April 2, 2014 6:26 pm
China property: In search of shelter
A stuttering housing market outside the country’s biggest cities represents a grave threat to the economy
©Reuters
Bleak houses: China’s smaller cities are experiencing an oversupply of housing and inadequate funding
The towers that were to house 10,000 people stand unfinished and abandoned, a ghastly apparition looming over the Chinese port city of Qinhuangdao. Construction was halted when Deda Property Development, the real estate company, ran out of funds. Hundreds of the homes had already been sold.
But last month, small notices were attached to the blue metal gates of the residential complex that showed its fortunes could be about to change. The government had arrived on the scene. It created a special “solve the Deda problem” work group and arranged for financing to resume construction.
“Maintain confidence and patience,” the notices read. “By working together, our homes will be built.”
After expanding more than 10-fold over the past decade, China’s property market now faces stiff headwinds. Qinhuangdao’s rush to rescue Deda is as sure a sign as any that officials are concerned. Their success – or failure – in steadying the shaky market will have global repercussions.
The Deda saga is not an isolated case. Similar stories are playing out across China, especially in smaller towns – from wealthy Zhejiang province in the east to poor Shaanxi province in the northwest. Property developers in these places are suffering and local officials face the uncomfortable decision of whether to bail them out or let them collapse.
The situation is different in China’s biggest cities such as Beijing and Shanghai, where the main problem is an undersupply of good housing. But smaller cities accounted for as much as two-thirds of China’s property under construction last year, according to Nomura. Even if confined to smaller cities, a sharp slowdown in building activity and homebuying in places such as Qinhuangdao will cast a long shadow over the Chinese economy. Zhang Zhiwei, Nomura’s chief China economist, rates the housing market as China’s “top risk” for this year and next, more than shadow banking or local government debt.
While the name Deda may not register with many foreign investors, the likes of Evergrande, Kaisa and Vanke – which all have developments close to Deda’s in Qinhuangdao and other troubled cities – should. Investors have lent them tens of billions of dollars over the past five years.
The international consequences of the ups and downs in the Chinese property market are often seen as important but largely indirect. Foreigners are in effect barred from buying homes. Instead, the market’s focus is on Chinese demand for commodities such as copper and iron ore to fuel its property boom – demand that would dry up in a bust.
Yet foreigners have amassed extensive direct exposure to Chinese property by lending to real estate companies through bond investments. Two facts about the boom in foreign lending to Chinese property developers are striking.
First, the scale has been vast. Since 2010, foreign investors have lent Chinese real estate companies $48bn in US dollar bonds and $6bn in renminbi-denominated debt, according to Dealogic. Developers accounted for a fifth of all non-financial dollar bonds sold by companies across Asia (excluding Japan) in 2013, and more than 40 per cent of new issuance this year.
Real estate bonds have been a favourite of private bank clients in Asia. Large fund managers have also been significant participants, in part because developers have dominated new issuance and have become increasingly important to benchmark bond indices. Data compiled by Morgan Stanley suggest a further $30bn in syndicated offshore loans to developers remain outstanding.
Some real estate companies are now heavily in thrall to foreign debt markets. Offshore credit accounts for more than half the total outstanding debt for at least six big developers, including Kaisa and Agile, according to research from Credit Suisse.
A second issue is that much of the lending has been priced at remarkably generous rates. China Vanke, the country’s biggest developer, raised $800m in five-year bonds in March 2013, paying 2.6 per cent a year. By that measure the company was considered more creditworthy than many governments. The same month, Brazil paid 4.6 per cent to borrow US dollars.
Sentiment appears to be switching fast as more bad news comes out of China concerning both the economy and the property market.
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The Chinese economy has had a wobbly start to the year, with exports, industrial production and investment all weaker than expected. Some economists have already downgraded their growth forecasts for 2014, amid growing calls for a fresh stimulus package.
Declining sales have led developers to cut prices, something rarely seen in China. Agile Property and Star River made the biggest moves, slashing prices by almost 40 per cent on some units in a luxury project they are developing jointly in Changzhou, a city near Shanghai.
Some analysts believe these price cuts simply reflect cyclicality in the Chinese property market. After prices surged as much as 20 per cent last year, they argue that a small correction seems healthy. In the wealthy city of Hangzhou, when one developer offered a 10 per cent discount in February, it quickly sold out. “I don’t get a sense that everything is deteriorating,” says Rosealea Yao of Gavekal Dragonomics, a research firm. “If you look at the total urban housing stock, still there is a shortage.”
Others see the price cuts as the start of a more ominous trend. “This is the beginning of the end for the real estate era,” says a private equity investor with holdings in at least one unlisted real estate developer. “They will try to sell their apartments as fast as they can. They want to get as much cash back as possible.”
The latest official data show that housing prices in China’s 70 biggest cities rose an average of 0.3 per cent month-on-month in February, a touch slower than recent months but hardly a meltdown.
But reported prices are misleading. Wary of damaging their image, developers have offered a range of special promotions instead of cutting their headline prices. Tianyang in Qinhuangdao has asked buyers to pay the full price upfront and promised to return 40 per cent in cash in the four years after the deal closes. Many developers such as Poly in the southwestern city of Chengdu are throwing in an extra balcony or parking space at no charge.
Wang Lei, 31, a civil engineer in Qinhuangdao, says he and many of his friends are at an age when they are ready to settle down and buy homes. But the uncertainty unsettles them: “What worries us is that if we take all the cash out of our pockets to buy and prices then tumble, that would be a true investment failure.”
It is not the first time that China’s property market has gone cold. Prices fell two years ago but soared again in 2013. Inventories of unsold homes are now rebounding towards levels last seen in early 2012 but with one crucial difference. The government was waging an all-out campaign to smother demand and rein in prices two years ago; this time it is the market itself that has weakened.
China’s real estate moguls have brushed aside the concerns, although they have sounded defensive in recent statements. Wang Jianlin, owner of Dalian Wanda, a developer, and the country’s richest man, told state media: “There are only two possibilities to explain why people are predicting a collapse of Chinese real estate. Either they have ulterior motives or they have insufficient intelligence.”
Many of the listed developers have been active in the smaller cities now suffering from oversupply. Country Garden and Evergrande – both active in offshore bond markets – have more than half of their developments in cities deemed “least preferred” by Alvin Wong, a Barclays analyst.
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Equity investors have fled the sector’s woes. Since the start of the year Country Garden shares have dropped by a third, Agile is down a quarter and Yuexiu Property almost 20 per cent.
Debt bankers say that there is now a creeping sense that bond investors are also having a profound change of heart and that a recalibration of the market is under way. Private bank clients, once the main driver of the market, are still active but far less aggressive in chasing deals, while asset managers have been hesitant in adding to their positions.
Bonds priced in the past few weeks have come with very high coupons – Times Property, for example, paid 12.8 per cent to raise more than $200m last month – and have performed poorly in the secondary market.
Most bonds issued early last year are deep underwater. Those sold by Evergrande, Country Garden and China Vanke trade at about 92 cents on the dollar, while the spread over US Treasuries has risen by about 200 basis points. Others have fallen further.
If China’s best developers found themselves cut off from global debt markets, it would place financing pressure on the sector as a whole.
Chinese banks have already turned away from lending to developers. With the government cutting down on shadow banks, alternative lending channels have also been choked off. To provide some relief, regulators gave developers permission to issue new shares in the domestic market for the first time in three years.
As the case of Qinhuangdao and Deda shows, local officials are also trying to patch up holes in their jurisdictions. But if the small holes grow into bigger tears in the market fabric, that will be hard to achieve. As it is, the “solve the Deda problem” work group is struggling.
“The government promised it would restart construction on March 15, but no more than 20 workers have showed up since then,” says Mr Wang, one of the buyers who has waited two years for his home. “I don’t see much hope.”
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Capital flows: The risk of transferring onshore funds
When investors lent $800m to China Vanke in March 2013, there was a different name on the paperwork, writes Josh Noble. Rather than Vanke of Shenzhen, the money was actually going to Bestgain Real Estate, a subsidiary registered in the British Virgin Islands.
Mainland companies tend to use offshore entities – often based in BVI or the Cayman Islands – to borrow foreign currency owing to tight restrictions on capital flows in and out of China. When doing so, they can use a variety of different structures in order to link the onshore and offshore companies, usually through a keepwell agreement, a bank guarantee or a standby letter of credit.
A “keepwell” agreement is one way for the parent company to lend its support to the offshore borrower, and requires no regulatory approval from mainland authorities. Under a keepwell, the onshore entity provides legally binding promises to backstop the offshore company – often through liquidity injections or by buying assets from the offshore company in order to cover any bond repayments.
The other common option is for a bank to issue a guarantee or an SBLC, through which an offshore entity seeks to draw on the credit rating of its bank, rather than its parent company. Under a guarantee, the bank takes responsibility for the debt if financing problems occur. With an SBLC, the bank – if called upon – is required to extend enough credit to the offshore company to cover the principal and any coupon payments.
Both systems remain untested, and carry legal and regulatory risk. For example, transferring funds from an onshore bank to an offshore branch requires approval from the mainland authorities, as does transferring cash offshore to buy assets in the case of a keepwell.
China’s foreign exchange regulator has proposed changes that would make it easier for onshore entities to guarantee offshore debt directly, potentially ending the need for keepwell agreements. However, the plans would still prevent offshore entities from bringing the cash raised in a bond deal onshore without approval, meaning that developers seeking to use the offshore market to help finance onshore activity would not see any benefit, according to Moody’s.
Copyright The Financial Times Limited 2014.
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