The year 2020 was the worst year for economic growth since World War II - all economies came to a standstill with the raging spread of the virus. However, China, the country where the first outbreak of COVID-19 was reported, was the only major economy in the world to report a positive GDP growth in that year.
Fast forward to November 2021, the second-largest economy seems to be in a precarious situation with various credit rating firms cutting down on its growth forecasts owing to glaring uncertainties in the nation.
In my last article, I covered China's crackdown on its tech sector. Now the ball has come rolling to its real estate sector.
Evergrande Group, China's second-largest property developer and the world’s most indebted real estate firm with liabilities amounting to $300 billion, informed bondholders in early September about its inability to honour its interest obligation. (For context, Russia's state debt in 2020 was $257 billion.)
Evergrande was founded by Mr Xu Jiayin, who was once the country’s richest man, in 1996, and was in the bottled water business. Later the company expanded into several areas, including pig farming, owning a football club, wealth management and the electric car segment. However, it was its real estate business for which it was widely known.
In 2020, it recorded a gross profit of nearly $19 billion and in the year before that, it was on the Fortune Global 500 list. The company owns 2% of all newly-constructed real estate in China and employs about 200,000 people directly and helps in sustaining more than 3.8 million jobs indirectly every year.
The possible collapse of an organisation this big can be brushed aside as a one-time occurrence, however, one cannot turn a blind eye when many such firms in that line of business are on the same path: Chinese luxury developer Fantasia Holding Group and the Sinic Holdings group have also announced a default on their debt repayment obligations in mid-October.
The cause of worry intensifies when one observes that around 30% of China’s Gross Domestic Product (GDP) is related to its real estate sector. Therefore, the fall of real estate companies can leave a dent not only in the Chinese economy but the global economy as well.
The State Of Real Estate In China
In the late 1980's, China started moving from public housing to the commercial property model. Post-1994, The central government decentralised the goals and interests of the policymakers - passing the responsibility of social welfare services to local administration but with taxes to be submitted back to them.
The imbalance of funds led provincial governments to create state-owned shell companies called Local Government Financing Vehicles (LGFV). They gave these LGFV free valuable lands which were then used to take out loans that the administration themselves could not. Consequently, this made the administration seem healthier because their debt was now hidden while at the same time they met quotas set by Beijing.
As a result, land became the backbone of local economies.
Additionally, steep discounts and low-interest rates were offered to citizens as an act of welfare. Strict regulation by the government on how much money leaves the country left citizens with limited investment options - stock markets became synonymous with volatility and risk and housing gained the reputation of safe and profitable investments in the country. Housing prices were also such that they fell only once in the two decades that followed the Asian Financial Crisis.
Due to the aforementioned reasons, real estate is one of the most loved sectors of the economy with homeownership in China being the highest in the world, i.e. around 90%. It has become the country's leading pillar of economic growth with a contribution of around 15-30% to the GDP. In the COVID-19 period alone, the sector has grown by 4.9%.
However, an unusual trend is seen in the country. The boom in real estate is coming at a cost: high vacancy rates in cities due to the vast majority of home purchases being second/third homes. In 2018, 87% of new home buyers already owned at least one flat.
Additionally, the societal norm in China is such that male marriages demand homeownership. Decades of the one-child policy have resulted in an imbalance between males and females with scales tipping in favour of the latter. As a result, female families have become awfully picky, with the groom's homeownership being one of the prerequisites. As per a study, home prices are higher in cities of disproportionate male-to-female ratios.
In cities like Shenzhen, Beijing, Shanghai - it takes nearly 40 years worth of an accumulated average income to afford a home. Thus the vast majority of homes are purchased even before the construction has begun, sometimes years in advance.
With overhead demand, some developers undertake techniques such as selling batches of properties in glitzy online events or through raffles-off in lotteries where thousands of apartments are often sold out in minutes, giving the winners mere hours to submit down payments or lose the opportunity.
What all these instances, numbers and facts point towards is that of a speculative market, i.e. the assumption that prices would only go up.
However the demographic of the country suggests otherwise. In the next ten years, the country’s over-55 cohort will increase in size by 120 million, but by the end of the century, the overall population will be cut in half. The majority of present home buyers are precisely from this segment which China would soon lose. In addition, with age, home requirements keep differing.
It was reasonable to anticipate a decade ago that the rapid urbanisation demand would be met by bringing in more than enough migrants to effectively cancel out the effects of ageing. Nonetheless, the statistics prove otherwise with the migration rate falling below the country’s 60% urbanisation rate. Moreover, such exorbitant home prices act as a further deterrent to the very people that were to be attracted by the construction of so many homes.
Thus, the demand-supply misproportion is haunting the real estate space.
With the context of speculative and overpriced real estate being understood, what consequences are in store, given the defaults of Evergrande and other real estate firms?
The trigger for this fall is attributed to new guidelines, known as The Red Lines, introduced by the government in August 2020 for property developers. The rule requires the ratio of liabilities-to-assets of developers and their net debt-to-equity ratio to be below 70% and 100% respectively whilst requiring real estate firms to maintain the cash-to-short term debt ratio at a minimum of 100%.
Any borrower failing to meet these requirements would be restricted from raising more funds, practically cutting off developers from taking on more debts. This means a complete alteration in the nature of the real estate business, which relies heavily on borrowing for its capital requirements.
The crackdown on developers is in line with China’s supremo Xi Jinping's slogan of ‘Common Prosperity’, where the estate market is being regulated so as to puncture the property bubble and make housing more affordable. Some also see this as an example of the government taking on influential private businessmen under the guise of the ‘common prosperity’ programme to fight income inequality.
This rule is about-turn, the government previously encouraged developers to take on huge debt through the heavily state-controlled financial sector to develop new properties. In the past, they have even bailed out troubled business entities thereby leading to the indiscriminate allocation of resources to the sector.
As per an analyst, “A regime shift is occurring without necessarily the markets fully comprehending the enormous underlying change to the structure of the economy.”
Many have called the Evergrande fiasco China’s own ‘Lehman moment', alluding to the failure of the US bank Lehman Brothers, which precipitated the 2008 financial crisis. Some observers believe that the current crisis was a long time coming owing to the company's unsustainable business model.
In 2012, Andrew Left of Citron Research argued that Evergrande was insolvent and that the company was engaged in aggressive accounting practices to cover up its troubles.
It was said that the company held properties that it could not sell on its balance sheet as inventory, thus avoiding the booking of losses. The company was also accused of running a Ponzi scheme as it relied on the constant inflow of funds to prop up a business model that is fundamentally unsustainable. Interestingly, Evergrande has over the years consistently reported strong profits and has showcased a strong balance sheet with sufficient liquid assets.
A letter leaked last year by Bloomberg showed Evergrande’s executives seeking financial assistance from the Chinese government by admitting their inability to meet their debt obligations to banks.
As per a Bloomberg report, the administration is potentially going ahead with the restructuring of debt. The company has sold off various units at a discounted price to meet funding requirements. The organisation's deal with state-owned Yuexiu Property to sell a 51% stake in its property services unit has also been put on hold.
Markets are closely observing the Chinese economic environment owing to growing uncertainties. Various countries are concerned about a possible slowdown resulting from the rebalancing of the economy away from the property sector.
China is the biggest steel importer and a drop in construction activities would affect the global steel prices. The IMF has estimated that a fall of 1% in demand from China would decrease global GDP by 25%.
The Chinese administration has sent a clear signal: the only expectation one should have is unpredictability and nothing more.
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