China Evergrande is facing a liquidity crunch issue. It is having difficulties in paying its onshore bond interest as well as US dollar offshore bond interest. As investors are still fresh with the pain that incurred during US subprime mortgage that bring down Lehman Brothers and caused a global financial crisis, market are speculating whether China Evergrande saga will trigger the China version of property crisis and impacting the global financial market stability. Will China Evergrande case is just a tip of an iceberg? Only time will tell.
Back to 2 decades ago, after China restructured many of its state owned enterprise and bad loans, China at that point of time also just enter the world trade organisation WTO. China was having a booming economy where foreign investment boom, factory being setup across China, and infrastructure boom. The income of Chinese people rose at unprecedented pace. This created huge demand for housing. China Evergrande established in 1996 and just in time to ride the decades boom in property market.
With 1.4bil population and starting from young demographic, the growth in China economy drive the property market for 2 decades without major setback. Property prices rose multiple folds in general over just under a recent decade. When the trend go on for so long, people thought that it is still the property that give the best and sure return over all the asset classes. Furthermore, with China strict capital control, there are not many investment options but property and stock market. Stock market has been volatile and not the cup of tea for most Chinese people.
In China, all land belong to the government. When property demand was strong, sales of land was very active. Soon, land sales became a major revenue for state government. In earlier years, GDP was the single most important KPI set by central government for state government. Hence, state government tend to spend big on fiscal spending like building roads, railways, airport that some news article may say many projects don't really make economic of sense. To cover the extra spending, the state government always can sell land.
Now turn to property developer. In China, you need to put in 40% down payment to buy a house. Part of the money collected by property developers need to put in escrow fund for construction. In order to achieve exponential growth, China property developers utilise significant amount of the downpayment (>50%) to fund the next land purchase and launch the next project as soon as they can. When the property market is hot, a property project normally can be sold out in a very short time. Then the property developer can use this new project deposit to fund more land purchase and launch more new project to collect more deposit and this cycle goes on. This ultra fast pace of expansion can go on because the construction progress which normally takes 3-5 years is so much longer than the land purchase and project launch cycle which in total takes only within 6-12 months.
No doubt, the booming property contributed significantly to China GDP from construction activity, the job created, the demand and supply for building material. Without this, China GDP growth would be much slower.
But at the same time, property prices has become one of the most unaffordable in the world in terms of price to income ratio. Since 2015 or earlier, China government turn to reducing the wealth gap by trying to control property prices by capping price increase, tightening borrowing criteria in property developer or buyer end, etc. But every time there is slowdown in China economy, Chinese government would always relax some property tightening measure, worry about either cannot meet GDP growth KPI, or worry about state government highly geared situation with their overly dependent on land sales revenue.
Although China government over the years tighten the funding to property developer by clamping down shadow financing, china domestic lending channel, the China property developer found ways to get funding through HK offshore bond or equity raising, engaging in off balance sheet property development activity by joining force in associate and joint venture to make their balance sheet look strong to entice investor. With property demand so strong, strong deposit booking, active land sales, property developer is willing to pay high interest of even up to 10% to get offshore funding to complete the construction or some even to fund further land purchase. International investor are so happy to subscribe with the US yield of merely 1.5% and thought that there is an implicit guarantee that China won't let property bubble pop and devastating its people and economy. The risk looks ring fenced.
In 2020/2021, China government KPI evolved from GDP growth to common prosperity. Besides regulating the overgrown internet giant, public resources issue such as housing again become government's pressing issues to solve the growing inequality problem in China. China set a stricter criteria for funding. With COVID 19 in the background, China property growth slowdown to single digit growth in sales, compared to 20-30% growth in the past few years. Suddenly for the overly expanded property developer where their land sales growth had far outpace the construction growth, their party came to an end.
Now, the reality kicks in that China Evergrande need to deliver all the properties. Likely no more new project and new deposit money, no more offshore funding channel. In order to survive, China government will have to engineer as the last resort to bridge it over in shorter term and China Evergrande will have to sell its projects to other property developer or whatever valuable asset to self fund the construction. Now the question come back to whether China Evergrande is just a tip of an iceberg? If many more trouble developers start to surface, are there enough property developers with stronger balance sheet to takeover those troubled developer's projects?
The China banks lending as a whole to property developer is less than 10% or may be 5-7%. Most of the China debt is domestic debt. On the banking side, I would like to think that China can stomach the current crisis. Luckily, Chinese people household debt is at around 60%, and they still have high saving rate. Compare to US subprime mortgage which the root cause is the house buyer default and spread through the over leverage financial system, China property bubble seems to be contend within the property developer which is much smaller in scale compare to the whole housing market. As long as China can maintain the property price without significant drop, the crisis will likely limit to financial market only, but not too much on the real economy.
Many bond holders, equity holders will lose money. There may be impact on other financial market as well where those investor who lose money will need to sell other profitable securities to cover the loss. In the real china economy, hopefully not much people will lose job. It may impact some buying sentiment and thus economy may experience some slowdown. If most Chinese people don't lose money, China economy will remain intact. The key is the Chinese government need to ensure that all the property sold to the people will be completed and there is not panic selling of property in China.
