Canary in the coal mine!. The largest asset class in the world… | by Sagar Singh Setia | August 2022

The largest asset class in the world has collapsed!

“Your house is not an asset; it is a passive”- Russell Cage.

The history of the idiom “Canary in the Coal Mine” is intriguing. Coal miners, while working one of the riskiest jobs in the world, face a dangerous work environment. One of the many hazards these miners face on the job is the annihilation of toxic carbon monoxide fumes. So Scott Haldane, the dad oxygen therapy, recommended: “canaries” (birds) for detecting colorless and odorless carbon monoxide in coal mines. Canaries are more sensitive to carbon monoxide than humans and are therefore good early detectors of this poisonous gas. If the canaries got sick or died, he would warn the miners to evacuate.

Source: Mirrorpix via Gettyimages

Therefore, “Canary in the coal mine” has become a saying for imminent danger or trouble due to deterioration of health or well-being.

In today’s “globalized” world, the canary in the coal mine is the “Chinese real estate market”. The world’s largest asset, worth $55 trillion, China’s real estate market has been in the news lately for all the wrong reasons.

Today we will discuss the collapse of the Real Estate (RE) sector in China.

As we all know, China has experienced hyperbolic growth over the past three decades. Led by the manufacturing sector, China has taken advantage of its human capital pool and become the global export hub.

The rapid growth of the economy has created immense wealth for the Chinese people. Thus, we have seen a paradigm shift in global net worth:

China accounted for just 1% of global net worth in 1990. This figure has grown significantly to 23% in 2020.

What is fascinating about this wealth generation is that most of the wealth created is in the real estate sector. The “Chinese” love the real estate sector, visible in the data.

Real assets, which were 5.7 times GDP in 2000, have increased to 8 times GDP in 2020! The biggest pie that explains net worth growth is the “asset price increases exceeding general inflation”. This indicates that speculative activity was rampant across various asset classes in China.

A huge proportion of China’s wealth is in the renewable energy sector. According estimates, about 70% of household wealth is in real estate. The highest allocation to the renewable energy sector indicates that Chinese households see the real estate sector as a “lucrative” asset class. China’s affection for renewable energy is a headache for the ruling political class due to the deep integration of the renewable energy sector into the Chinese economy. Let’s understand:

The renewable energy sector contributes about 29% to China’s GDP. To understand the real estate sector in China, we need to understand the local rules and regulations of the RE sector.

In China, the government owns the rights to all city land. Businesses and individuals can purchase land use rights from the government for up to 70 years, after which the lease can be extended.

Land sales are an important source of revenue for local governments. In addition, the funds generated by the sale of land are used to finance various public infrastructure projects.

The exposure of the banking sector is massive to the RE sector. Nearly 27.4% of total outstanding loans were for the renewable energy sector in 2020.

So we have real estate developers, households, local authorities and the banking sector. A lethal combination!

Well, we also have foreign creditors.

China’s renewable energy sector was the elephant in the room. Heavily ‘leveraged’ property developers and longstanding ‘speculation’ in the renewable energy sector were preparing to systematic risk.

As a result, the CCP introduced the ‘three red lines’ policy in August 2020 to limit lending to large developers.

  • An asset-liability ratio (after excluding anticipated receipts) not exceeding 70%.
  • A net debt ratio not exceeding 100%.
  • Cash-to-short-term debt ratio of one or less.

At the end of 2020, only half of the 66 largest developers were complying with the new regulations, exposing the vulnerability of the real estate sector.

The crisis began to unfold in early 2021 when second-largest property developer Evergrande Group, with $310 billion in liabilities and deemed too big to fail by the Chinese government, halted construction on its projects, and the bond prices of all major real estate developers, including Evergrande, fell. In December 2021, Evergrande defaulted on US$1.2 billion of its overseas obligations.

To understand the precarious situation of real estate developers, one must know how real estate developers operate in China.

First of all, we need to understand the main sources of developer funding. The two most significant components are:

  • Deposits and presales: The largest source of income indicates that developers rely heavily on “speculative” activity to finance their projects. Any halt in speculative activity can have disastrous consequences for promoters and lead to severe liquidity shortages. Developers raised more than 6.6 trillion RMB (US$1 trillion) from these two sources in 2020.
  • Self-raised funds and private mortgages: These funds are raised from offshore global investors who, in search of higher returns [due to depressed yields in their home markets (EU and USA)], invest in Chinese debt. Also, a high percentage of private mortgage loans suggests shadow banking involvement in the RE sector.

Secondlywe need to understand the capital structure of major Chinese developers.

The capital structure consists mainly of offshore bonds. Usually, offshore bonds make up 50-80% of the total capital structure. The two reasons to raise offshore debt are:

  • Raising too much onshore debt can violate the three red lines policy.
  • All secured developer debt is onshore debt. Offshore, and therefore unsecured, debt carries a higher coupon than onshore debt.

Thirdly, developers have most of their cash balance in project companies instead of holding companies. As a result, the repayment capacity of the holding company weakens, as it cannot access all their cash to repay their debts.

These are the reasons that have led to the current crisis in the renewable energy sector in China. What started with Evergrande spread like wildfire and led to a series of unstoppable flaws.

A total of 18 property developers have defaulted in the offshore market so far this year, nearly the annual total of 21 in 2021. Chinese issuer defaults have topped 20 billion US dollars so far this year, compared to about US$9 billion for all of last year.

According Goldman Sachs Kenneth Ho:

“In 2022, we have a baseline estimate for a high yield property default rate in China of 19%. Last year it was over 28%, so it’s still at very high levels of payment defaults.

The negative case of 31.6% for the default estimate.

Although many analysts see defaults peaking this year, however, it is too early to call the peak because:

  • Developers are still heavily in debt: In June 2021, the real estate development sector had a debt of 33.5 trillion RMB (5.2 trillion US dollars), according to nomura.
  • Contraction of sales: Most important source of income, sales contract, leading to tighter liquidity conditions. According IHS Rankingscontracted sales will drop 10-20% in 2022. To generate cash, developers have resorted to extreme measures such as accepting Payments in wheat, garlic and peaches!!

With housing starts down to levels last seen in 2015 and completions lagging behind, unfinished projects have seen an astronomical increase. As a result, homebuyers have stopped to pay their mortgage payments. A nationwide embargo on mortgage payments has compounded problems for government and regulators.

About 1.5 trillion yuan ($220 billion) in mortgages are tied to unfinished residential projects. This move by homebuyers has raised suspicions of possible contagion in the banking sector.

There are few options for the CCP to clean up the housing mess. This year, the CCP has taken proactive measures to alleviate the shortage of liquidity in the renewable energy market.

The ultimate solution to completing stalled projects is to resume “stuck” RE projects. The CCP has, to date, taken the following actions:

  • CCP plans to exclude M&A loans from property developers’ debt calculations and allow them to increase their debt levels by 5%. This will make it easier for companies with better liquidity to buy assets from indebted developers.
  • $148 billion funding for cash-strapped developers to complete stalled projects.
  • Launch a real estate fund worth $44 billion.

For cash-strapped state governments, China’s regulator last year announced for the first time a five-year property tax pilot in select areas.

Property tax can be beneficial in two ways:

  • It will supplement the finances of state governments which have dried up after the fall in land sales.
  • This can potentially curb speculative activity in the renewable energy sector as it will become expensive to own a home after the tax is imposed.

Sentiment in the renewable energy sector in China has turned extremely sour. The negative wealth effect (falling prices) coupled with gloomy sentiment does not bode well for Chinese consumer confidence, which has plunged to an all-time low this year.

Source: Crescat Capital

Even though the PBOC and CCP are working around the clock to eliminate malaise in the real estate industry, it would take years for normalization to occur as homebuyers have lost their faith in developers.

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