House Of Cards: China’s Real Estate Problem

Across China, real estate developers are getting desperate. Borderlining on bizarre, a developer in one of the provinces of East China announced a generous barter, declaring that buyers could pay for the dwellings in watermelons, capping the upper limit of the 'fruitful transaction' at 5,000 kilograms and 100,000 yuan.

While the promotional activity was suspended after it became a subject of ridicule within the economic and political circles, the developer maintained that the objective was to aid and support the local watermelon farmers.

This is not the first bizarre story from China’s real estate sector. In the second-half of 2021, authorities in China demolished 15 skyscrapers with 4.6 tons of explosives across 85,000 blasting points, all in 45 seconds. The buildings, unoccupied for almost a decade, were described as an eye-sore in the local newspapers.

The developer behind the project had already filed for bankruptcy, citing heavy losses. The demolished skyscrapers, however, were only a tip in the ocean of the real estate crisis that threatens the Chinese economy today.

Earlier this month, buyers launched a protest, an unthinkable in China, stating that they would not make their monthly mortgage payments until the projects were completed.

Not deterred by the impact on their social credit scores that could restrict their travel and label them as troublemakers, the movement threatens to takedown the entire real estate market in China, given how many developers grapple with the liquidity crisis.

The concerns are not limited to the developers alone, for bankers and promoters behind these projects, many of them local, could face a run on their deposits, triggering another crisis. Given a lot of the buyers make 100 per cent payments before the houses are delivered, the consumption economy also suffers.

Together, close to $590 billion can be attributed to unfinished real estate projects in China. The authorities immediately swung into action, with the Chinese banking regulator assuring that the construction would be accelerated.

The story of China’s real estate crisis begins after the Great Recession of 2008, incidentally, triggered by another housing situation in the United States. Three factors triggered the building spree in China.

One, the economic stimulus that almost all major economies ushered after the slowdown of 2008. Two, the growing urbanisation and an anticipation of housing demand in cities, and finally, the generous capital that was available to developers at throwaway interest rates, thanks to the backing of the state.

The building spree aided other sectors of the economy as well, thus accelerating the overall economic growth. The magnitude of the building spree can be gauged from the fact that China’s debt-to-GDP went from a little over 150 per cent in 2008 to more than 260 per cent by 2016, majority of which was held by corporations.

Post-2015, the ‘Ghost City’ phenomenon started becoming common. Houses with no residents, commercial estates with no offices, and localities with no communities.

The consequences of the ‘Ghost City’ phenomenon led to low returns for the local governments while they were taking on more debt. Eventually, to service the previous debt, these provincial and local administrations took more loans, thus getting trapped in a debt loop.

Today, in 2022, after two years of Covid and fifteen years of unchecked infrastructural expansion, the prices of the houses are falling, even with a generous mortgage policy, loose monetary policy, and other subsidies.

When the signs of the ‘Ghost City’ phenomenon first appeared, developers introduced many promotional schemes. While not lowering the price of the dwellings on paper, the developers were offering discounts as high as 50 per cent in some cities, back in 2013-14.

To push couples into making the purchase, some were giving away a session with the wedding photographer for free, some were giving a one-plus-one deal on apartments, some offered free furniture and appliances, and some went too far, offering a plot to grow vegetables with every villa. Eventually, the watermelons arrived, eight years later.

Around $19 billion of it is owed in dollar bonds alone. In 2022 alone, bond payments in excess of $7 billion were due for the developer.

While the exact details of Evergrande’s restructuring are currently under wraps, the objective would be to protect the Chinese homebuyers before the offshore bond holders. Almost two million in number, the restructuring process will ensure that the existing buyers do not lose out on their homes, most of them unbuilt as of today, and will factor the need to keep the company’s other real estate projects going.

The offshore bond holders, however, will have to prepare for a haircut or a prolonged payment process, and perhaps may have to settle for as much as 20 cents on a dollar.

What complicates their case further is the workaround Chinese companies have been employing for almost a decade now, also known as the Keepwell obligations. Just as is the case with the variable interest entity (VIE) structures with the stock market listings in the United States, the bond market equivalent is the Keepwell obligation, which is nothing but a word of promise from the borrower.

For offshore borrowing through bonds, a Chinese company’s offshore subsidiary raises money from foreign investors with the parent company in mainland China, otherwise not allowed to directly borrow from foreign investors, guarantees the financial backing and payment on the bonds issued.

Therefore, there is no formal guarantee from the parent company in mainland China on the bond, and in case of defaults, as is the case with Evergrande, there is no formal avenue or recourse available.

Thus, the impact is being felt by other developers who used dollar bonds to take on more debt to continue their building spree. In March 2022, some of these bonds were paying a 32 per cent yield, higher than what was in 2008. In the last few quarters, the quantum of dollar bonds issued has also come down significantly, compared to 2018 and 2019.

For Q1, 2022, the issuance was down by 97 per cent compared to Q1, 2021, thus triggering another crisis for the developers. The other worrying sign is the $13 billion payment in interest due for the next 12 months.

Beijing, late though, was not oblivious to the growing crisis, and in August 2021 introduced the ‘three red lines’ system under which the financial health of a real estate group was evaluated. The parameters included ratio of liabilities to assets, net debt to equity, and cash to short-term borrowings.

According to an analysis in the Financial Times, as many as 14 of China’s big developers were in violation of these guidelines. Most developers had a liability to assets ratio in excess of 70 per cent. While the cash to short-term debt ratio was not alarming most developers, they were flirting with trouble. For Evergrande, for instance, it was 0.55.

The falling home prices, the lack of demand, the unfinished projects, and the constraints in raising dollar debt will test the resolve of President Xi Jinping and his economic experts in Beijing.

The mortgage protests may be silenced in the coming weeks, but the consumer sentiment has been dented for more than a few quarters now. What else explains Beijing’s crackdown last year on property prices while advocating a three-child policy for couples.

China’s real estate sector and its related activities make up for 30 per cent of the country’s economy. This includes construction, raw materials, interiors, and so forth. Even then, the real estate crisis, starting with Evergrande, is not heading for a Lehman-like crash, for even the latter was a miscalculated step on the part of the Federal Reserve.

However, the music is slowing down for more state sponsored debt cannot fix the underlying debt trap problem, more construction cannot fix the pricing bubble, low interest rates cannot fix the demand problem, and finally, no longer can China build its civilisational renaissance in ‘Ghost Cities’.

If Lehman was a point-blank shot to the head of America’s economy, China’s real estate crisis will resemble a knife slowly piercing through the economic spine.

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