightened restrictions to limit the second order effects of this ripple of defaults. Some measures - including restricting the access property developers have to their cash - precipitated the second wave of defaults and sell-off seen last week. A significant amount of cash is typically held at the escrow and project level: we now understand that many companies are unable to use their cash, despite having high cash balances and a short-term cash to debt cover ratio of over 1x. This inability to tap cash has alarmed the market and further fuelled the downward spiral over the past week.

 

Higher risk of a hard landing

That said, we believe policy response thus far is only marginal, and not significant enough to solve the fundamental issues and restore confidence. The sector’s fundamental problems are an unprecedented squeeze on liquidity, and the inability of central and local government regulators to act together. As such, we see a higher risk of a hard landing for China’s property sector, and in turn, higher systemic risk to China’s economy in the next 3-6 months should policy stance not change materially.

The table below outlines possible scenarios that might arise going forward, and their implications. It is hard to pinpoint one as the central scenario since a lot rests on the nature and timing of the policy path chosen by the authorities. Scenario 1 represents the read-through for the sector if there is no response, and we believe this is an unstable equilibrium since the ultimate consequences are likely unpalatable to China as a whole. Once this is recognized, we are left with two scenarios, one that is a ‘half-measure’ muddle through (scenario 2) and another that is  a more forceful, holistic response (scenario 3). We would expect that scenario 3 becomes that ultimate equilibrium point but the risks are still finely balanced.

#

Scenario

Implication

Probability

1

Status quo – No significant response or very delayed response by the authorities

Implications for China Property market

  • USD market stays frozen, no refinancing possible
  • >60% of China’s HY developers forced to default, triggering a cascade of further defaults
  • Local governments directed to take over defaulted projects to completion to ensure social stability

Global macro implications – hard landing for China

  • Volume of home sales falls as confidence declines
  • Secondary market property prices decrease
  • Consumer spending declines and a lower wealth effect causes further slowdown
  • Chinese growth slows, linked commodity prices and emerging markets slow
  • Local government financing vehicle (LGFV) defaults spike and local government finances are challenged, resulting in limited infrastructure spending
  • Global risk aversion takes a hold

Medium – not a stable equilibrium

2

Back-channel or stealth easing onshore with selective rescues

Implications for China Property market

  • >40% China HY developers market likely move into selective default, requiring an orderly resolution
  • China offshore USD market permanently closed to HY issuers  

Global macro implications

  • Investability of the China offshore USD market called into question
  • Offshore structures - such as variable interest rate entity (VIE) in equities and keepwells - become untenable
  • Slower global growth as China’s economic growth eases

Low/Medium

3

Strong, quick response from authorities involving measures to meaningfully ease the liquidity pressure onshore and offshore [bullish case]

Implications for China Property market

  • Orderly resolution of already defaulted HY credits
  • Normalization of stressed investment grade (IG) names to trading on spread levels rather than distressed price levels
  • High quality HY with diversified funding channels can potentially refinance their offshore debt
  • Some weak USD “B” rated developers allowed to default 

Global macro implications

Limited

Medium

 

Next steps: more defaults, policy uncertainty, maximising recovery

Given the evolution of events, we believe that further HY defaults will be inevitable given the drastic sales declines in September-October and mainly onshore cash restrictions. These are currently being sparked by liquidity considerations rather than solvency constraints. However, a permanently weaker buyer base for the physical market going forward could impact solvency in the medium term.

Sticking with the status quo would be politically and economically untenable for China, especially with the start of a third term for President Xi next year. As a result, we would expect some form of a policy response for the sector, although the risk of it being too little too late is definitely rising.

Current valuations in the offshore market for China are severely dislocated and many HY developers are trading at or below their recovery values. To maximise recovery, investors should be prepared to ring-fence exposure to weak credits and pursue an orderly resolution for those credits that are forced into selective default due to liquidity pressures.

For the remainder of property names able to survive until a forceful policy response is forthcoming, we would recommend staying invested in the sector and would expect their yield curves to normalise over time. These names potentially offer strong upside from current levels, including for state-owned and quasi-sovereign real estate firms, in our view.

Overall uncertainty and lack of clarity around China’s policy response is high. As such, we are maintaining our exposure to the property sector but not increasing it until a clear policy response emerges. High quality developers should have ample room to rally once there is greater precision, in our view.

 

Sources

1 Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.

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