From Country Garden to Systematic Defects (Part I)
Chinese Property Sector Crisis Overview and Difficulties in Carrying out Immediate Rescue
Date: 15 September 2023
Entrance of Shunde Country Garden.
Courtesy of SDBKU (2006).
China’s property and housing market is on its way to potential turmoil. Country Garden, one of China’s most financially magnificent and profitable property management companies, failed to repay offshore US dollar bonds worth a total of 45 million USD on August 6th. The confidence of investors and shareholders plunged. By August 14, Country Garden’s share value dropped 17.4% in the Hong Kong stock market to HK$ 0.81. Even though the price slightly rose after China’s politburo announced a 50% cut in stock stamp duty, the value is still far from its highest point of HKD$3.24 in 2023. Similarly, property sales for Country Garden dropped to 7.98 billion in August, which resulted in a 72.4% and 33.9% decrease when compared to figures last year and last month respectively.
The primary concern to observers is whether the incident will trigger a crisis acute to the 2008 financial crisis. Large-scale collapses in the housing sector often have a significant impact on banks and trusts who funded the construction, investors who supported the corporations, presale property house owners who are waiting for their property to be completed, as well as the general market which is correlated with all three. While I do not concur that a Lehman-style incident will occur immediately in China, the incident does reflect systematic issues lurking in China’s model of economic development. In this article, I aim to explore the implications of the incident on China’s economic expansion, both immediately and potentially in the long run.
I will first explain why the possibility of the incident turning into a global or even regional financial crisis is limited. Then, I will turn to explain how in the short run, the Country Garden incident may magnify investors’ distrust towards the Chinese economy, slowing down its process of recovery. In terms of future implications, I will showcase the detrimental effects of inconsiderate state measures on China’s way of economic development. Overall, these consequences are bred out because of long-term policies enacted by the Chinese state. Therefore, whether China can sustain its path of extraordinary development remains a question one could ponder.
Skyline of Guangzhou City, China.
Courtesy of Wallpaper Flare (2023).
A Spreading Crisis?
Most noted that the Country Garden incident and the Lehman Brothers crisis bear similarity in that both corporations involved are financial giants engaged in high-risk investment, are linked to the banking sector and involved a large number of investors, and in Country Garden’s case, property owners. Nevertheless, a major difference is that Country Garden’s demise is more or less a ‘grey rhino’ event, which could be more or less predicted according to Chinese policy and market trends.
Unlike the 2008 financial crisis, which stemmed from a sudden crash of a renowned financial firm, the debt crisis faced by Country Garden is precedented by a similar issue confronted by Evergrande, another property giant. Evergrande has similarly engaged in large-scale off-balance sheet financing, with approximately 96 billion spent in 2017 alone in acquiring land-use rights through fundings possibly acquired from trust companies. The oversupply of property and huge rate of loans gradually resulted in liquidity problems within Evergrande, with signs of missing payments rising from August to September 2021. In November, Evergrande defaulted on multiple bonds, including those issued in US dollars.
Behind Evergrande’s liquidity problem is an overheated property market. The high-leverage operation of property developers is unsustainable because it is based on overestimating the aggregate demand for housing. Although residential property prices have recorded a 4.8% growth in 2020, around 20% to 30% of real estate properties are in a state of vacancy. The elevated vacancy rate is both due to high prices and oversupply. In 2020, more than 90% of households in China owned homes, with 20% owning more than one. However, at the same time, the housing supply has not slowed down, with 400 to 500 million square metres of living spaces in construction. The high property supply does not match the real demand for housing, resulting in an economic bubble.
Chinese construction worker standing outside of a building yet to finish.
Courtesy of the World Bank (2007): https://flic.kr/p/3jP9wP.
In the case of Evergrande, the insufficient demand limited its ability to profit, which made it difficult to repay debts. Speculators and investors alike also gradually lose confidence in continuous market growth. This is why the former president of China’s central bank Zhou Xiaochuan has warned of a Minsky Moment, a sudden collapse in asset value due to the economic cycle, if the housing market in China continues to be overvalued. This certainly is the case for Evergrande’s default, when its use of high leverage operation to support an oversupply of properties collapsed in the face of liquidity problems. However, the impact of the Country Garden crisis is not on the same scale.
Since Evergrade and a range of other property corporations have already gone into default in 2020, the market had low expectations for the performance of the property sector prior to the Country Garden crisis. Therefore, the shock caused directly by the Country Garden crisis was not as vigorous as the former crashes. Fewer investors have brought in shares from related corporations, limiting the overall damage caused. The same could be said for actors that gradually withdrew cooperation with property developers, one of which is the group of local governments of China.
While land sales have accounted for approximately 20% of local governments’ income, the local administrations have started taking measures to curtail cooperation with private property investors since the Evergrande incident. For instance, in 2021, the provincial-owned Huaibei Mining Group requested to terminate its collaboration on construction projects with Lu’an Hengda Real Estate, an Evergrande subsidiary. Therefore, even though local governments’ revenues are undoubtedly affected by Country Garden’s delay in payments, the role that the incident played is much smaller than that of the initial shock in 2020. Nevertheless, it should be noted that certain industries did not untie themselves from the estate real sector. As a result, they bore higher risks. The shadow banking industry that financed property development is one of the unfortunate stakeholders.
The role of shadow banking in funding the property sector only increased significantly after the Chinese government enacted policies to limit excessive borrowing and leverage in 2020. Property developers shifted to using shadow banking services, most notably trust companies, to finance their projects. As a result, Country Garden’s collapse resulted in financial difficulties among trusts. For instance, having invested 79.3 billion in the property market sector, ZRT, a trust company under the Zhongzhi Enterprise Group, failed to repay the profits for wealth investment products of at least 94 million RMB (around 12 billion USD) within weeks after Country Garden declared its inability to repay offshore debt.
China Construction Bank building in Guizhou, China.
Courtesy of Huangdan (2019).
Irreversible Decline?
One of the major impacts of the Country Garden crisis is that it may further erode the willingness of investors and shareholders to invest in the Chinese market, domestic or foreign alike. This in turn will slow down the recovery of the Chinese economy. In August, China’s consumer price index (CPI) dropped 0.3%. Being a measurement for inflation, the CPI’s decrease raised the question of whether China is in a state of deflation. Deflation refers to a contraction in prices for goods and services. If deflation persists it may result in a downward spiral, in which low prices slow down corporations’ ability to provide services and may lead to a decline in wages and aggregate demand. This scenario could already be partly observed by the decline in China’s official manufacturing Purchasing Managers’ Index (PMI), which measures the economic activities in the industrial and construction sectors. Even before the Country Garden incident, the index in May recorded a 0.08% drop in comparison to the data in April. Therefore, without taking into account the Country Garden incident, the Chinese economy is already facing difficulties after the post-COVID stimulus had run its course.
What makes the short-term contraction more jarring is that for a long time, China’s economic growth has been on the decline. The last time its annual GDP growth reached the height of 10% was in 2010. Since then, the figure has been decreasing per year, with the only exception being in 2021, after China recovered from the 4% drop in GDP growth due to COVID-19. Under this context, the Country Garden crisis, if not handled properly, might result in a further deterioration of the current situation. After all, Real estate and related industries have been estimated to generate around 30% of China’s GDP in 2023.
In the long run, if the overheated properties market is not a channel for sustainable economic growth, there is a need for the central government to enact structural reform to transform its economy away from the real estate sector. This is especially the case when investors no longer have confidence in this particular area. Take Country Garden’s stock in the Hong Kong exchange for instance. On 6th September, the price of Country Garden’s stock per share was 1.22 HKD. The current price is far off from its all-time height in 2018, when the price reached 17.08 HKD. The continuous decline of the stock price since that very year illustrates that investors have been more and more hesitant to finance its development. After the crisis, it is even more difficult to regain the confidence of investors in this particular sector, even though temporary debt restructuring may lead to a short-term rise in stock prices.
However, what is tricky for the Chinese government is that it could not let Country Garden and the rest of the real estate sector enter a stage of free fall. A large number of families have bought housing units in construction. The inability of Country Garden to provide the finished properties may result in serious debt problems for those who have already paid part of the amount for their ownership. Meanwhile, commercially, it is only through finishing and selling finished properties that Country Garden could gain profit and pay off its debt. If Country Garden fell into bankruptcy, the rapid cut in services and construction projects would also result in mass unemployment. Therefore, there is an imminent need for the Chinese government to stabilise the market and the plummeting stock prices of the real estate sector.
Billboard displaying price fluctuations of stocks within the Hong Kong Stock Exchange.
Courtesy of Newwavegurly (2006): https://flic.kr/p/hqbtV.
To regain market confidence, many Western analysts have proposed that the government should enact a state bailout. If the central government could evince that it considers the private property sector important and is willing to salvage property corporations, such as Country Garden, out of their indebtedness, it may be able to directly put an end to the downward spiral and withdrawal. Nevertheless, it may not be, as a matter of fact, willing to do so.
The central government had been reluctant to support high-risk investments and speculation within the property sector. Due to the concern that an overvalued property sector may result in the burst of economic bubble and social unrest, as early as 2016, Chinese President Xi Jinping stated that ‘houses are for living in, not for speculation’. The central government is obviously dismissive towards the high-leverage style of operation in the properties sector. This may be the reason why Beijing refused to bail out Evergrande.
Moreover, even though the property sector is important to maintaining social stability, it is not of the most strategic importance to the central government, contrary to industries such as telecommunications. Therefore, the focus on sustaining the property market more or less rests on the shoulders of the local government. However, the local government is also weary of the highly speculative operation of the property market. The local government debt has already reached 92 trillion RMB (12.8 trillion USD). The overall local government debt had reached around 76% of China’s 2022 economic output, with a significant proportion dedicated to infrastructure development. Therefore, it may be financially inept to cater to the needs of Country Garden.
Owing to these factors, whether the government is willing to take the lead to bailout Country Garden remains questionable, and it is a policy that the state has yet to enact. Nevertheless, this demonstration of inaction would only worsen the situation, which was largely borne out due to the Chinese government’s mismanagement in the first place. Click here to continue reading about the role government regulations played in constituting the China’s property debt crisis.
Worker in Shenzhen taking down used national flag after event.
Courtesy of wallpaper flare (2020).
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