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China property: will the Wood Dragon bring some luck to the endless crisis?

Editorial by the Team Emerging Markets/Corporate Debt

Three years have passed since Chinese authorities rolled out the first patch of measures to contain speculation in the real estate market. While Beijing has finally taken the property downturn seriously, more needs to be done as the government refrained once again from going all in, preferring to maintain some spare policy capacity. Improving the economic and employment outlook together with house price expectations is mandatory in the short term. Monetary policy and banks need to remain accommodative in the mid-term to avoid a credit crunch affecting the entire economy similarly to what happened to Japan in the 90s. We prefer to remain cautious on the sector at this point. However, investors with patience and a long enough investment horizon can still find some value in idiosyncratic stories.  Next year is the year of the Wood Dragon in China; dragons are usually associated with leadership, achieving goals and are seen as a symbol of luck. Hopefully, the year of the Wood Dragon will bring some luck to the Chinese property sector in 2024.

Current situation

Housing activity has risen strongly in China during the last 20 years, driven by urbanisation, increasing disposable income and speculation. Thanks to the latter, buying multiple houses became a popular investment for Chinese households as, in their opinion, past performance was a guarantee of future growth.  However, while Chinese developers were beating new sales records, authorities in Beijing were growing anxious and, driven by the philosophy that “houses are for living and not for speculation”, introduced in August 2020 a set of policies aimed at containing the speculation in the real estate market and the indebtedness of constructors. This regulation caused several headaches for many companies that soon turned into a liquidity crisis. The introduction of stringent pandemic-related restrictions worsened this crisis and, at the same time, hit households’ confidence. The removal of these restrictions in 2022 was not enough to cure the issues above. Some lower-tier cities (i.e. less developed cities) tried to stimulate demand by relaxing home purchase restrictions and improving home affordability. However, an uncoordinated response, depressed sentiment and the evaporation of investor demand (due to Beijing’s crackdown on speculation), resulted in weak demand. Finally, it is only in August 2023 that the Beijing leadership decided for the first time to truly step up its support at national level. The main measures included the floor for downpayment ratios being lowered to 20% for first homes and 30% for second homes, the lowering of existing first-home mortgage rates and second-home mortgage rates and allowing local governments to widen the definition of first-home buyers. While these are nationwide measures, cities retain a broad level of powers in how to apply them.

Following August’s measures, the sales of September’s top 100 developers were up 17.9% MoM (-29.2% YoY). While these numbers are not impressive and positive seasonality also played a role in the monthly rebound, it is still too early to look at house sales given that policies takes some time to be felt. According to the feedback of some brokers in Beijing and Shanghai, buyers’ interest cooled down towards the end of September after picking up in the first week after the new measures were rolled out.

Short-term view

In the short term, we believe that the recovery will mainly be confined to tier 1 cities (the most developed ones, i.e. Beijing, Shanghai, Guangzhou and Shenzhen) and tier 2 cities given their spared policy capacity compared to lower tier ones. Cities like Beijing and Shanghai can still lower down payment ratios to the new minimum levels and relax home purchase restrictions in line with what Guangzhou did in September (residents are now allowed to buy up to two houses in four new districts, and non-residents are allowed to buy one house with only two years of social insurance/personal income tax proof). While this spared policy capacity can slowly be rolled out in the main cities to provide some boost, there remains some friction preventing the overall market from recovering strongly:

  • Investor demand will be difficult to gain back.
  • Tier 3 and tier 4 cities already started reducing down payment ratios and softening home purchase restrictions in 2022 with poor results. Flat or negative population flows together with elevated housing inventories makes it difficult to get new housing starts and sales rolling.
  • Ongoing defaults of property developers and uncertainty over whether projects will be delivered.
  • Expectations of falling property prices.
  • Uncertain economic outlook. Youth unemployment has been rising at unprecedented levels and private investments remain depressed.

The main short-term challenge for authorities is to boost households’ sentiment and private investments in order to improve house price expectations and ultimately stimulate housing demand.

Mid-term view

The “lost decade” – this is how we refer to the period of economic stagnation that followed the burst of the real estate bubble in Japan in the 90s. Beijing is now faced with a similar scenario. Below, we highlight the main challenges that China faces in reference to the Japanese experience.

Aging and declining population. While Japan’s population was still growing in the 70-80s, the working age population ratio started falling as the proportion of elderly people was increasing. China is now facing a similar pattern, with the working age population already declining and total population expected almost to halve from current levels by 2100. Figure 1 shows this very well. This, together with expectations of persisting negative migration flows (UN data), represents a strong mid-to-long-term headwind for housing demand. Financial incentives have so far not managed to change this outlook.

Figure 1: China vs Japan – population dynamics

Source: UN, OECD, MainFirst; data as of October 2023.

Monetary policy overtightening: by 1990, Japanese residential land prices had increased by almost 6x in 20 years. In an attempt to burst the bubble and control inflation, the Japanese central bank tightened its monetary policy in the late 80s. Monetary policy then remained restrictive for the next couple of years at a time when land prices started coming down and the yen had strongly appreciated. At current inflation rates close to zero, Chinese policy rates are also restrictive despite the recent easing. However, plugging in expectations for rising inflation, real rates are lower than in Japan and the PBoC has an easing bias currently, opposite to the BoJ in the late 80s. At this point, it is crucial for China to manage its monetary policy not to burst the bubble, while a coordination of monetary, fiscal and legislative policies try to avoid a hard landing scenario.

Banking problem: as land prices were rising in the decades preceding the burst, the banks accepted more of this as collateral. When the bubble burst and prices deflated, the banks made losses. This, together with Basel I rules forcing banks to hold 8% of capital, resulted into a credit crunch. This affected not only the real estate market but also other industries, especially in the SMEs space. In case of a downfall, Chinese authorities need to avoid this scenario.  Figure 2 below shows the loans exposure of three of the largest Chinese banks to the construction and real estate sectors. The exposure of Japanese banks to these sectors when the bubble burst was much higher at around 14–17%. The capital ratios of banks today are also higher and are within a 16–19% range for the three banks below (total capital adequacy ratios). Chinese banks are therefore better positioned than Japanese ones.

Figure 2: Weight of Construction and Real Estate loans on selected Chinese banks

Source: Company statements, MainFirst; data as of H1 2023.

Failing fiscal policy and low investments: Japan failed to target the right investments during the lost decade. The current economic pessimism and the geopolitical tensions have reduced FDIs and private investments. The authorities need to work hard to re-start the investment engine.  

Investment implications:

Given the short-to-mid terms challenges, we remain cautious on this asset class and are monitoring the milestones described above.

The main beneficiaries of the measures recently unleashed are state-linked developers with strong balance sheets exposed to tier 1 cities, as these cities maintain spare policy capacity to continue stimulating demand. Additionally, these cities also still enjoy a population inflow from smaller cities and are therefore less exposed to the decreasing population trend to come over the next years. Some of the largest developers in tier 1 cities are also SOEs (State-Owned Enterprises). SOE developers have been partially benefitting from the property market turmoil, increasing their market share at the expense of POEs (Private-Owned Enterprises) ones. Large SOEs enjoy public ownership, stronger balance sheets and the favour of homebuyers, given their trust that projects will be delivered.

The good news is that such companies have outstanding bonds. However, they don’t trade at very attractive levels, especially when considering the macro and sector risks. Developers like COLI and China Resources Land (CR Land) meet the requirements described above; however, their bonds’ valuations are not very attractive with a yield currently between 5.5–7.5%.

On the other side, the bonds of many POE developers trade at undemanding valuations around 1–15 cents. We advise against adding a large exposure on the segment at this point as volatility remains high and sentiment fragile. Many of these developers are largely exposed to low tier cities where the supply/demand balance is very unfavourable. Some of these companies are likely to not make it given sluggish contracted sales, high leverage and short-term headwinds. However, the recent resolution of SUNAC restructuring offers a good template for other companies to follow. SUNAC is a developer with large land exposure to tier 1 and tier 2 cities that defaulted in 2022. The group achieved contracted sales of CNY 389bn (USD 54bn) in 2021 before seeing the number dropping to CNy 98bn in 2022. This restructuring improves the capital structure of the company by converting USD 4.5bn/10.2bn of offshore debt into equity or equity-linked instruments (convertible and mandatory convertible bonds). Companies with high-quality land bank and/or SOE links that are willing to go through a similar restructuring process must be monitored by investors. Other stories to follow are companies that can dispose of projects and use the proceeds to repay bondholders. While a lot depends on how the short-to-mid-term factors highlighted above develop, patient investors should keep an eye on these kind of stories as the cash levels of the bonds are very low and might ultimately result in higher recovery values in the mid-term.

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