The Chinese real estate market is facing a controlled explosion that has started with the Evergrande default. The real estate giant has begun to default on bonds in dollars, which has led the Fitch agency to announce the official default of the developer together with its competitor Kaisa, the third largest in the country. Now, China and its central bank will seek to contain the impact of the chronicle of an announced death.
Fund manager Federated Hermes believes that the measures taken by the government “to cool investment demand, while reducing risk in the sector and stabilizing property prices, have slowed speculative activity, but have also put a damper on it. I manifest the financial fragility of the country’s promoters, “leading to a strong collapse in the sector, they explain.
Experts point out that, although there has been a recovery, sales in the sector still have a few months ahead, since “the positive change in sentiment not driven by a profound change in fundamentalsBut because of market expectations that the government will soften the policy. “
“The world is witnessing the end of the decade-long real estate boom, but we believe that the era that will replace it will be positive for credit “, say these experts. In the short term, investors who are exposed should diversify, but from Federated Hermes they emphasize that the process of massive destabilization of the balance of the sector will be” beneficial “in the medium and long term for these.
The Chinese real estate market is considered the most important industrial sector in the world. For the past decade, it has been the engine of global economic growth.
A brick elephant
Valued at $ 55 trillion, the weight of all Chinese homes and buildings represents four times the size of the country’s GDP, two-thirds of the world’s GDP, and twice its American counterpart. But all is not well in the sector and given its size all investors – exposed directly or indirectly – will be deeply affected by what you do next.
In September, the Chinese government managed to contain the crisis of the world’s most indebted real estate developer, but the problems underlying the Evergrande crisis – debt and demographics – continue to plague the system.
China’s real estate and construction sector, inflated by overinvestment and construction, represents 29% of economic growthBut a fifth of the country’s homes are empty. Much of the stock remains outside the financial reach of the vast majority of the population and, instead, is underpinned by investment, that is, by speculative demand. The slowdown in urbanization, the decline in marriages and a fertility rate that remains very low mean that demographic demand does not appear on the horizon.
The Chinese government, well aware of this, is trying to reallocate property capital to new sources of economic growth, namely technology, as it aims to improve productivity factors and offset the impact of declining demographics in economic production.
All of this is part of a new growth paradigm that the Government has baptized as “common prosperity”; a fundamental part of it is promoting property as an instrument of life and not speculation.
Beijing tools
To achieve this, it has numerous tools to cool investment demand and, at the same time, reduce the risk of the sector and stabilize property prices. These tools include:
-The three red lines: a supply-side reform aimed at reducing excessive leverage
-The two red lines: a demand-side reform aimed at reducing systemic “real estate” risk within the financial system
-Pre-sale system: The widespread practice of selling properties before they are finished is under government scrutiny and in the crossfire of reform.
-Property tax reforms, which are now linked to the common prosperity goal
Brake on speculative activity
Taken together, these measures have managed to curb speculative activity, but they have also revealed the financial fragility of the country’s developers.
As a result, since September, the sector has plummeted. However, the worst of the crisis has been contained in the high-yield segment, and the market has seen only a few defaults among the smaller developers and no total bankruptcies among the largest names (Evergrande and Kaisa Group have defaulted only with international creditors).
At the time of writing, higher-quality companies have already started to rebound from late October and early November sales, Federated Hermes economists say. This positive shift in sentiment is not driven by a profound shift in fundamentals, but rather by market expectations that the government will soften the policy, particularly in relation to the three red lines and real estate loans. For now, the central bank has lowered the cash ratio so that banks can provide more credit and liquidity to the economy, reducing the possible impact of a crisis.
“In our opinion, this optimism is wrong. Unlike previous cycles, in which the easing of the government created excess stimulus, we do not expect this to be repeated this time. Instead, we forecast a slow and gradual easing process. , since the policies of three and two red lines continue to be the baseline of the government’s long-term political objective for the real estate sector, “they assure from Federated Hermes.
With a large volume of debt onshore Y offshore Due December 2021 / January 2022, we believe that industry sales still have a few months to go before a tipping point is reached.
What is hidden …
Furthermore, these experts are concerned the omnipresence of hidden debt in the system, and we consider this to be a possible tail risk in the first half of 2022. The lack of financial transparency across the sector has created an epidemic of off-balance-sheet loans of which it is difficult to know who owes what to who.
For example, the rating agency Fitch informed the market that Fantasia Group Holding (a major Chinese developer) had recently disclosed “for the first time” that it had $ 150 million in private bonds that did not appear on its balance sheet or other financial statements. .
This proliferation of “unknowns” adds to our continued caution
On the policy side, Federated Hermes experts do not expect any significant relaxation activity by the government in the two main tools to curb speculation (i.e. the two and three red lines). So far, the authorities have done “the right thing” to manage systemic risk to avoid mass unemployment and protect home buyers while deleveraging the sector. We do not believe that this approach to “doing the right thing” will change in the short or medium term.
Consequently, investors with direct exposure to Chinese promoters should, in our opinion, take diversification measures.
In the short term, the consequences of a stricter political regime are negative for credit, which translates into the possibility of:
-More aggressive price concessions in the short term to accelerate cash flows and deleveraging (as seen in Evergrande);
-Less transparency in finances (plus joint ventures and off-balance sheet debt);
-Lower growth prospectsas debt-financed growth is no longer available.
Medium term hope
That said, the medium-term impacts are positive for the industry as a whole and, in particular, for China’s high-performing real estate sector, as it will promote healthier balance sheets and lower borrowing costs in the long run. It is also likely to support quality growth and improve margins, while accelerating industry consolidation.
In general, the world is seeing the end of the decade-long real estate boom, but we believe the era that will replace it will be “credit positive.” The sector is in the midst of a massive destabilization of its balance sheet and, for investors, this will be beneficial in the medium and long term.
However, China’s real estate outlook could improve in the coming months, but two things need to happen for things to improve in the troubled sector, an analyst says to the CNBC this Friday. On the one hand, property sales stabilize by promoting greater access to liquidity within China, which could help re-boost the real estate sector in the country, says Logan Wright, director of China market research at the Rhodium consultancy. Group.
On the other hand, that Beijing supports the sector by looking for ways to avoid a massive fall in the price of housing that will drag down the rest of the developers. Even if the boom is over, the real estate market could find a new, more sustainable equilibrium.
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