18/08/23, 09:08 (18) Tremors in the East - The Last Bear Standing

Tremors in the East

#67: China's property woes are far from over.
THE LAST BEAR STANDING
18/08/2023 ∙ PAID

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Over the past several months, headlines have signaled trouble in the world’s second
largest economy. The great China reopening has sputtered, the yuan is tanking,
imports and exports have flopped. After surging on hopes of a post-COVID revival
earlier this year, Chinese equity markets on the mainland and in Hong Kong have
slumped yet again.

Now, China’s property woes have resurfaced as massive property developer Country
Garden warned it may default on its debt, Evergrande filed for bankruptcy in the U.S.
1, and investment firm Zhongzhi froze payments on real estate linked products,
sparking fears of contagion. But haven’t we heard all of this before?

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We have been reading about China’s property failures for the past two years, and
despite ominous headlines, there have been few knock-on effects internationally. For
global markets, it is easy to assume that concerns are overblown. But I don’t think
they are.

Two years ago, at the earliest stages of the Chinese property crisis, I fell into a rabbit
hole of research, tracking bond prices of little known developers and writing
impassioned screeds on Twitter (endorsed by Michael Burry).

I wasn’t drawn to the subject because some big company overseas was going bust, but
rather because the largest industry in the world was going bust. The estimated value of the
Chinese property market exceeded that of the U.S. stock market and had served as
the primary engine of economic growth in China for two decades. Enormous sums of
debt were backed by speculative and unsustainable property prices.

By clamping down on over-levered and arguably insolvent property developers in an

effort to rein in the property bubble, regulators risked spurring mass contagion in the
property sector. Given the massive exposure to property across Chinese banks, this
even risked a new financial crisis. In my view, it was nearly impossible to overstate
the potential impact both for China and the rest of the world.

I was right about certain things. For one, the collapse of Evergrande in the summer
of 2021 did indeed lead to mass contagion, freezing financing channels and property
sales, and leading to 17 consecutive months of property price declines 2. As
predicted, the entire offshore bond market worth tens of billions collapsed in short
order 3.

And yet, the transmission to the onshore financial sector did not happen as quickly
as I thought. It became clear that the wider effects would take years to play out.

Now, two years later, Country Garden’s default and Zhongzhi’s liquidity crisis are
merely a continuation of a process that began with the Three Red Lines 4 in 2020.
Neither event is surprising nor globally impactful, in isolation. But that doesn’t mean
that we should dismiss them as inconsequential.

Rather, we are witnessing the ongoing deflation of the Chinese property bubble and a
fundamental rewiring of the engine of growth in the country. This tectonic shift is
still underway and the conclusion has yet to be written.

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The Property Engine

The property engine works like this. The government invests in infrastructure,
building roads and utilities which enable large scale residential development of
previously underdeveloped or rural areas. Local governments with limited tax
revenue raise critical funds via land sales to property developers. Developers fund
their land acquisitions by property sales to citizens, as well as financing from banks,
shadow banks, and offshore investors. Meanwhile, property construction generates
significant economic activity including wages for citizens and business income for a
slew of related industries.

At the core of this process, land (and property) is monetized and supports money
creation via credit expansion. Credit flows down from the central bank, the People’s
Bank of China (PBOC), and through state-owned major banks, to smaller banks and

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the shadow banking system. The real economy receives a steady flow of new money,
while lenders receive debt obligations inherently backed by the value of property.

So long as land and property values appreciate, this cycle is virtuous. Local governments
receive more land sale revenue, rising property values support the growing debt
obligations of property developers, and increasing consumer wealth supports
confidence in the sector and the recycling of savings into more real-estate purchases.

Property appreciation and credit creation are both chicken and egg. Higher prices
provide the basis to extend credit, while the flow of credit allows prices to appreciate.

During the early days of private property ownership and urbanization, there was
seemingly unlimited demand to build and unlimited room for housing prices to rise.
Even after the market was likely oversaturated compared to primary demand for
living space, real estate remained the most popular and profitable investment.
Ironically, the necessity of rising property prices for economic stability made the
asset appear safe to many. It was assumed that the government could not risk and
would not allow property prices to decline.

But this flywheel structure is inherently fragile. If property prices fall, this virtuous
cycle becomes vicious 5. Local government revenue falls, citizen wealth is destroyed,
developers and contractors go bust, and the vast sums of credit that were written against
property go bad.

While the development model was clearly unsustainable, the precarious state of the
property developers at the center of the web made the situation much worse. Most
developers were reliant on a constant stream of new financing and pre-sales of
unbuilt apartments in order to pay off old debts.

Recognizing the precarious and unproductive path of development, central

authorities tried to rein in the bubble by establishing buyer restrictions on multiple
properties and famously warning “houses are for living in, not speculation”.

In 2020, the Three Red Lines regulations - aimed at curbing property developer debt -
did what stern warnings could not. By halting the expansion of credit, regulators
popped the property bubble.

Fallout

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At the epicenter of the property bust are the property developers, but the risks and
ramifications continue to extend into the financial sector and broader economy.

Property Developers: If a company is reliant on new debt to repay interest on old debt,
it is in a debt spiral. If a company in a debt spiral loses access to new financing, it
goes bust.

Shortly after the Three Red Lines cut off new financing to over-levered developers,
they began to drop like flies, most notably Evergrande.

Evergrande USD bond price, from July 2019 - July 2022.

Evergrande was not the first to fall, but its failure carried significance due to its size
and the precedent it established. Contrary to conventional wisdom, there was no
government rescue for the behemoth. Instead, debt would be resolved through a
market-based unwind.

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The collapse led to mass contagion throughout the sector by fundamentally altering
the credit risk involved in property-based lending while also shattering consumer
confidence in property prices. Today, nearly all private property developers are in
some stage of extreme distress, restructuring, or liquidation.

Country Garden’s stress has been well understood for years. Nevertheless given its
enormous size and former prestige, its default is significant and indicates that the
industry is still falling, not recovering.

Offshore Financing: Offshore financing, such as U.S. Dollar (USD) denominated bonds,
was a popular and relatively low-cost source of financing for property developers in
the last several years of the bubble.

This debt was first in line to get hosed. First, offshore debt is the most isolated
source of financing, with relatively little interconnection elsewhere in the property
web. Further, offshore debt repayments are the lowest priority after construction
capex, trade payables, and onshore debts.

Trading prices of USD bonds began to fall across the board shortly after Evergrande’s
collapse and have not recovered. Today, over 50% of USD property bonds are in
default.

Indexed total return (including accrued interest) of eight major property

developer’s offshore USD bonds from July 2019 - July 2022.

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While bad for original investors, these bonds are mostly held by private investment
funds that have already recognized losses on a MTM basis. Therefore, ongoing
systemic risk here is minimal.

Regional Banks: In the past, I’ve made a vocal case that regional banks posed the
greatest systemic risk given their massive direct and indirect credit exposure to the
property sector. Regional banks are further removed from PBOC liquidity and could
come under liquidity pressure due to extensions or refinancing of bad loans.

Drawing the comparison to the 2008 U.S. housing crisis, a sudden realization of loan
losses and counterparty risk could risk financial calamity.

It is clear that banks were indeed under liquidity pressure as mortgage boycotts
spread in the summer of 2022. However, I believe that a quiet recapitalization of at-
risk banks occurred behind the scenes in late 2022, relieving acute stress for the time
being.

For my money, the rural and regional banks still represent a systemic risk, even if the
system benefits from opacity and strong-arm tactics not available to banks in other
jurisdictions. Yet, clearly these entities are still more likely to receive central support
than private developers, shadow banks, or offshore financiers.

Shadow Banks: Trust and Wealth Management Products (WMPs) represent more than
¥20 trillion ($2.9 trillion) of high-yielding investment products sold to individual
investors as an alternative to low-yielding bank deposits. These investment funds
have been a significant source of financing for the property sector 6.

Zhongzhi’s recent liquidity crisis has put the spotlight back to these at-risk entities,
though it is not the first real estate trust to halt payments 7. Authorities have tried to
crack down on shadow lending for years and are less likely to provide support to
struggling entities. As such, investors in these products - Chinese citizens - are most
at risk.

A related area worth monitoring is insurance products related to real estate such as
those underwritten by Ping An (HKSE: 2318) which came under investigation in 2021.

Local Governments and LGFVs: Falling land sales have starved local governments of
critical revenue. To replace this funding, local governments have turned to their

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Local Government Financing Vehicles (LGFVs), off-balance sheet entities, to plug the
hole despite little capacity to repay such loans.

LGFVs - originally created to skirt local government financing rules - have long been
a source of concern, with an estimated ¥50 trillion ($9 trillion) in debt outstanding.
Now, severe cracks are showing.

In July 2023, 48 LGFVs were overdue on commercial paper obligations, up from just
29 in June. While no LGFV has defaulted on a public bond so far, it is clear that large
scale intervention will be necessary to maintain that record. Today, lenders to LGFVS
are relying on de-facto national backing, as there is little chance that many local
governments will be able to repay these debts on their own.

Given their quasi-government status and the sheer magnitude of their liabilities,
these entities are more likely to receive central government support via the major
policy banks. Already, municipalities in Shandong, Liaoning, and Hunan have
entered agreements with state-owned banks to help.

If LGFVs do not receive adequate state support and default on obligations, it would
likely send shockwaves throughout the onshore financial system.

Consumers: Perhaps the least discussed, but most significant impact of the property
collapse is on the Chinese consumer.

A significant portion of citizens’ wealth has already evaporated due to the depressed
market. While policy makers seek to manage the epic piles of bad debt to avoid
financial calamity, there is less hope for a sustained revival in home prices. Many are
paying mortgages for properties that have yet to be completed and whose value has
already been greatly diminished.

Consumer exposure extends beyond the value of properties. Investments in Trusts

and WMPs could yield substantial losses. The slowdown in construction pressures
smaller businesses and employment. Overall negative consumer sentiment feeds on
itself in lower consumption, business revenue, and economic activity.

Some have suggested that direct demand stimulus is warranted in these

circumstances, and perhaps this would be helpful on the margin. But even still, these

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overhangs are likely to be significant for years to come, in a way that mirrors the
impact on consumers in the U.S. during the great recession.

Whimper or Bang
There is little chance that China will return to its property-led economic engine.
Declining population and housing oversupply provides little support for long-term
demand for real estate. Reliance on such an unsustainable model is what has caused
the mess in the first place.

Therefore, the critical question is whether the property bubble ends in a whimper or
a bang. Will Beijing be able to manage the fallout in such a way that avoids onshore
financial turmoil that rocks global markets?

So far, the answer has been yes, though the challenges are far from over. It has been
three years since the Three Red Lines, two years since Evergrande’s failure, and yet
some of the largest dominoes like Country Garden are still falling. As pressure
continues to build in LGFVs, regional banks, and shadow banks, the task will become
more daunting.

For my part, I am more open to the idea that financial turmoil can be avoided than I
was two years ago. The Chinese financial system differs from the U.S. in important
ways, and we have already seen how central support has been effective to date. Two
years of unfulfilled anticipation also has a way of eroding conviction.

Even if the property crisis does not cause financial chaos, the overhang on China’s
economy is likely to persist for years to come. Yet in the long-run, the property
engine had to be stopped. While painful today, it will ultimately lead to a more
productive future.

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As always, thank you for reading.

-TLBS

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1 While a notable headline, Evergrande’s fate has been effectively sealed since 2021. The
recent U.S. bankruptcy filing has little practical relevance in understanding the current
dynamics in the property market.

2 According to official data, as reported by Bloomberg.

3 Back in September 2021, when Country Garden’s USD bonds traded at par, I made the
case that Country Garden and other “healthy” property developers were likely to collapse
and the value of these offshore bonds would trade to 25 cents on the dollar in the near
term. By July 2022, County Garden bonds hit 25 cents.

4 The policy sets three key financial indicators, each represented by a "red line," that real
estate developers are required to adhere to in order to obtain financing from banks and
other financial institutions. These indicators include a limit on a developer's debt-to-
assets ratio, a restriction on their net gearing ratio, and a cap on their cash-to-short-term
debt ratio.

5 Further, for long-term productivity, a housing bubble can juice nominal economic output,
but the endless construction of cement boxes provides little value while wasting vast
resources.

6 Bloomberg reported in 2022 on large development products that were purchased by trusts
from struggling developers. However, my suspicion is that many of these “purchases” were
transfers of ownership in lieu of cash payment on debts - effectively handing the keys to
the trusts. If the projects could be monetized directly through sales, the developers would
have already done so.

7 Evergrande ran its own WMP - which it forced employees to invest in - which funded the
company’s ongoing debt spiral. Outgoing payments on the WMPs were frozen during the
company’s liquidity crisis.

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