A building crisis

Many consumers in China shop on Taobao. Part of the reason is that they know they can request refunds if the goods turn out to be defective. Trust is at stake. Sellers on the platform risk their reputations being trashed by unhappy buyers on review sites.

Are buyer rights’ properly protected if the purchase is a property, however, probably the most important investment for many people? This has been a hotly-debated question over the past week as thousands of frustrated homebuyers join a growing revolt by refusing to pay their mortgages on unfinished residential projects.

Many of them said they wouldn’t be making any further payments until developers fulfilled their contractual obligations to deliver finished apartments. The protest may tarnish their social credit scores and even put their downpayments at risk. But the protesting group seems unbowed. And their defiance is starting to prompt larger questions about the robustness of the Chinese banking system, not to the mention the prospects of the beleaguered real estate sector.

What has happened?

Jiangxi was the ‘revolutionary base’ from which Mao Zedong first gained control of the Communist Party of China. It is also the province from which the first shots in the “Stop Mortgage Payment” campaign were fired. Disputes between angry homebuyers and developers that fail to deliver pre-sold homes on time aren’t unprecedented. But cases have increased notably since 2020, when the real estate sector was first hit by the double whammy of the pandemic and credit tightening from the central government known as the ‘three red lines’ policy. Developers were suddenly struggling for cash, creatingmajor delays in construction and leaving many projects in limbo. Homebuyers were left with debts, but no homes.

Frustration has been building for months. At the end of June, a group of buyers in Evergrande Longting, a project developed by the beleaguered China Evergrande in Jiangxi’s Jingdezhen, published an open letter claiming that their legal rights as consumers and investors had been ignored since construction of the project came to a halt in May 2021 (just months after about 900 units were pre-sold).

The group claimed that the pre-sale proceeds for the project – which should have been kept in a dedicated bank account and only deployed in financing the project itself (more on the pre-sale system later) – had been misappropriated by Evergrande’s provincial unit in Jiangxi. The homebuyers warned that they would stop repaying their mortgages in November, unless construction was resumed at Evergrande Longting by October.

In a sign of how widespread the problem of delayed construction has become, screen grabs of the letter spread like a bushfire across social media. Homebuyers in other uncompleted properties were quick to follow suit and the ‘Stop Mortgage Payment’ movement began to spread.

By the end of last week homebuyers in more than 100 residential projects across 20 provinces were threatening the same course of action, according to CBN, a local newspaper. About one third of the projects are located in Henan, a province where some property developers have been so desperate to do business that some have been accepting wheat and garlic from farmers as part-downpayment.

The Henan government has also been in crisis mode for weeks, rush- ing to bail out the province’s biggest property firm Jianye and trying to quell a banking crisis across a group of smaller rural lenders. For the time being, there is no indication that the two crises are related although smaller regional banks are believed to be a key force in financing the construction boom in rural areas over the past few years.

Unsurprisingly it is Evergrande, China’s biggest homebuilder before the credit crunch crippled its operations, that is the source of much of the anger. A much-forwarded list of 100 of the unfinished property projects in which homeowners are threatening collective default suggests that Evergrande is involved in about a third of the deals.

Investors have been spooked too. Evergrande’s listed flagship in Hong Kong has been suspended from trading since March after it failed to deliver its 2021 annual report, pending the outcome of a state-led restructuring. The share price of Country Garden, which has replaced its Guangdong rival as the leading property firm by sales, has dropped more than 25% in the past month as well (and 50% year-to-date).

The crisis has also spilled over to some of the banks that lend into the sector. The Shanghai-listed stock of China Merchants Bank, a lender with one of the leading exposures to property loans, traded lower across 11 consecutive sessions this month. Shares in China Construction Bank also declined sharply for three straight sessions at one point last week, with more than $6 billion in market value wiped out during the retreat.

What’s at the root of the problem?

Investors shouldn’t be too surprised by the boom-and-bust cycles in the real estate market. After all the sector has served for years as a key tool for policymakers in regulating the pace of China’s economic growth. For instance, in a series of high-level meetings in late 2013 Chinese President Xi Jinping demanded that officials should “exert every effort” to increase the supply of more affordable housing. But that diktat was then modified in 2015 with Xi urging a “destocking” of the property market instead.

Under the “destocking” banner local governments began to offer subsidies to migrant workers to buy urban real estate (including in smaller cities in Henan). Meanwhile, the People’s Bank of China injected fresh funding worth Rmb1 trillion via a new facility known as ‘pledged supplementary lending’ (PSL), a move that acted as a shot of adrenaline for the market.

Transmitted through the China Development Bank, this lending was mainly provided to local governments in smaller cities to carry out ‘shantytown’ redevelopment. But the result was a spectacular boom in construction in smaller cities and counties (generally described as ‘third-tier’ and below). The annual sales of each of the Big Three developers – aka Evergrande, Country Garden and Vanke – almost doubled in two years to top Rmb500 billion by 2017.

“The two years of ‘destocking’ was the best of times for the likes of Evergrande and Country Garden. They gobbled up one small city after another. Local governments and homebuyers embraced the leading developers,” observed the influential WeChat blogger with the pseudonym of Shouye, or ‘Grandpa Beast’ (one of his previous scoops was an article on how a Belt and Road project in Malaysia signified the beginning of the end of Wanda’s overseas M&A drive).

Still, it’s hardly unique for a financially-troubled developer to fail to finish a new piece of real estate. Colloquially known as “rotten-tail buildings”, these projects dot the landscape of many cities during periods when the economy is struggling (the pre-sale practice was an innovation introduced in Hong Kong in the 1950s by Henry Fok Ying-tung, a staunch supporter of the Chinese Communist Party, who allegedly made his fortune shipping materials into mainland China during the Korean War).

In fact, developers are required to dedicate the proceeds of the pre-sold contracts with buyers to working capital for the remaining construction work. The lenders who also provide capital – often the same banks that provide mortgages to buyers of the project – are given supervisory powers to make sure the cash is being properly deployed.

Financial regulations like these have been ignored in places like Henan province, however. Citing an internal document, Grandpa Beast reported that Evergrande has 37 unfinished projects in Henan alone. About Rmb42.3 billion in capital is required to complete their construction but only Rmb2.5 billion in sale proceeds is available in the designated bank accounts of Evergrande’s Henan branch, .

The problem is not confined to Henan, most analysts agree, as evidenced by the way that the ‘Stop Mortgage Payment’ movement has spread across other provinces.

The widespread suspicion: much of the money has been siphoned off to meet other commitments, including the building of other new projects – which helps to explain some of the incredible growth in sales from the larger developers in recent years.

That’s also why a lot of local governments are desperate to deal with the crisis before the central government orders a fuller review. They know that regulations have been ignored and that they will be held responsible for a lack of oversight at local level.

For instance, in a bid to free up some cash and get construction moving again in Henan, officials have been in talks with Evergrande about delaying some of the payments it owes to local governments or even waiving the taxes and land sale fees typically incurred by the developer.

In a number of other projects, Grandpa Beast reports, requests were even made for municipal authorities to return charity donations that Evergrande had made in the past to fund poverty alleviation programmes.

Will the crisis spread to other parts of the Chinese economy?

Ma Guangyuan, an economist and widely-followed influencer, argues that financial regulators must intervene more forcefully to prevent the crisis from worsening. There are already signs that other borrowers are planning intentional defaults – not just aggrieved homebuyers. Hundreds of contractors are complaining that they can’t pay their own debts because of non-payment of fees owed by developers such as Evergrande, Caixin reported this week. “We decided to stop paying all loans and arrears, and advise our peers to decline any requests to be paid on credit or commercial bills,” a group of contractors announced in a letter dated July 15, Bloomberg has reported. “Evergrande should be held responsible for any consequence that follows because of the chain reaction of the crisis.”

The bigger question is whether the mortgage strike could have wider repercussions for the financial system. Song Houze, an analyst at the Paulson Institute in Chicago, reckons that more than $5 trillion of residential property has been pre-sold in China since 2019. Even assuming that just 5% of these contracts can’t be completed, that’s $250 billion at risk.

Senior leaders in Beijing had initially tried to stay away from the situation, relying on local governments to deal with the crisis, Song adds. But many local governments lack the resources to mount fuller rescues, which is why more of these problem situations are emerging. Banks can’t help much either because capital injections are limited by regulations, he says.

The state media has closed ranks to refute concerns that the mortgage boycott could be corrosive for the banking system as a whole, however. “Some Western media outlets have overhyped the issue, alleging that the defaults will pose a threat to social stability,” the Global Times scoffed, insisting that the crisis won’t damage the general health of Chinese banks.

China’s securities regulator also asked banks to report on their mortgage exposure in a bid to boost confidence, according to a report in the Financial Times.

Sixteen banks said they held a collective $414 million in overdue loans on unfinished homes, although not all the banks disclosed their loan numbers.

Song at the Paulson Institute also tried to put the crisis in more context by pointing out that the reversals in China’s property market are much smaller than in the US in 2008. Also different is that households are stopping their mortgage payments because they want their apartments completed, not because they don’t have the money to make the repayments.

Another reason for optimists to think that the crunch will be resolved is that some of the state-backed developers are in better shape financially. Backed by state-owned lenders, they may even benefit from the situation by snapping up quality assets on the cheap. State-owned construction firms have also taken over the contracts of a couple of Evergrande’s stalled projects in Henan. The leading SOEs may end up owning large equity interests in the struggling projects if their work is paid off in this way. (Country Garden’s founder Yang Guoqiang also worked as a contractor until he was forced to take over a massive ‘rotten-tail’ project in Foshan, which laid the foundations for Country Garden as we know it today.)

This might also explain why the share prices of some of the state-controlled property firms have defied weak sentiment in the broader market this year. As of Wednesday, China Overseas Land had climbed 20% since January. Yuexiu Property, a Guangzhou-based SOE that’s reportedly involved in Evergrande’s restructuring, has seen its shares rise nearly 40% during the same period.

Responding to the mounting pressure, Chinese banking regulators have also intervened, vowing publicly to work with local governments to protect homebuyers’ rights. That includes an instruction to lenders to extend loans to developers that allow them to finish unbuilt projects. Officials are also said to be considering allowing homebuyers to hold off on mortgage payments without penalties.

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