China Property Crisis Spreads to Markets: Waiting for A Rescue
Bottom Line: Timely action is required from China’s authorities to avoid financial market problems intensifying the headwinds for the property sector and economy. It is interesting that a Yuan 1trn LGFV debt swap package is being delivered to support the weakest LGFV’s (here). However, the authorities will likely still use the opaque Evergrande model for any large property developers restructuring, while problems for weaker wealth managers or banks will likely be followed by forced takeovers (PBOC feels that the system has a whole is stable (Figure 1)). This can stop the financial crisis from spreading, but is not aggressive enough to cause an improvement in property and consumer sentiment and can act as a further drag on the economy.
Reports that a major China property developer is looking to extend maturing Yuan bonds after missing USD bond payments last week, plus reports that a wealth management company has delayed paying clients, has caused new jitters about the property spill over into Chinese financial markets.
Market Implications: China’s markets will likely be on a rollercoaster with worries increasing through August that the crisis is spreading. Though this mainly impacts China borrowers and creditors it can spill over to global markets if it causes a China growth scare. Action from China authorities should arrive and this can calm the fears, though not remove them completely.
Figure 1: PBOC Banking Sector Stress Tests (%)
Source: PBOC 2022 Financial Stability Report (here)
The fallout from China’s property market is now spread into financial markets, through two channels. Firstly, lower property transactions are hurting developer’s profitability and LFGV’s revenue, as property prices have not been adjusting enough and this is hurting sales and taxes. Secondly, concerns about weaker borrowers/intermediaries solvency is causing difficulties in rolling over debt/securing new debt or sustain the old model of homeowners making large prepayments for new property construction. This is a systemic issue for China’s weakest borrowers and not just one or two institutions. Friday already saw China’s authorities dealing with the weakest LGFV’s with a Yuan 1trn debt swap to ensure survival for the weakest LGFV’s.W hat will the authorities do to rescue the weakest property developers/wealth management companies and banks to avoid a wider financial crisis?
Country Garden remains in the spotlight with USD bond payments overdue (now in a 30 day grace period before September 6), but reports that they want to extend a maturing Yuan bond -- the company is a major developer in tier 3 and 4 cities. China authorities will likely soon get involves as a full scale default would sent shockwaves through the property sector and financial market. The opaque Evergrande model will likely be used for any major property developers where provinces/major banks and private sector companies take control and design a multi-year shrinkage that ensures existing construction is complete and supporting stakeholders (employees, sub-contractors, LGFV’s etc.) and that only a weak rump company is left. Such a move ensures that the restructuring occurs on a multi-year basis, but will not restore confidence towards property developers. A more aggressive policy of a government backed bad property asset company (like Ireland NAMA) or a direct government bailout is unlikely.
Problems from the property sector are also spreading to holders of property developers bonds and loans, with Zhongrong international trust (part of a large wealth manager) reported to have delayed payments to clients (here). Trust and wealth management companies have invested in the stock and bond markets, but will likely have seen some losses from defaults from small to mid-sized property developers (e.g. KWG here) and this could be impacting this sector. The normal approach for China is the global approach of ensuring a takeover by a stronger wealth manager or bank. This may need to be done if sentiment sours any further and withdrawal pressure increases.
The 4th spillover segment is weaker rural and commercial banks that have provided loans to the weakest property developers and LFGV’s, where the lagged feedthrough of lower property sales will hurt loan repayment and cause NPL problems for the weakest banks.This is not just a function of the size of NPL’s, but also loss on default (LOD) – property developers bonds shows fears of large LOD. The game plan from China’s authorities is likely to remain the same as outlined to the IMF in 2022 (here).The IMF at the time judged that property developer’s bank debt was a modest percentage of GDP (Figure 2).
Figure 2: Chinese Real Estate Firms’ Liabilities (% of GDP)
Source: IMF GSR April 2022
The Chinese authorities stated in the IMF Article IV consultation that the policy was to encourage capital for sustainable banks (though public recapitalizations as a final backstop to reduce moral hazard) and that unsustainable banks should make an exit. Though the IMF idea of a temporary fiscal backstop for a weak bank resolution fund was rejected, China’s authorities have enough experience and flexibility to provide tailored support/takeover for select banks or a group of banks or close failed banks if required. This was most clearly shown in the 1997-05 big bank rescue. The weakest area of the banking system is rural commercial banks, with PBOC 2022 financial stability report making clear that the PBOC is comfortable with stress tests for systemically important banks (Figure 1). Weaker banks will likely be bailed out or directed to merge by local governments. This occurred in 2022 with the merger of five rural banks in Shanxi and three in Jiangsu. Finally, unsustainable banks could be left to fail once good assets have been removed, like Baoshang Bank in 2021 (here) — though depositors and wealth management product holders were paid out by the authorities.
The PBOC feels that systemically important banks (D-SIB’s) can weather the severe adverse scenario of 1.80% and 2.86% GDP growth in 2022 and 2023. Any individual problems could be dealt with via use of excess provisioning and profitability hits. These 19 D-SIB banks loans at the end of 2021 was Yuan120.2trn or 71.2% of the total banking system. However, the 3989 non-D-SIB banks were more stressed than SIB’s in all five stress tests and a 400bps increase in NPL’s would cause widespread problems (Figure 3).These 3989 non SIB banks have a total of Yuan 48.5trn loans end 2021 and are 125 city commercial banks and the rest rural banks/cooperative and village banks.
Figure 3: Solvency Stress Test for Systemically Important and Non Systemic Banks
Source: PBOC 2022 Financial Stability Report (here)
All of these financial safety nets are likely to be actively used to curtail spillover damage to the banking and financial sectors. However, the growing spillover of the crisis in sales in the property sector can hurt wider business and consumer sentiment, due to financial support programs for four parts of the financial and economic system: the weakest LGFV’s, property developers, wealth management companies and banks. With policy rescues likely to be patchwork, it is likely that the authorities will not be seen to be aggressive and this could cause more adverse effects on the economy. Timely action is also required, as it is mistake to intervene too late and allow a major failure to occur in the financial ecosystem.