Why the loss of confidence in China’s property market is set to persist

Beijing has been more resolute in reining in the excesses in the property sector in the face of a sharp slowdown than markets anticipated
Expectations of a dramatic reversal are unrealistic. Restrictions will be gradually eased, but the priority of taking the heat out of the market remains unchanged

Nicholas Spiro

Published: 6:45am, 4 Jan 2022

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In financial markets, there are many examples of investors getting ahead of themselves. One of the most conspicuous ones in the past few months is the improvement in sentiment in China’s equity and corporate bond markets in response to signals from Beijing that monetary and fiscal policy will become more accommodative this year.

Since last October, a growing number of leading investment banks and asset managers have turned bullish on Chinese stocks, enticed by cheap valuations and a belief that most of the bad news is already priced in. JPMorgan expects offshore Chinese shares to rise by as much as 32 per cent from current levels by the end of 2022.

Implicit in these optimistic predictions is the view that the downturn in the property market – the largest driver of China’s economy and the acid test of Beijing’s efforts to reduce corporate indebtedness and social inequality – will bottom out as the government takes action to shore up demand and prevent more widespread financial contagion.

Investors have drawn comfort from a series of growth-friendly statements and measures in recent months. The government has leaned on major banks to speed up mortgage approvals and made it easier for creditworthy developers to issue debt onshore.

The moves have reinforced a perception in markets that Beijing has decided its deleveraging campaign has reached its limits and the slowdown in the housing market must be reversed. Yet, while investor sentiment towards the property sector may have stabilised, confidence among homebuyers, developers, creditors and local governments continues to erode.

China’s debt-to-GDP ratio falls, but pace of deleveraging slows

In a sign of how much the fundamentals of China’s residential real estate market have deteriorated, nearly 30 per cent of the sector’s high-yield bonds – which account for the bulk of Asia’s sub-investment grade corporate debt market – were trading at distressed levels early last month, according to JPMorgan data.

The prices of new homes in 70 cities, which began a month-on-month decline in September, continued to fall in November. Meanwhile, sales were down 17 per cent year on year.

The declines will be much sharper in the coming months as base effects from comparisons with the post-pandemic surge in demand in the first half of last year magnify the impact of the slowdown. In a report published on November 26, Macquarie predicted the first half of this year would be “the darkest moment”, with key property indicators likely to “look awful”.

At the heart of the acute stresses in China’s housing market is the far-reaching regulatory changes in the way developers finance, build and market their schemes. A clampdown on the use of presale income – the practice of selling flats long before they are delivered – to ensure developers have sufficient funds to complete ongoing projects has opened a Pandora’s box of problems for the sector.

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Chinese real estate giants Evergrande and Kaisa continue unloading assets to cover debt

Other sources of financing, notably bank loans, have dwindled in recent years. As that happened, developers’ heavy reliance on the proceeds from prepaid homes – which account for nearly half of builders’ cash inflows, according to Bloomberg – has exacerbated a funding squeeze that has upended companies’ business models and amplified the threat posed by the housing slowdown.

This has set off a dangerous chain reaction of panic and uncertainty across the sector. Local governments, worried some projects will never be completed, are tightening monitoring of presale proceeds, making it more difficult for weaker developers to repay their debts and worsening the liquidity crunch.

Homebuyers are losing faith in developers and postponing their purchases. Risk aversion among creditors and investors is intensifying, increasing the probability of further defaults.

In a report published last month, ratings agency Moody’s said China’s property industry was “caught in a negative credit loop”. This means the sector is suffering a crisis of confidence that threatens to become self-fulfilling if the government does not take more aggressive action to stabilise the market.

Many equity and corporate bond investors seem to believe a shift towards looser policy will become more apparent in the coming months. Yet, the level of conviction over the timing, scope and efficacy of a policy shift, even among the most bullish investors, is strikingly weak.

This is because Beijing has been more resolute in reining in the excesses in the property sector in the face of a sharp slowdown than markets anticipated. In its report, Macquarie said the biggest risk this year was “policy undershooting”, with Beijing refraining from taking much stronger action lest it return to its discredited playbook of using real estate as the vehicle for delivering stimulus.

While the precise level of the government’s pain threshold is unclear, expectations of a dramatic reversal in policy are unrealistic and should not be the overriding reason for investors to pile back into Chinese equities this year.

A far more likely scenario is that policymakers’ recent change of tone on the property market becomes more pronounced in the coming months. Restrictions on the sector will continue to be gradually eased, but the priority of taking the heat out of the market remains unchanged.

Doing the bare minimum to support the housing sector increases the risk of a policy mistake, and it makes it more likely that confidence in the industry will continue to deteriorate. While Beijing has the tools to avert a sharper downturn, its reluctance to use them more forcefully is an underappreciated risk in markets.

Nicholas Spiro is a partner at Lauressa Advisory

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