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Plenty of pixels have been devoted to China’s property problems — especially as the grace periods on Country Garden bonds slip away.
Now Goldman Sachs has a handy Q&A out with a summary of its main analysis on the country’s property-sector collapse, where the bank tries to unpack the potential implications for its financial system and markets. So we thought we would cover some of the main points.
First, China’s property sector has a lot of debt! (And not only in “that’s a big number” terms, that’s relative to GDP as well.) From the bank:
USD 8.4tn (Rmb 58tn) of property sector debts. The increase in China property sector debts mirror the growth in the China property sector over the past 15 years. We estimate that back in 2008, mortgage borrowing and developer indebtedness were relatively low at 9.3% and 7.3% of GDP respectively, totalling 16.6% of GDP (Exhibit 4). The following decade saw very sharp increases, with total real estate debt peaking at 54.5% of GDP at the end of 2020, of which mortgage debt/GDP reached 34.0% and developer borrowing rose to 20.5% of GDP. This was part of a broader “debt boom” that ranks as among the largest in world history — with China’s overall debt-to-GDP ratio nearly doubling from 2008 to 2023 . . . Following the imposition of the “Three Red Lines” and other tightening measures from late 2020, leverage has declined. We estimate that total borrowing fell to 48% of GDP at the end of 2022, with the total amount of property sector debts outstanding at Rmb 58tn (USD 8.4tn), of which Rmb 39tn (USD 5.4tn) were in mortgage loans and Rmb 19tn (USD 2.6tn) from developer borrowings.
While the mortgage figures might look scary, China’s home buyers generally contribute large downpayments on their homes, and their loans are full recourse. The biggest bite will come from debt-servicing costs, Goldman Sachs argues, as that burden grew to 22 per cent of household disposable income in the first half of last year. The analysts expect the worst mortgage-related stress to hit smaller cities.
The real pain will probably surface in loans to developers. China’s property sector saw some deleveraging after the government imposed credit controls in 2020. But, uh, that trend has been “uneven”, the bank says:
On the one hand, bank loans to developers have continued to increase — as policymakers have encouraged banks to provide credit for project completions, and made it easier to roll over loans — rising further to Rmb 12.7tn at the end of 2022. On the other hand, non-bank financing (ie onshore and offshore bonds plus shadow banking) has dropped significantly on tighter market conditions and shadow bank regulation. As a result, bank loans have become an even larger part of developer borrowing (76% at the end of 2022)
Imagine a grimacing emoji here.
About 75 per cent of Chinese property developers’ debt is held by banks, the bank found, with 16 per cent held by trust companies and 6 per cent by insurers. This means “any broad restructuring efforts towards developer debts would have implications across both Chinese banks and trust companies. The latter has been evident in recent days with reports that three Chinese firms failed to receive payment from maturing trust products linked to Zhongzhi Enterprise Group,” the strategists write.
So what does this mean for banks? Probably nothing good!
GS estimates an average 10-per-cent loss rate to conclude that there could be Rmb 1.9tn of “systemwide property credit losses”. Of that, 61 per cent could be “absorbed by the banks . . . the concentration potential losses within banks indicates why a comprehensive restructuring of China property debts could require recapitalisation for certain segments of the China banking sector.”
As long as defaults don’t spill over into mortgages, the banking system in China has “significant capacity” to handle losses on loans to property developers, the bank says. But the strategists see more weakness in smaller banks, and say “a comprehensive restructuring of the property sector may need to be accompanied by restructuring or recapitalisation” of that group.
Even the bigger banks will face issues from the property meltdown:
Banks do face margin pressure, however. We see risk of an ‘impossible trinity’ for banks — that they cannot maintain the desired balance of provisions, capital and dividends at the same time owing to squeezed earnings. We assume local governments’ default risk will be limited as long as debt rollover is permitted and net balances continue to increase, and assess the potential multiyear margin loss of banks on the back of local government debt rollover due to lowering rates. We also stress-test that a ~60 bps rate cut per year on local government debt would trigger non-covered banks to face recapitalisation risk. With developers and local governments finding it difficult to secure financing, further policy changes are needed to boost confidence and address the issue of mortgage demand, plus liquidity risk of small banks and shadow banking.
So how does the problem get solved? Construction has slowed, which is a step in the right direction. Now it’s become an excess-inventory problem. We’ve added one line of emphasis in the passage below:
Over USD 2tn in inventory liquidation needed to handle the stock problem. With the construction of new housing declining, policymakers are likely to shift their attention from dealing with the “flow” credit issues towards the “stock” problem — namely, the excess inventory currently sitting on developers’ balance sheets, including raw land and undeveloped projects. Of developers’ estimated Rmb 107tn in total assets at the end of 2022, by far the largest component is inventories at 60%. This is followed by other assets at 16%, account receivables at 14% and cash at 9% . . . Therefore, the ability of property developers to generate sufficient cash to repay liabilities hinges on realising value from their high levels of inventories. To put this into context, our China property team’s estimate of 2023E primary market property sales is Rmb 13.2tn, meaning that developers’ inventory equates to around 4.8 yrs in terms of current sales. Our China property team has estimated the liquidation value for the inventory sitting on stressed developers’ balance sheets is between Rmb 15tn (USD 2.2tn) in their base case scenario, and Rmb 20tn (to USD 2.9tn) in their bull case. For stressed developers to engage in comprehensive restructurings of their balance sheets, we believe large-scale asset liquidations will be needed. This will require liquidating projects from mostly privately owned developers, many of which are located in lower tier cities.
So we’ve discussed what this means for banks and developers. What about the broader Chinese economy? GS estimates that the property meltdown could take a 1.5-percentage-point bite out of GDP this year. But that will be the worst it gets, argues GS, which estimates property-related economic headwinds will start to recede, albeit slowly, next year.
What about the takeaways for markets? The strategists argue that Chinese stocks are close to a trough from this property panic; credit is still looking ugly and distressed bonds probably won’t prove to be bargains; and interest rates and government-bond yields should continue to decline until the economic picture brightens.
Their view on the renminbi is interesting:
Currency: Still Renminbi downside, but mostly on a trade-weighted basis. The Renminbi has been under renewed pressure on the back of softer-than-expected activity data and the persistent weakness in the property sector, which led the authorities to ease further with a policy rate cut last week. Given this backdrop of weak growth and subdued inflation, easier financial conditions via both lower rates and a weaker currency are likely part of the solution. Still, the PBoC has stepped up its efforts to slow the pace of currency depreciation, with the countercyclical factor (CCF) rising further in recent days and offshore CNH funding costs rising. With onshore rates likely to go at least slightly lower, the widening interest rate differential is likely to remain an important and persistent headwind for the Renminbi. However, given the PBoC’s preference and ample tools at their disposal (such as stronger CCF fixings, potentially cutting FX deposit reserve requirement ratio, and/or adding FX forward sales reserve requirement), we expect the pace of depreciation to moderate in line with the recent slower trend. We see the USD/CNY cross at 7.30, 7.20, 7.00 in 3-, 6- and 12-months, respectively. We view the risks to our near-term forecasts as skewed to the upside and think the Renminbi remains an attractive funding candidate for carry trades given the declining rates and managed volatility (we have an open trade recommendation to be long BRL and COP funded out of CNY).
And they argue that iron ore has farther to fall:
Commodities: Iron ore’s property leverage means more downside. Despite iron ore being the most obvious commodity proxy for China’s continued contraction in early cycle property activity — with close to 25% of global seaborne demand tied to that sector — the market has remained relatively tight so far this year. Benchmark iron ore prices have displayed resilience close to $100/t, a level which hardly prices any supply-side margin pressure. This discordance with fundamental intuition has been rooted in a tighter than expected iron ore market so far this year, in turn reflecting a combination of surging China steel exports and domestic steel scrap tightness. However, in our view this micro tightness is not sustainable in an environment of global steel demand deterioration, which is now weighing on China’s export flows and broader mill margins. It also appears from media reports that Beijing is set to enforce policy cuts across the steel sector between now and year-end, in-line with the policy target of limiting domestic steel output to a flat full year profile. Set against materially stronger seaborne supply in H2 versus H1 (10% higher), our Commodities research team anticipate an inflection towards a 56Mt surplus in H2 and continue to hold our 3M $80/t target and $90/t average for the rest of this year. As the expected surpluses over the remainder of this year and 2024/25 enable a progressive rebuild in inventories from current low levels, that should support an average iron ore price level trading deeper into the cost curve.
GS also argues that unlike Japan, “China avoided large FX and equity overvaluation, has more headroom for urbanisation and income convergence than Japan did in the 1990s, and has moved more quickly on deleveraging.”
So while China is definitely giving off Japan-in-the-1990s vibes, there may be a few differences that could help limit the carnage (relatively speaking).
