The Chinese construction sector is set to suffer further setbacks in the coming months as embattled developers struggle to stay afloat amid receding demand for new properties and a decline in real estate investments. Analysts are warning that a potential collapse could have repercussions on the wider financial sector.
China’s real estate market is the largest in the world by total value. According to a study by research company Savills, China’s properties are worth $42.7tn or 21% of the global total. However, the sector is poised to suffer over the next few years due to shrinking demand.
Edward Chan, director at S&P Global Ratings, says that he expects nationwide property sales to drop significantly compared to their 2021 level of Rmb18tn ($2.5tn). “We think that in 2023, property sales will drop from Rmb13tn to Rmb12tn. But the chance of property sales dropping further is increasing,” he says.
In August, Evergrande Group, China’s biggest property developer — and the world’s most indebted — filed for bankruptcy under Chapter 15 of the US bankruptcy code. The move, which follows the company’s default on its debt in 2021, worth more than $300bn, shook the region’s real estate construction and supply chain.
Although Evergrande has been working on offshore agreements with creditors as part of its debt restructuring process, the company posted losses of $81bn during 2022 and 2021, raising eyebrows as to the effectiveness of its business strategy.
In a filing posted on August 18, Evergrande reassured its creditors that it plans to go ahead with its restructuring plan. “The application is a normal procedure for the offshore debt restructuring and does not involve bankruptcy petition,” the statement reads.
Evergrande is a Global 500 company that employs more than 200,000 people and is headquartered in the southern port city of Guangzhou, one of the four first-tier cities in the country alongside Beijing, Shanghai and Shenzhen. In 2020, the company’s total asset value reached an estimated $342bn.
In July, China lowered several of its key interest rates and scrapped its benchmark lending rate in an attempt to salvage struggling businesses and boost the demand for credit.
The government lowered one-year loan prime rates to 3.45%, a 10-basis-point decrease from its original 3.55% rate. However, the recent devaluation of the yuan, which has dropped 6% against the dollar so far in 2023, means that the Chinese central bank has less leeway to lower its interest rates and boost credit availability.
Vivian Xue, director of Asia-Pacific financial institutions at Fitch Ratings, says the loan-prime-rate reduction will help lower the borrowing costs, but a “material and sustained recovery in retail loan demand is less likely until home buyer confidence improves meaningfully”.
Leading the way down the rabbit hole?
Following in Evergrande’s trembling footsteps, a slew of other Chinese developers have defaulted on their sales. One of the latest is Country Garden (Cogard), the nation’s largest real estate developer by assets, which this week made payments on two dollar-denominated bonds after missing its deadline in early August.
Cogard’s payment of its $22.5m-worth of interest on those bonds, with an outstanding value of $1bn, means that it has narrowly avoided a default. However, the company’s 11th-hour payment hasn’t reassured traders that China’s embattled real estate market will see revived interest from buyers and a boost in liquidity any time soon.
“As Cogard went into distress, we are assessing how that would impact the property sector,” says Mr Chan. “Not just for the developers, but also [regarding] the consequences of prolonged deterioration of the property sector for suppliers and other companies alongside the value chain.”
A recent report from S&P Global Ratings points out the vulnerable position that small construction contractors and suppliers find themselves in, due to their reliance on customers like Cogard. Following recent developments, these companies have set new rules aimed at protecting themselves when entering commercial bills, which include requesting advance cash payments.
Nonetheless, failing developers have had an impact on multiple segments of the real estate market. Construction, real estate and interior design companies are often denied payments for their work. A bursting property bubble and a slowing economy have left Chinese businesses of different sizes awaiting paycheques, which are now long overdue.
Alicia García-Herrero, chief economist for Asia-Pacific at Natixis, says Cogard’s last-minute payments on its coupons shows that lifting regulatory constraints introduced to limit the leverage by real estate developers is “not enough to change the trend and make people want to buy property while prices keep experiencing a negative growth”. The question remains on how to revive the sector amid an abundance of external factors, including a declining Chinese population and a slowing national economy.
Link to shadow banking
“The Chinese real estate sector could not have grown so exponentially without shadow banking,” says Ms García-Herrero. Back in 2009 and 2010, China propelled its growth through a fiscal stimulus that focused on infrastructure and real estate. The framework put constraints on banks’ ability to lend to developers, which instead relied on other entities, including government vehicles, trusts and insurance companies.
“Due to the early restrictions on real estate loans from banks, the sector is not as exposed to developers’ own balance sheets because the share of their loans to such firms is quite minimal,” says Ms García-Herrero. “On the other hand, the off-balance sheet exposure of other financial institutions is much bigger,” she says.
More on Chinese banks
In August, Zhongzhi Enterprise Group, a major player in the Chinese asset management sphere, announced that it would enter into a debt restructuring plan to redress its missing repayments. The group’s trust, like many others in the country, works outside of the framework that governs commercial banks and funds its operations through wealth management products, among other tools, which are commonly used by the Chinese shadow banking sector.
The trust’s extensive real estate exposure, which accounts for more than $80bn worth of assets under management, has raised red flags not only on the impact of the crisis on the real estate sector, but also on the broader banking and financial sphere.
“While the risk is likely greater for smaller lenders with a higher concentration in Tier 3 and lower cities, if the property stress worsens and spills over to other sectors, it will intensify revenue and margin pressure at Chinese banks,” says Elaine Xu, who is also a director of Asia-Pacific financial institutions at Fitch Ratings.
Nevertheless, analysts believe that continued policy support to promote housing completions and the increased relaxation of home purchasing restrictions will help mitigate asset quality risks for banks. “Banks remain selective with granting new developer loans, and their direct exposure to developers has already declined to around 5%,” says Ms Xu.
