Chinese real estate: from idiosyncratic to systemic risk

In the latest instalment of Simply Put, where we make macro calls with a multi-asset perspective, we consider whether the Chinese property market has transitioned from idiosyncratic risk to systemic risk.   

 

Need to know The Chinese property market has experienced a significant slowdown following the central government’s acute tightening of regulation. Over the past quarter, risk for the sector has shifted from idiosyncratic to systemic, with a 30% default rate costing approximately USD 50 billion. The Chinese authorities are now partially loosening some of their restrictions and the PBoC has cut its reserve requirement ratios, meaning the risk of contagion looks more under control for now.

 

The Chinese property market has made headlines recently. Primary market sales have seen an eye-popping collapse of around 30% during the last two months. Similarities with the demise of Lehman Brothers resonate eerily in investors’ memories. But what is really going on? Do we have Lehman Brothers 2.0 on our hands or will it be different this time?

At the beginning of the year, the Chinese government strengthened its rules to realign the real estate sector, stating that “housing is for living and not for speculation”. It believes that marginal demand for property has been driven by speculative demand rather than by pure underlying demand for the last few years. The result is that property affordability has been pushed down for the middle class in urban areas.

More than 400 new regulations have been issued to tighten the real estate market, including curbs on mortgages and bank loan disbursement.  At the tightest point of policy, in October, it took a homebuyer up to six months to obtain a mortgage that had previously only taken around one month. Property developers had been taking advantage of various funding channels both onshore and offshore to increase their scale and expand into non-core business activities. Yet, these new policies have caused Evergrande¹, formerly one of the most valuable real estate companies in the world, to enter into a technical default and led to its bond yield skyrocketing.

 

Stressed funding for property developers

More globally, property developer funding has been extremely stressed. Liquidity abruptly dropped from twelve months to just one month as various restrictions took hold and the Evergrande fall-out continues to rumble on in the background. At first, this issue only affected Evergrande and not the market as a whole. However, as the government continued to tighten its rules, more and more property companies started to default (Fantasia Holdings, Modern Land China¹).

In our view, what started as an idiosyncratic risk has now become a systemic one. There is a 30% default rate in the offshore USD China high yield real estate market.  In addition, as shown on chart 1, Chinese credit default swaps (CDS) have started to price in the risk of default – a clear sign that risk has become systemic.

 

Chart 1. China CDS versus Evergrande 2022 Bond Yield

 Source: Bloomberg, LOIM.

 

The Chinese real estate sector is worth USD 60 trillion, encompassing 60% of household wealth and representing of up to 30% of the country’s GDP both directly and indirectly.  If it collapses, the effects could ripple across the board, potentially leading to a decline in economic activity, as occurred in 2015. Indeed, there is also a high risk of contagion as the activities of real estate developers cascade down the supply chain (for example, unpaid contractors, unbuilt homes).

We estimate that a 10% reduction in construction equates to a 2% loss in GDP and, based on the current state of private sector property developers’ funding, we believe annualised construction levels could be reduced by as much as 30-40% if these stresses continue. All eyes are now on the Chinese government. Will it bail out Evergrande or will it relax its policies?

 

In our view, sticking with the status quo would be politically and economically untenable for China, especially as a third term for President Xi starts next year. As a result, we expect some form of policy response for the sector, which can already be observed in Chart 2. The People's Bank of China (PBoC) has now recognised the significance of the situation and has decided to cut its reserve ratio by 50 bps. This policy move implies two things:

1. The housing market is now a clear systemic risk for the Chinese economy;
2. The risk of contagion is being taken seriously by policy makers, who are actively taking action.

This point is also clearly shown in chart 1. The recent increase in Evergrande’s yield was accompanied by a decrease in the Chinese CDS. This suggests that markets seem to be regaining their faith in the authorities’ intent to cushion this risk and are therefore less inclined to adopt the contagion narrative. We expect the authorities to institute new policies that should reduce stress for real estate developers in order for them to obtain funding at reasonable and sustainable yields.  As pressure is eased, we believe higher quality debt will rally from current stressed and elevated yield levels.

 

Chart 2. China Reserve Requirement Ratio (in %)

Source: Bloomberg, LOIM.

Simply put, we believe the Chinese regulatory clampdown on the property market has transitioned into a systemic risk. With the PBoC stepping in this risk should now be cushioned, opening the door to a period of stabilisation.

 

Click here to read more of the team’s views on this topic.

 

Sources

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

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