China Credit Contagion Risk Is Phantom, Structural Challenges Are Real

Dire news from two iconic Chinese property developers, Country Garden Holdings (2007.HK) and China Evergrande Group (3333.HK), hit the press this month. Country Garden missed a scheduled bond payment, its bonds stopped trading and it was de-listed from the Hang Seng Index. Evergrande declared bankruptcy seeking Chapter 15 protection on USD 31.7BN of obligations to keep its creditor restructuring plans on track.

Is this China’s Lehman Moment? The answer may depend on what Lehman means to you. Bob Ivry, now Forbes Executive Editor for enterprise, snagged this quote from me in 2011—

Working at Moody’s Investors Service and Hong Kong’s Futures Exchange in the 1990s, I knew even then that America’s fourth-largest investment bank was carrying staggering, unsustainable, sometimes illegal, levels of leverage. So, in this most basic sense, yes. Shenzhen-based China Evergrande Group (3333.HK) is a bit like Lehman: a private, working-capital intensive company buoyed by portfolio size and name recognition, that lived beyond its means for years. They each collapsed in September, 2008 and 2021, a neat coincidence.

But Lehman existed to break rules. Post-deregulation, the U.S. had built up an enviable, reasonably well-functioning system to fund economic growth using calibrated risk and leverage in off-balance sheet financings. Lehman, the cowboy, was the exception…until the rest of the market sabotaged itself and regulators decided to turn a blind eye.

Whereas it is probable that Evergrande had to break rules now and then to exist. China’s policymakers had long recognized its banking system’s limitations for the massive funding requirements to keep China growing at scale. They set out the 12th Five-Year Plan (2011-2015) to build new financial system infrastructure, including a copycat securitization market that would legitimize and regulate China’s risk and heretofore unregulated shadow banks.

The plan yielded mixed results. China’s securitization market functions reasonably well even now. But balance sheet private indebtedness went from 150% to 200% of China’s GDP in five years. And uncontrolled stock borrowing provoked a massive, humiliating collapse of China’s stock market in 2015.

If There Was A Lehman Moment, July 2021 Was It. Or Maybe July 2022.

China’s 13th Plan (2016-2020) engineered a sharp shift away from trends put in motion in the Twelfth, including capital market development. Of specific relevance to real estate, the People’s Bank of China (PBOC) Three Red Lines policy (August 2020) scuttled the industry’s popular preconstruction sales model that had allowed developers to fund their growth by selling homes before they were built. Land sales in key cities with liquid housing markets were restricted in early 2021, adding a new layer of challenge to firms whose main source of capital is land.

These abrupt policy changes conspired with the cooling economy to knock back the heretofore profitable industry. Earnings announcements in July 2021 for the first half of 2021 were a bloodbath, and some enterprises went under. Evergrande held on, in part because its funds earmarked for construction were diverted to pay creditors and keep the lights on, and it stayed in a holding pattern through mid-2022.

But in July, a surprise creditor class revolted: the homeowners. They refused to go on paying their mortgage without a home to move into. News of the boycott spread like wildfire through China’s social media. Over 100 cities were involved and an estimated 5-10% of residential real estate loans in China were affected. Government intervened with special bailout funds, because the political implications of remaining hands-off were too dire. The interventions have continued into early 2023.

Private Capital On A Rocky Road

The other source of bad news is Country Garden Holdings, founded in 1992 and headquartered in Foshan, Guangdong—an hour by bullet train from Shenzhen, the city where Evergrande (1996) is headquartered. Shenzhen is a new, fast-money city inside the Shenzhen Special Economic Zone founded in 1980. Foshan is an upgraded old city, one of China’s four major markets in the Ming Dynasty, birthplace of Cantonese opera and the storied gongfu master, Ip Man.

Country Garden has been a model of governance for the industry and is ranked #1. But it too has been caught in a downward cycle, with sales plunging -36% between 2021 and 2022. On August 6, the developer missed two coupon payments and later announced a net loss of USD 6.2BN for the first half of 2023. On August 17, Hang Seng Indexes Co. pulled Country Garden Holdings from the broad market Hang Seng Index (HSI) of Hong Kong blue chip stocks, just as it previously removed China property companies Evergrande, Sunac, Kaisa Group, China Aoyuan and Shimao Groups, July 2022.

Country Garden is still top-ranked and solvent. It counts BlackRock, HSBC, Fidelity, Allianz, UBS, JPMorgan and Apollo among its large bond investors. These relationships may be perceived as bringing special value to Country Garden so long as China continues to seek outside capital for domestic expansion. But dropping out of the Index telegraphs a new status for Country Garden, as a fallen angel.

Country Garden, together with Chongqing-based Longfor Properties, are the only two remaining private capital holdouts in the rankings of China’s top 10 developers. The rest are State Owned Enterprises, whose relative positions may continue to rise through the end of the 14th Plan (2021-2026) given the industry’s increasing reliance on government support and access. This structural arrangement comes at a potentially very large opportunity cost—but one that tends to keep Lehman Moments off the record.