No ‘Lehman moment’ but financial stress is not over

China’s developers in a perfect storm

Financial markets have calmed down over the past week with Evergrande moving to the background again. Confidence has grown that the Chinese government will step in and avoid a ‘Lehman moment’. A default of Evergrande is more or less a done deal, in our view, but Beijing will work to ringfence it and support other developers if dominos start to roll. The property sector is under severe stress, though, and more financial stress will be difficult to avoid.

There are already signs that some other big developers are coming under significant pressure. On Monday, the fifth largest developer measured on assets, Sunac China Holdings, supposedly asked the city of Shaoxing for help saying the market had almost frozen adding that the face “huge p ressure”. Sunac later said the letter had not actually been submitted to the city government. But it does reveal the challenges facing most developers right now as all sources of funding and liquidity is under pressure:

1. Bank loans: Lending to developers from banks have fallen substantially after new regulation this year put limits on how much real estate exposure banks are allowed to have, see top chart and box on page 3.

2. Bond financing: The Evergrande woes have been a wake-up call for investors in real estate bonds. Evergrande is in a league of its’ own when it comes to leverage and creative financing. But it is far from the only developer that has run a business model with very high leverage (see table at the end of the paper). When China introduced the ‘three red lines’ on debt and liquidity in August 2020, around 1/3 of the 30 biggest developers breached all three lines. Fears of other possible defaults risk freezing investor demand for developer bonds. This has to some extent already hap p ened and China’s high y ield rates have increased to 15%, levels that are not sustainable for developers.

3. Home sales: With a squeeze on financing after the ‘three red linies’ were introduced many developers started to sell out of their inventory of apartments to provide finance of their business. Incomes from this channel was boosted last year when home sales shot higher during the pandemic. But in recent months a decline in home sales has cut into this source of raising money. Early indicators suggest home sales in September continued lower. A dangerous scenario would be if people become reluctant to buy housing from developers that are seen as vulnerable. In a market with many both private and state owned players, home buyers could decide they would rather buy from state-owned developers as they are deemed more secure. This would be detrimental for private developers.

4. Shadow finance: Another source of finance for some developers has been Wealth Management Products (WMP) typically sold through trust funds. The funds come from savings of Chinese households looking for an extra return while mostly expecting the funds to be secure. If people start redeeming money in these products realizing it is not a secure investment, another financing channel dries up for develop ers. Evergrande is said to have USD6 bn outstanding in WMP’s already and has begun to offer repayment through physical assets such as discounted apartments, office, retail space or car parks.

5. Accounts payable: When develop ers were hit by the ‘three red lines’ another strategy to raise finance was to lengthen credit maturities with suppliers and thus increase accounts payable. This source is also likely to dry up with suppliers not being eager to offer long credit to developers under financial pressure.

Another risk for developers is a decline in the price of their assets (land and inventory of housing) as this would push up leverage through a decline in the denominator of their debt-to-asset ratio. Fire sales of land or property to raise money is thus not a viable solution for the sector as a whole.

In sum, developers are currently hit by a perfect storm with home sales falling and external financing sources being significantly squeezed.

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