Seafarer®

Pursuing Lasting Progress in Emerging Markets

China’s Indebted Residential Property Development Sector

November 2018

In October 2018, Chinese President Xi Jinping vowed “unwavering” support for China’s private sector enterprises.1 “Any words and practices that negate and weaken the private economy are wrong,” said Xi. He emphasized that “supporting the development of private enterprises is the [Chinese Communist] Party Central Committee’s consistent policy.”1 Vice Premier Liu He subsequently sent the same policy signals. With China facing slower economic growth, escalating trade war tensions and a struggling stock market, President Xi’s comments prompt questions as to which sectors of the economy this “unwavering” support will apply. Specifically, will China’s highly-indebted residential property development sector receive government support?

Debt in the Property Development Sector

For some time now, the financial solvency of China’s residential property development sector has been in question. The sector has always been highly-indebted, and in recent years, it has taken on staggering new levels of debt, such that its leverage has only grown. The publicly-listed Chinese property developers have aggregate total debt of 858 billion U.S. dollar (USD)-equivalent, with more than 275 billion of that amount denominated in U.S. dollars.23 Debt in the publicly-listed portion of the sector has grown rapidly over the past three years, up from 327 billion USD-equivalent at the end of 2014.4 Listed developers in the sector have suggested that such leverage is necessary to supplement and grow land reserves; yet the absolute and ever-growing amount of debt issued by these companies is alarming. Perhaps the only thing more alarming is the nascent profits of the listed sector. Figure 1 below illustrates the total revenues, common equity and net income of all publicly listed property developers in China alongside the sector’s total debt, as well as the portion of that total debt which is denominated in U.S. dollars.45

Figure 1. Listed Chinese Property Developers and Home Builders

Sources: Bloomberg, company filings. Amounts are USD-equivalents in billions.
Includes all listed Chinese homebuilders with a market capitalization above USD 250 million.
Note: USD denominated debt includes both bank debt and bonds issued. Total USD bonds issued by the sector exceed USD 116 billion as of 30 September 2018.
Past performance does not guarantee future results.

Cross-currency Risk

Developers’ expanding U.S. dollar-denominated debts mean that the sector is exposed to a great deal of cross-currency risk on its consolidated balance sheet. As of August 2018, 25% of all bonds issued in the sector were U.S. dollar-denominated.4 With nearly all of property developers’ revenues and costs denominated in renminbi (RMB), this cross-currency debt represents a significant financial risk for these companies. Property developers are a sizable segment of the Chinese economy, and they are reliant on foreign currency financing; this funding is often secured through special purpose vehicles or shell companies domiciled in tax havens.6 Such legal structures would make it difficult for offshore creditors to make claims on the underlying assets, should default occur. In fact, the annual financial stability report of the People’s Bank of China (PBOC) specifically calls out China’s listed property developers for having high leverage and complicated financing methods, stating such structures have “increased the difficulty for regulatory authorities to grasp the true flow of funds and weakened the regulatory effect.”7 The risks associated with such financing structures and the increasing cross-currency exposure for many property developers are further exacerbated by the absolute amount of debt in the sector and the questionable quality of local bond ratings.

Land Bank Sales are an Increasingly Integral Part of the Government’s Fiscal Position

One plausible explanation as to why Chinese authorities have allowed the listed portion of the sector to lever up so substantially, contrary to their stated commitment to reduce leverage in the financial system, is that this arrangement has been beneficial to the financial standing of the central and local governments. The debt assumed by the property developers has been used in large part to fund land bank purchases. A significant percentage of the proceeds from these land bank purchases goes to national and local government coffers. This can be seen in China’s national accounts, where the most recent data shows more than RMB 5 trillion grossed from the sale of state-owned land use rights in 2017 (see the light blue line in Figure 2 below).8 This represents more than 30% of China’s total national government revenues (see the dark blue line in Figure 2 below). Another way to understand the importance of land bank sales to government coffers is to look at net expenditure financed by land sales (see the dotted blue line in Figure 2 below), which is defined as the “net expenditure financed by land sales estimated by subtracting the acquisition cost, compensation to farmers, and land development from the gross land sale proceeds.”9 By subtracting development, relocation and other associated costs, this dotted blue line is arguably a more accurate reflection of the government’s net proceeds from land sales. Either way you look at it, a large percentage of China’s national budget is tied to the sale of state-owned land use rights.

Figure 2. National Government Revenues Contributed by the Sale of State-Owned Land Use Rights

Sources: National Bureau of Statistics of China, International Monetary Fund, Seafarer.
Amounts are in RMB billions.
Past performance does not guarantee future results.

Potential Mitigating Factors for the Risk in this Sector

There are several possible mitigating factors that may keep China’s property market and the levered property developers on an even (and solvent) keel. China’s housing policy includes initiatives to build housing to lure young professionals in tier 2 and tier 3 cities and thereby enhance these cities’ competitiveness and attract corporations. The regulators are allowing more bond issuance in the property sector to refinance near-term liabilities (as we have seen with July and August 2018 issuance trends).10 In addition, some state-run banks have the ability to selectively offer attractive mortgage rates to buyers (as Industrial and Commercial Bank of China (ICBC) in Shanghai did in August 2018). Authorities are granting sale permits on new units with less stringent price cap requirements (as some listed developers have reported on their most recent earnings calls).11 Other policies that the authorities have employed to cap and support housing prices in different regions include resale time restrictions, presale price restrictions, loosening hukou restrictions in certain markets, and down payment minimum requirements. Add in the government’s recently articulated “unwavering” support for the private sector, and it is hard to dismiss the potential power of such levers and the ability of the government to quickly employ property-related policy shifts.

Conclusion

The Chinese government has indirectly raised capital by selling land bank to developers at robust prices. Developers have taken on substantial debt to acquire this land bank. Based on the percentage of government revenues related to the sale of state-owned land use rights, the fiscal position of local governments does seem rather dependent on continued land bank sales. Furthermore, the use of U.S. dollar funding by many developers means that this leverage is at least partially funded from outside of the Chinese financial system. I wonder, have some portion of the proceeds gone to support government-directed stimulus in the economy – particularly in 2016 and 2017? If land bank sales decline – as they appear to be doing now – what will be the consequences for China’s ability to engage in fiscal stimulus? And when will the consequences arrive? In the meantime, as China’s currency comes under pressure due to trade-related tariffs, the property development sector’s ability to refinance its U.S. dollar-denominated debts may come under increasing strain, perhaps ultimately testing Xi’s resolve to follow through with “unwavering” support.12

Kate Jaquet
  1. Xi Vows ‘Unwavering’ Support for Private Sector After China Rout,” Bloomberg News, 21 October 2018.
  2. As of August 2018, there are 198 publicly-listed property developers in China with market capitalizations above USD 250 million. It is this group of companies that I have used to assemble the data for the listed property developers in this market commentary. Market capitalizations for this group of companies range from 250 million to 47 billion USD-equivalent. Data referring to “listed property developers” does not incorporate the thousands of smaller, unlisted property developers in China. By way of broader comparison, we estimate that as of August 2018, close to 11% of the financing to the entire property sector (bank debt and bonds issued by both listed and unlisted property developers) is USD-denominated.
  3. Seafarer, Bloomberg, Wind Information, National Bureau of Statistics. Accessed 30 August 2018.
  4. Seafarer, Bloomberg. Accessed 30 August 2018.
  5. Data presented in this table is for companies with a market capitalization of more than USD 250 million.
  6. The recently issued bonds by Evergrande through a special purpose vehicle named Scenery Journey Ltd are just one example of this bond issuance structure. See Prospectus.
  7. 中国金融稳定报告 (2018) (People’s Bank of China’s annual China Financial Stability Report 2018),” November 2018.
  8. Wind Information. Accessed 30 October 2018.
  9. People’s Republic of China: 2018 Article IV Consultation,” 26 July 2018.
  10. Wind Information, Bloomberg. Accessed 10 October 2018.
  11. Nicole Wong, “China Property: Mispriced,” CLSA, 10 August 2018.
  12. A clear example of refinancing strain in the sector is a bond issuance by Evergrande on 31 October 2018. This three-tranche bond deal has interest rates of up to 13.75%, well above the 8.75% for similar bonds issued by the company just last year. In a further sign of strain, the Chairman of Evergrande, Hui Ka Yan, purchased more than half of the overall USD 1.8 billion issuance. Sources: Bloomberg; Hornby, Wildau and Smith, “Evergrande chairman props up $1.8bn bond,” Financial Times, 31 October 2018.

References

  • The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
  • As of September 30, 2018 the Seafarer Funds had no economic interest in the entities referenced in this commentary.