As China’s property crisis plagues its economy and financial system, is a ‘Lehman Moment’ looming?
- China Evergrande Group reported losses of 812 billion yuan (US$112 billion) for 2021 and 2022, while fellow property developer Country Garden is on the verge of a bond default
- A so-called Lehman moment – where one company’s problems become everyone’s problems – is seen as unlikely, but mounting problems are set to test Beijing
Two years after the bond default by one of China’s biggest real estate developers created the first shock waves, Beijing’s promise that everything is under control is becoming increasingly harder to sell to investors.
Its bankruptcy protection application filed in a US court last week also grabbed significant attention on Chinese social media.
How can it comfort hundreds of thousands of people who are making mortgage payments for homes that have not been delivered? How can it appease worried investors who are shunning Chinese equities? How can it turn around a growing number of bearish views about China’s financial system and its economic growth?
Global investors, Chinese homebuyers and economists are now holding their breath to see which domino will be the next to fall, and what tools Beijing can use to prevent its own so-called Lehman moment – a phase drawn from the late 2008 bankruptcy of global investment bank Lehman Brothers to describe the trigger of a systemic risk outbreak.
And dozens of private developers in China could also follow suit.
“I don’t think there’ll be a Lehman moment,” said George Magnus, a research associate at Oxford University’s China Centre.
“In a state banking system, the authorities can move liabilities around the financial system and use ‘extend and pretend’ accounting to ensure that major banks don’t fail and that smaller ones can be made good or merged as necessary.”
However, multiple failures with high connectivity will test Beijing’s capacity to prevent contagion, he warned.
“If anyone is expecting a single sudden event to cause a near collapse of the banking sector then they don’t understand how the system is set up and structured,” said Fraser Howie, co-author of Red Capitalism: The Fragile Financial Foundations of China’s Extraordinary Rise.
China’s banking system, which is estimated to have large exposure to the property sector, is largely controlled by state-owned players such as the Big Four banks of the Industrial and Commercial Bank of China, China Construction Bank, the Bank of China and the Agricultural Bank of China.
However, “pressures play out in a different way,” added Howie.
Property is the most prominent risk in China, in addition to local debt and small bank stress, because it is deeply integrated into the national economy, affecting anyone from iron ore miners to steel and cement producers, home decoration businesses, domestic appliance makers, construction workers and millions of homebuyers.
It is also deemed as systemically important worldwide.
The US subprime loan crisis 17 years ago – which involved offering mortgages to prospective borrowers with impaired credit records – was amplified by complicated financial packaging and eventually evolved into a global financial crisis.
Following the collapse of Lehman Brothers, Washington bailed out the likes of AIG and Goldman Sachs, while the British government also nationalised Northern Rock Bank.
“One challenge in the specific Chinese situation is that very high growth can hide a multitude of problems, which then gets exposed when growth slows,” said Jon Danielsson, director of the systemic risk centre at the London School of Economics.
“Just like when the level of water in a lake falls, we see a lot of things we didn’t know existed.”
The Chinese translation of Danielsson’s book, The Illusion of Control: Why Financial Crises Happen, and What We Can (and Can’t) Do About It, recently attracted attention after it was translated by China’s vice-minister of finance, Liao Min.
Danielsson particularly warned about the “unknown-unknown risk”, which is beyond the capability of a government to know and to deal with.
“The lesson is that the trigger for a crisis episode can come out of nowhere, just like the [US] subprime [crisis], and there is no way for a government authority to be aware of all of them,” he said.
“What matters is how it reacts to the crisis.
“[However,] when the policymakers and government react at the last moment without having planned or thought through all the angles beforehand, often because they hope things will get better, is the scenario that is particularly costly.”
It turned into a pillar industry which contributed to more than a quarter of the national growth in its heyday in 2010s.
Rising home prices also drew increased speculation, forcing Beijing to install a variety of purchase, sales, mortgage and credit restrictions.
According to a survey by the People’s Bank of China in early 2020, property accounted for 59.1 per cent of household wealth and three quarters of their household liabilities.
China’s property crisis initially started in early 2020, when the coronavirus halted the cash flows of major developers.
They were originally rolled out under the thought that the property sector is China’s largest “grey rhino” risk and answered President Xi Jinping’s warning that “houses are for living in, not for speculation”.
At the end of June, outstanding bank loans to the property sector grew by 0.5 per cent from a year earlier to 53.37 trillion yuan (US$7.4 trillion), government data showed. It includes 13.1 trillion yuan for property developers and around 38 trillion yuan of mortgage loans.
According to calculations by 132 domestically listed developers by Chinese data provider Wind, combined sales revenue fell by 8.3 per cent last year – the first since 2005 – while their debt ratio was 78.99 per cent in 2022, only slightly lower than 79.03 per cent in 2019.
The data, though, did not include Evergrande and other Hong Kong listed firms.
Their return on equities registered the first decline on record of 3.78 per cent, and the domestically listed developers reported a combined loss of 66 billion yuan (US$9.1 billion) – also the first loss since the data became available.
They also had a new cash outflow of 285.6 billion yuan from their fundraising activities – a sign that the sector is struggling to seek external funding from banks, investments or bonds.
But the problems have not significantly spilled over into the financial system.
The non-performing loan ratio in the property sector was 1.4 per cent when it was last released in 2020, the highest since 2010 but lower than 9.2 per cent in 2005 and 3.35 per cent in 2008, according to data provided by the National Financial Regulatory Administration.
China, though, has not updated the non-performing loan ratio for the property sector since 2020.
But the overall non-performing loan ratio for commercial banks was just 1.62 per cent by the end of June, lower than 1.81 per cent four years ago.
“State ownership provides Chinese banks with a degree of protection against problems elsewhere in the financial system and there are currently few signs of any strains in the interbank market,” said Julian Evans-Pritchard, chief China economist at Capital Economics.
“But even if a wider financial crisis is avoided, shadow bank failures are likely to result in tighter credit conditions for subprime borrowers.”
Zhongzhi Enterprise Group, one of the country’s largest private wealth managers, have reportedly failed to repay some maturing products under more than 1 trillion yuan of assets that the company manages.
“The next few weeks are crucial, as the clock is ticking for some of the major developers,” said Larry Hu, chief China economist at Macquarie Capital, who attributed the ongoing property woes to a downward spiral between confidence and sales.
“Now the game changer is a package of policy measures, which is strong enough to turn around the market expectation and pull the housing market out of the current downward spiral.”
The one-way bet on property is now waning as the myth that China’s property prices will keep rising has been broken.
The value of property sales in the first seven months of the year fell by 1.5 per cent to 7.05 trillion yuan, while the floor space sold dropped by 6.5 per cent from a year earlier to 665.6 million square metres (7.1 billion sq ft), government data showed.
In June, the central bank extended 200 billion yuan of relending quotas to ensure completion of unfinished property units and allow commercial banks to roll over maturing loans after the Evergrande crisis, extending the policies until the end of next year.
Different from Western bailouts, Beijing tends to allow state-owned players and banks to help absorb troubled companies.
In the case of Evergrande, authorities dispatched special teams to the company to ensure the delivery of property units, the management of debt repayment and to ensure overall social stability.
In a de-risking conference on Friday, China’s central bank, as well as its banking and securities regulators, pledged to optimise credit policies and enrich tools to defuse local debt risk.
“We must firmly defend the bottom line of preventing systemic risk,” they said.
Bridgewater founder Ray Dalio said that China is better positioned than many other countries because debts are largely in yuan and they are largely owed to domestic citizens and institutions.
“There is an obvious need for a big debt restructuring of the sort that Zhu Rongji engineered in the late 1990s, just much bigger,” he said on Friday, referring to Zhu’s move to set up four national asset management companies to split bad loans from state banks.
The legendary fund manager’s “beautiful deleveraging” theory, which balances deflationary defaults and restructurings with debt monetisation to spread out the burden, has attracted significant attention from high-ranking Chinese officials in the past five years.
“If the government has tools to change the dire economic situation then they either aren’t using them or they are not working,” added Howie.
“The best scenario is muddling through where the government manages a slew of chronic economic problems and hopes they don’t become acute ones which could have significant shocks or cause panic, i.e. allowing localised bank failures but ensuring the state banks in big cities don’t see [bank] runs.”
A likely outcome, according to Magnus, is that the real estate waves are likely to last a long time and the only viable solution is by allocating the costs of the crisis to someone – government, banks or homebuyers.
“In China’s case, this might mean the resocialisation of much of the housing sector,” he said.
“I don’t think anyone should think there’s a free lunch out there or that this won’t be a painful experience.”