Talking Point

Red alert for real estate

How will China’s new credit tightening measures impact Evergrande?

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In January 2010 China Evergrande surprised investors with a stock exchange disclosure that its chairman Xu Jiayin needed to borrow $40 million from state bank ICBC. Xu also had to pledge a 1.8% stake in his property firm as collateral for the two-year loan.

Xu had just been awarded the title of China’s richest man by Forbes magazine and he was estimated to be worth more than $4 billion, following Evergrande’s IPO in Hong Kong a few months earlier. Evidently the newly minted billionaire wasn’t that cash-rich, the local media gossiped. Domestic newspapers later reported that Xu had needed to fork out $150 million to a group of investors after Evergrande’s stock price failed to meet a guaranteed minimum (see WiC364).

That elaborate transaction was just one of the financing deals Xu had forged, in part because Evergrande had struggled to secure funds in the wake of one of the periodic tightening campaigns the government had imposed on the frothy real estate sector. Over the ensuing decade Evergrande grew ever grander, despite what many analysts classed as an unsustainable financing model. Nor was it alone in adopting a debt-fuelled strategy. So much so that Chinese regulators unleashed a new round of credit tightening measures last month – known colloquially as “the three red lines”. The design: to reduce some of the risks to the financial system posed by overleveraged property firms like Evergrande.

How quickly have property heavyweights grown their sales and debts?

In 2009 Evergrande made Rmb30.3 billion ($4.4 billion) in contracted home sales. Sales had ballooned nearly 20 times to Rmb601 billion by last year. That was only enough to put the Shenzhen-based company in third place in developer sales, however. According to CRIC China, a research unit, Country Garden and China Vanke topped the rankings with Rmb772 billion and Rmb631 billion in contracted sales respectively.

Nonetheless, China Entrepreneur magazine detected “a mid-life crisis” for the property majors as they struggled to grow their business at the same breakneck speed as in prior years. The percentage increase in the top trio’s contracted sales had slowed to single digits in 2019, it remarked.

Some of the developers have leveraged themselves to the hilt too. Evergrande’s total borrowings stood at Rmb14 billion a decade ago. Its debt load had spiked to nearly Rmb800 billion by the end of last year, with half of it maturing in 2020.

Speculation over Evergrande’s financial health is hardly new. In the past decade the company has battled against a series of sceptics, who have questioned its finances. In one case in 2012 the short-selling research firm Citron even claimed Evergrande was sitting on negative equity (an allegation that landed Citron a heavy fine in Hong Kong). But the fact that Evergrande has defied its detractors for so long has led other commentators – including Bloomberg columnist Nisha Gopalan last year – to postulate that Chinese property giants such as Evergrande had simply grown “too big to fail”.

That conclusion may need to be revised, following the regulators’ recent interventions.

Why the latest policy changes?

Many local governments are heavily reliant on their property markets for economic growth and fiscal revenue. Yet something striking happened in the middle of this year – even as city officials struggled to revive their local economies following the Covid-19 outbreak, a number of cities rolled out measures to cool down their real estate markets.

Most notably Shenzhen unveiled new rules on July 15, including home purchase bans, higher downpayments, and new scrutiny to prevent married couples faking divorces in order to skirt restrictions on new purchases.

Guo Shuqing, chairman of the China Banking and Insurance Regulatory Commission (CBIRC), then made the central government’s intentions clearer in an article published last month in Qiushi, a key Party journal.

Guo discussed in depth how regulators should do more to eliminate major risks in the financial system. Their task was deemed more critical this year, he wrote, as part of the bid to accomplish a key government goal in building a “moderately prosperous society” by 2021 (when the Party will celebrate the 100th anniversary of its founding).

The risk of an “asset bubble” in the real estate sector was the “biggest threat to financial security”, Guo added.

A few days after the article was published the People’s Bank of China (PBoC) put out a brief statement discussing a seminar with other financial regulators including the CBIRC (the banking and insurance regulator), the Ministry of Housing and Urban-Rural Development, together with “representatives of some property firms”.

The meeting was aimed at developing a “long-term regulation mechanism” for the market, the statement said, and the PBoC was going to team up with other regulators to formulate “financial management rules” for “major real estate enterprises”.

The statement gave little detail on the proposed new framework, although Chinese media widely reported that property firms were soon to be subjected to the test of the “three red lines”.

What are the “three red lines”?

The red lines are: first, a 70% ceiling for a developer’s debt-to-asset ratio; next a 100% upper limit for its net debt-to-equity ratio; and third, a one-to-one ratio for cash against short-term debt.

After undergoing these stress tests, property firms will then be classified in a four-tier system. Companies transgressing all three lines go into the “red tier”; those failing respectively two or one of the tests will be put into the orange and yellow tiers; firms which pass all three tests will be classified in the green zone.

The government will then impose a differential set of regulations according to the ‘colour’ of the ranking. For example, developers in the ‘red’ zone won’t be allowed to increase their debt loads any further. Those in the yellow zone will be permitted to increase their debt level by 10% a year, with 15% of leeway for the more prudent players in green.

After going through last year’s annual reports for 30 major property firms last week, ThePaper.cn concluded that five will have fluffed all three red lines. Evergrande is one of them, alongside Sunac, R&F, China Fortune and Greenland.

Both Vanke and Country Garden will fail only one of the tests, the report suggested, so they are likely to go into the yellow tier.

Six other firms will sail more safely into the green zone. They are mostly state-backed players such as Poly, China Overseas Land and Investment and China Resources.

What impact might this have on the sector?

The new categorisations could mean that more indebted firms will be shut out of the domestic bond market (although it is not immediately clear if regulators will also try to stop them from selling bonds offshore).

In the time period before investors were exposed to the full impact of the coronavirus outbreak, they had been buying a flurry of real estate issuances in the local interbank bond market. Evergrande was also able to raise a further $6 billion in Hong Kong through the sale of preferred shares and bonds carrying double-digit interest rates. The value of these bonds took a dive at the height of the virus outbreak (see WiC488). Spotting a debt crisis in the making, the CBIRC took new action last month and banned homebuilders from selling new bonds this year as a means of refinancing existing debt.

Company executives who’ve just been through the stress tests are making all the right noises, claiming to be ‘highly supportive’ of the proposed new regulatory regime.

Wang Mengde, CEO of Sunac China, told ThePaper.cn that the government’s housing market policies have been effective in keeping home prices stable. In recent years, Sunac has served as a serial white knight, riding to the rescue of several debt-ridden peers including Wanda Group and LeEco’s property unit. And Wang said he was confident that Sunac could cut its debt-to-asset ratio to about 120% by the end of 2020 and thereafter lower its gearing to meet the new 70% “red line” within three years’ time.

Evergrande, the poster child of the debt-fuelled growth model, has been similarly supportive, even vowing to become the “model student” for the new approach.

Xia Haijun, the developer’s chief executive, told ThePaper.cn that it also plans to cut its debt load significantly this year. To this end the company announced another nationwide sales push this week, saying that it will be slashing 30% off the price of units in its residential projects until the end of the week-long holidays in early October, which is typically peak home buying season.

The aim is to sell Rmb200 billion of apartments during the period, domestic media reports.

Sales campaigns with discounted prices have been a tried-and-tested tactic in steering the company away from past financing crunches and Evergrande was already offering some deals this year in a bid to meet short-term debt obligations coming due. The impact showed up in its earnings for the first half of the year: a 37% slump in first-half underlying profit despite a 24% increase in sales.

But the latest sales campaign is offering the biggest discounts in Evergrande’s history, with Xia mustering his senior staff last weekend with a “military order” to deliver success, according to a company statement.

There was another reminder of the urgency in the first-half earnings announcement: Evergrande’s total debt rose 4% to Rmb835 billion as of June 30, compared with the end of 2019.

Will the government’s move bring real change to the sector?

Back in 2016 Chinese leader Xi Jinping told housing policymakers to respect the principle that “houses are for living in, not for speculation”.

In recent years, planners have been talking up the need for a “long-term management mechanism” for the real estate market. The introduction of the “three red lines” feeds into this line of thinking.

But the balancing act for Beijing is that GDP growth is still strongly linked to property sales. Michelle Kwok, head of Asia-Pacific real estate research at HSBC, noted in a recent report that the real estate sector’s contribution to GDP still held up at 9.2% last year, including construction activity. “This indicates that the real estate industry remains one of the key pillars of the economy with a direct impact on GDP growth. Therefore, it is hard to imagine an overly restrictive environment, given the prevailing economic headwinds,” she wrote.

In fact, property heavyweights in China have always found alternative ways to replenish their balance sheets. The latest funding channel comes from the equity market. Lockdown measures during the Covid-19 pandemic saw millions of people stuck in their residential complexes. The crucial role played by their building’s property management firms during that period – ranging from sourcing supplies of food to arranging limited recreational activities – highlighted some of their hidden value on developer balance sheets. Since then Evergrande, Sunac and China Resources have all filed listing applications in Hong Kong to spin off these units as separate companies.

Evergrande Management has been valued at more than $10 billion after concluding a new round of pre-IPO financing last month that raised another $3 billion for Evergrande’s debt repayment drive.

The route to a share sale in Hong Kong is an easier path for the mainland developers, who have been largely prevented from going public in the A-share market for almost a decade. Evergrande has tried to get regulatory approval for a Shenzhen listing for its property development business, for instance, and while it hoped to do so by the end of this year it looks likely the plan will be shelved again.

The China Securities Regulatory Commission (CSRC) also said this week it that had blocked the listing application of another Shenzhen-based developer Tahoe Group. That firm defaulted on an onshore bond in July and reports are rife that Vanke will take on the role of white knight this time by taking a strategic stake in its cross-city counterpart.

Shenzhen should be one of the leading contenders among cities in China proving capable of reducing its reliance on land sales income, given its growing status as an innovation and technology hub.

Indeed, local government officials there have been floating the idea of adopting the “Singapore model” in formulating future housing policies. Given the city’s history as the pilot for economic reforms, this will be worth watching, as the municipal government switches emphasis to building more subsidised housing (in Singapore this makes up the majority of residential apartment stock) and away from the Hong Kong-style model of land price inflation that the Shenzhen government has relied on for years.

That would represent a new era for the real estate sector in the city too, signalling a lower growth outlook for its property firms. Another reason, perhaps, for Evergrande to review its property business, as well as another indicator for why Xu Jiayin has turned some of his attention to new areas, including Evergrande’s massive investment in electric car manufacturing (see WiC507).


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