How China’s real estate developers got into such a mess

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Real estate is very important for China: Since President Xi Jinping took office a decade ago, real estate construction and sales have been the biggest engines of economic growth. Real estate prices have skyrocketed — sixfold over the past 15 years — as a burgeoning middle class gravitated to real estate as one of the few safe investments available. The boom led to speculative buying as new homes were pre-sold by developers who increasingly turned to international investors for funds. As Chinese officials took steps to reduce the risk of a bubble and mitigate the inequality that unaffordable housing can create, it sparked a crisis that has pushed some big developers into default. A slump in sales that began during the pandemic has been deepened by aggressive measures to contain Covid-19. So far, government intervention has prevented a disorderly real estate collapse that could undermine the financial system and also shake the global economy.

1. What fueled the real estate boom?

When China created a nationwide housing market in 1998 after decades of severely restricting private sales, only a third of its population lived in cities. Now nearly two-thirds do, adding 480 million to the city’s population. The real estate sector was also expanding rapidly, but struggled to keep up. Boom cities like Shenzhen became less affordable than London or New York on a price-to-income basis, frustrating a generation of prospective buyers. Local and regional authorities, which depend for a large part of their income on the sale of public land, encouraged more development, which also helped meet the central government’s ambitious annual targets for economic growth, which were often in double digits. The debt piled up as builders rushed to meet demand. Annual sales of offshore dollar-denominated bonds — those sold primarily to foreign investors — rose to $64.7 billion in 2020 from $675 million in 2009, leading to a rising interest burden . Developers had about $207 billion in dollar-denominated bonds outstanding at the end of last year, about a quarter of the total for all Chinese borrowers. Additional, opaque liabilities complicate the assessment of real credit risks.

2. What has the government done?

It has tried for years to defuse the debt bomb amid fears an explosion could trigger a catastrophic financial crisis. In mid-2020, she began forcing new financing on real estate developers to reduce the threat and urged banks to slow the pace of mortgage lending. New loan metrics introduced for developers proved to be a game changer. Dubbed the “three red lines” by state media, they aimed to reduce reckless borrowing by setting thresholds on a developer’s liabilities, debt and cash holdings. Annual borrowing would be capped based on the number of parameters met.

3. What happened to the developers?

Those who did not have enough cash on hand to cover their liabilities found themselves in a bind. At least 18 have defaulted on offshore bonds after the raid began. China Evergrande Group, once the country’s biggest developer, was declared in default for the first time in December after missing payments on several bonds. The establishment of a “Risk Management Committee” dominated by provincial officials was quickly announced to avert a complete collapse of the company. (Bondholders were still wondering how much they would take in once the dust settled.) Others, including Kaisa Group Holdings Ltd. and Sunac China Holdings Ltd., followed. Fears of further contagion are reverberating across the industry and economy, pounding domestic growth, eroding consumer confidence and rattling global markets that have long assumed China’s property giants would be government bailout.

4. Where is the industry?

In a deep slump. The combined revenues of the top 100 developers have halved in the first four months of this year compared to the previous year. Home loan growth slowed to its weakest pace in over two decades in late March. Construction activity fell 14% year-on-year in 2021, the steepest decline in six years. All of this is of great importance as the real estate sector in China accounts for nearly a quarter of gross domestic product when non-residential construction, building materials and related activities such as real estate services are included.

Across China, millions of square feet of unfinished homes are gathering dust as developers face liquidity problems. House prices began falling in September for the first time in six years. A full-blown housing crisis could leave in limbo millions more homebuyers who put up money up front. (Buyer protections common overseas, such as escrow and installment payments, have tended to be weak.) Fire sales would further plunder the market, pressure other developers and hurt related industries and suppliers. The risk of civil unrest – more than 70% of China’s cities’ wealth is stored in housing – would rise and unsettle the government. A historic offshore bond sell-off would spill over into the much larger domestic credit market, spreading from lower-rated real estate companies to stronger peers and banks. Global investors would sell even more.

The government has adjusted some rules to stabilize the situation. For example, the central bank increased its support for several distressed property developers, and banks were directed to provide growth in both home mortgages and property developer loans in some areas. Most importantly, avoiding a “Lehman moment” – when the US bank collapse in 2008 sent shockwaves through global markets – is a priority ahead of this year’s Communist Party congress, where Xi is expected to win a third term. This political necessity most likely means that the government will try to contain the crisis, at least in the short term.

More stories like this are available on bloomberg.com

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