Chinese property developer Evergrande is still struggling. It has missed an international bond payment and it is not clear if it can come up with the money though it is still within the 30-day grace period. The analyst consensus is that a financial crisis will be avoided. I agree, though I don’t regard the risks of a financial crisis as zero.
Governments make mistakes. Beijing has become increasingly strident in its approach to business and seems determined to instil more discipline and greater Communist Party control. They may get it wrong. And if China does experience a major crisis over the next year, we will all kick ourselves because the warning signs are clearly there.
Still, the most likely result is a continuing slowdown in the property market, feeding through to slower overall GDP growth. China’s property sector is estimated to directly or indirectly account for as much as 29% of the economy, according to a paper by Ken Rogoff, whereas for most countries the figure is 10-15%. The direct construction sector, on its own, accounts for a heady 14% of GDP.
New home sales were down 24% y/y in August and reportedly much lower still in early September. With buyers reluctant to put down deposits on new builds, developers will have to slow projects and many more may face similar cash flow problems to Evergrande. Another company, Fantasia, missed a payment on an offshore bond just this week. As developers’ cash flow sours, they will slow projects and delay paying their suppliers who will in turn face cash flow issues. The near halving of the international price of iron ore since July is an indication of market worries about a sudden slump.
Also, local authorities rely on land sales (to these developers) for 40% of their revenues. If land sales slow, even for a while, local governments will be squeezed and will be forced to scale back spending, especially on infrastructure.
The ‘Three Red Lines’
The Evergrande crisis has arisen now because the government imposed new debt limits last year, the so-called ‘three red lines’, (caps on debt-to-cash, debt-to-assets and debt-to-equity ratios), which the company is struggling to meet. But other Chinese developers are struggling to meet them too and the stock prices of all the leading Chinese developers are down 30-50% in recent months. The government is unlikely to reverse its policy of forcing property developers (and other companies) to limit their debt ratios, which points to a delicate policy balancing act in coming months.
Beijing also wants to slow house price inflation, which it believes threaten social cohesion. Moreover household debt has risen strongly in recent years, much of it driven by mortgages. That said, if fewer properties are built over the next year or two the laws of supply and demand would point to price rises rather than price falls.
Dealing with over-investment
My view has long been that China’s economy is going to slow. We should get used to GDP growth in the 3-5% range at best. This view seems to have become more mainstream in recent weeks, as analysts appreciate that China’s property boom is finally coming to an end.
The problem with Chinese over-investment is not that they won’t eventually need all the roads, airports and houses that they are building. It is that they are too far ahead of demand. The show has stayed on the road because growth keeps coming along behind at a sufficient pace. As growth slows this becomes less certain. Another problem is that some of the projects will never work – they are white elephants. They will be more exposed amid slower overall growth.
Implications for markets
Exactly how China treats foreign bondholders will be scrutinised. Only about $20 bn of Evergrande debt is in foreign currency but still – an unequal treatment would further dent the view that China is a good place to invest.
However, one view is that if ordinary Chinese are reluctant to speculate on property they will turn to stocks, making China’s stock market an attractive investment. The stock market has gone nowhere this year, in contrast to double digit gains in most major developed markets. But if the economy is slowing down and the government is no longer particularly supportive of private companies this seems like a risky call. The government crackdown on leading Chinese technology firms and some of their listing plans has cautioned market speculators.
For the rest of the world, an economic slowdown in China could take some of the pressure off energy prices and alleviate widespread supply shortages, for example in semi-conductors. This would be good for controlling inflation in developed countries, just like the Asian crisis in 1997. The Fed postponed expected rate rises in 1997, though admittedly that was in the context of a crisis, not just a slowdown. The other side of the coin is that it won’t be good for many countries, dependent on raw material or other exports to China.
Overall, the Evergrande crisis bears continuing close attention. Don’t be surprised if other major developers run into problems. And don’t be surprised if major markets are roiled by Chinese property news from time to time. The long-term effect is probably to keep world growth and inflation slower and interest rates lower than they would be otherwise.