Evergrande – has the bubble already burst?

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the Evergrande (HKG:3333) the saga continues. Singapore-based REDD Intelligence reported that Chinese authorities plan to exclude debt accrued by property developers in relation to troubled assets when assessing their adherence to the “three red lines” policy.

This latest initiative was introduced in August 2020 to limit leverage ratios within China’s massively indebted real estate development industry, specifically liabilities to assets, net debt and cash to debt. short term.

You never feel quite confident when quoting state-sanctioned economic data out of China, but there were signs that the actual forced deleveraging had taken some of the steam from the local real estate market. Initially, this even resulted in several rating upgrades for real estate developers.

You would be justified in wondering if these upgrades were too optimistic. Because if Beijing intends to falsify the basis on which debt ratios are calculated, it could signal that prices and volumes within the sector remain under severe pressure.

This raises the question of whether China’s housing bubble has already burst and whether we haven’t noticed or acknowledged it due to broader pandemic-related distractions? It may sound like a somewhat fanciful notion, but few have identified the systemic flaws in the US housing market that undermined the global financial system in 2008.

China’s exposure to the sector is well rated. With a dearth of alternative paper assets, investors have had few places to park their money. Thus, about 90% of households in the country own an apartment, but about a quarter of apartments in China are empty. This partly reflects the constant “rollover” of properties, which has significantly driven churn and prices.

Although buyers in the country generally come to the market with significantly higher deposit levels than in the UK, they have a greater proportion of their net worth tied up in speculative property assets, a real problem when prices rise. reverse for a while. In December, transaction volumes fell 38% year-on-year.

Bubbles develop against assumptions about future prices that are unsustainable. Consider pre-pandemic analysis by the US-based Urban Reform Institute, which found China’s housing market to be “severely unaffordable” based on a price-to-income ratio of median house price . Admittedly, housing affordability has deteriorated in many geographical areas, but China remains an exception in this respect.

Chinese property developers must repay double the amount of dollar-denominated offshore debt in the first quarter of 2022 compared to the fourth quarter of last year, a period during which they struggled to meet their funding obligations. Institutional investors are clearly getting nervous due to the collection of defaults offshore. Reuters reports that an ongoing bond sale is impacting China’s largest homebuilder, country garden (HKG:2007), left most of its debt securities in international markets below face value.

It is possible that the Chinese economy will find sufficient support due to the increase in liquidity caused by the actions of the People’s Bank of China, in particular a reduction in the reserve requirement ratio for banks. But the potential scale of the problem for policymakers in Beijing is clear enough given that the real estate sector accounts for about 30% of China’s economic output, so its health is tied to the outlook for the global economy.

Closer to home, investors would not be unscathed if a controlled (structured) decline in China’s property market gives way to an uncontrolled collapse amid a cascade of defaults. Shareholders in the mining sector are already feeling the ripple effects of the first. Spot iron ore prices have contracted 42.6% in the past six months as a growing number of real estate development projects in China have been suspended or cancelled.

The ripple effect will not be limited to the commodity complex. If the adverse effects of China’s real estate crisis continue to ripple through the wider economy, the outlook for overseas-listed companies with significant business interests in China will also deteriorate, while luxury goods suppliers will also suffer a severe blow. The reality is that real estate investment supports a range of industry sectors, including construction, building materials and consumer electronics.

Some pundits have drawn parallels between China’s current woes and the asset price bubble that foreshadowed Japan’s so-called “lost decade.” This might be overstated given that the problem in Japan was largely due to inadequate oversight of the corporate audit process, allowing companies to hide the exact level of their indebtedness through subsidiaries. Nevertheless, there is a certain irony in the fact that it was also widely believed that Japan was on the verge of eclipsing the United States as the world’s preeminent economy before things turned sour.

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