• Chinese property developers’ expanding USD-denominated debts expose the sector to significant cross-currency risk.
• Elevated yields for USD-denominated bonds issued by large property developers serve as a warning signal for the issuers’ financial health.
• A large percentage of China’s national budget is tied to the sale of land-use rights to the highly-indebted property sector.

China’s listed residential property developers were not in a terribly strong financial position before Covid-19; now, the sector faces the additional challenges of shuttered showrooms and tepid consumer sentiment impacting home purchases. Some developers are offering marked discounts on properties, which will erode margins and impact debt servicing abilities.¹ With the global economy facing headwinds on multiple fronts, how will this sector that is so vital to the overall Chinese economy fare and how much government support will it receive?

In October 2018, Chinese President Xi Jinping vowed “unwavering” support for China’s private sector enterprises: “Any words and practices that negate and weaken the private economy are wrong,” said Xi. He emphasized that “supporting the development of private enterprises is the [Chinese Communist] Party Central Committee’s consistent policy.”² Vice Premier Liu He has subsequently sent the same policy signals and in December of 2019, China’s State Council unveiled a slate of measures designed to bolster private sector businesses, including improved access to the financial markets, equalizing regulatory treatment with state-owned peers, easing the tax burden of private firms and enhancing the capabilities of financial institutions to serve private enterprises.³ It is noteworthy that these measures were released as a unified central-government communique, marking the first time that Beijing has ever published a document specifically focused only on the private sector.⁴

With China facing slower economic growth, the fallout from Covid-19, continued trade war tensions and a struggling stock market, President Xi’s comments prompt questions as to which sectors of the economy this “unwavering” support will apply. Specifically, will China’s highly-indebted residential property development sector receive government support? As debt maturities approach for property developers and their U.S. dollar-denominated bond yields soar, this question is becoming more relevant as each day passes.

Debt in the Property Development Sector

For some time now, the financial solvency of China’s residential property development sector has been in question. The sector has always been highly-indebted, and in recent years, leverage has increased as developers have taken on staggering new levels of debt. The publicly-listed Chinese property developers have aggregate total debt of 1,046 billion U.S. dollar (USD)-equivalent, with more than 375 billion of that amount denominated in U.S. dollars.⁵⁶ Debt in the publicly-listed portion of the sector has grown rapidly over the past five years, up from 327 billion USD-equivalent at the end of 2014.⁷ Listed developers in the sector have suggested that such leverage is necessary to supplement and grow land reserves; yet the absolute and ever-growing amount of debt issued by these companies is alarming. Perhaps the only thing more alarming than the large and growing amount of debt is the nascent profits of the listed sector. Figure 1 illustrates the total revenues, common equity and net income of all publicly listed property developers in China alongside the sector’s total debt, as well as the portion of that total debt which is denominated in U.S. dollars.⁷

Sources: Bloomberg, company filings.

Includes all listed Chinese homebuilders with a market capitalization above 250 million USD-equivalent.

Note: USD-denominated debt includes both bank debt and bonds issued.

Cross-currency Risk

Developers’ expanding U.S. dollar-denominated debts mean that the sector is exposed to a great deal of cross-currency risk. As of December 2019, more than 30% of all bonds issued in the sector were U.S. dollar-denominated.⁷ With nearly all of property developers’ revenues and costs denominated in renminbi (RMB), this cross-currency liability represents a significant financial risk for these companies. Property developers are a sizable segment of the Chinese economy, and they are increasingly reliant on foreign currency financing; this funding is often secured through special purpose vehicles or shell companies domiciled in tax havens.⁸ Such legal structures would make it difficult for offshore creditors to make claims on the underlying assets, should default occur.

In fact, the annual financial stability report of the People’s Bank of China (PBOC) specifically calls out China’s listed property developers for having high leverage and complicated financing methods, stating such structures have “increased the difficulty for regulatory authorities to grasp the true flow of funds and weakened the regulatory effect.”⁹ The 2019 version of the same report articulates concerns about “growing housing development loans” as “developers bring loans back onto their balance sheets.”¹⁰ The risks associated with such financing structures and the increasing cross-currency exposure for many property developers are further exacerbated by the absolute amount of debt in the sector and the questionable quality of local bond ratings.

Yield Differentials

The ability to tap different markets in different currencies is generally considered positive from a credit-worthiness perspective. Chinese property developers have access to the local and international bank and bond markets for their funding needs. However, when the yields of similarly ranked bonds from the same issuer diverge meaningfully, the markets are issuing a warning signal. Figure 2 shows the yield differentials for a sampling of similarly ranked and similar maturity RMB and USD-denominated bonds issued by five large property developers in China.

As you can see, the yields on the USD-denominated bonds for these developers are considerably higher than the yields on the RMB-denominated bonds. This is admittedly a nuanced comparison, as RMB- and USD-denominated bonds are not often issued by the same legal entity, rendering some bondholders closer to the assets of the company than others. For example, the USD-denominated bonds of Chinese property developers tend to be issued via special purpose vehicles, often domiciled overseas, thereby structurally further from the actual assets (the land bank) in China. That said, some of these USD-denominated bonds come with keepwell agreements, contracts between a parent and subsidiary that commits to maintain the solvency and financial backing of the subsidiary throughout a set term. These agreements in theory make the USD-denominated bonds at least similar in credit worthiness to the RMB-denominated bonds. Today’s bond yield differentials tell a very different story, particularly for the more indebted property developers like China Evergrande.

Which market is correct? Is this yield differential a sign of waning overseas support for these borrowers and their USD funding strategies? That could be the case. The differential could also reflect elevated international tensions amid the fallout of the Covid-19 pandemic, or a concern about USD / RMB exchange rates more broadly. Is this marked yield differential an indication that China’s State Administration of Foreign Exchange (SAFE) is not allowing the property developers to exchange RMB for USD in order to repay these USD-denominated bonds? Regulatory approval is needed for companies to transfer currency offshore for the repayment of USD-denominated debt. While recent announcements indicate that SAFE may streamline or ease rules to facilitate cross border investment, the bond yield differentials of these property developers indicate that this effort continues to be a work in progress.¹¹ There are many potential reasons for the yield differential, but the most glaring explanation is that this is a clear warning signal about the financial health of the bond issuer itself.

Land Bank Sales are an Integral Part of the Government’s Fiscal Position

One plausible explanation as to why Chinese authorities have allowed the listed portion of the sector to lever up so substantially, contrary to their stated commitment to reduce leverage in the financial system, is that this arrangement has been beneficial to the financial standing of the central and local governments. The debt assumed by the property developers has been used in large part to fund land bank purchases. A significant percentage of the proceeds from these land bank purchases goes to national and local government coffers. This can be seen in China’s national accounts, where the most recent data shows more than 7 trillion RMB grossed from the sale of state-owned land use rights in 2019 (see the light blue line in Figure 3).¹² This represents more than 38% of China’s total national government revenues (see the dark blue line in Figure 3).

Another way to understand the importance of land bank sales to government coffers is to look at net expenditure financed by land sales (see the dotted blue line in Figure 3), which is defined as the “net expenditure financed by land sales estimated by subtracting the acquisition cost, compensation to farmers, and land development from the gross land sale proceeds.”¹³ By subtracting development, relocation and other associated costs, this dotted blue line is arguably a more accurate reflection of the government’s net proceeds from land sales. Either way you look at it, a large percentage of China’s national budget is tied to the sale of state-owned land use rights. The International Monetary Fund’s 2019 Article IV Consultation on China is projecting the revenues from the sale of land use rights to decrease in the coming years.¹⁴ How that hole in the budget will be filled is a big and increasingly pressing question.

Numbers in red denote percentage of China’s total national government revenues.

Sources: National Bureau of Statistics of China, International Monetary Fund, Seafarer.

Potential Mitigating Factors for the Risk in this Sector

Several possible mitigating factors may ultimately keep China’s property market and the levered property development sector on an even (and solvent) keel. China’s housing policy includes initiatives to build housing to lure young professionals to tier 2 and tier 3 cities and thereby enhance these cities’ competitiveness and attract corporations. The regulators are allowing more bond issuance in the property sector to refinance near-term liabilities.¹⁵ In addition, some state-run banks can selectively offer attractive mortgage rates to buyers (as Industrial and Commercial Bank of China (ICBC) in Shanghai did in August 2018). Attractive mortgage financing rates and recently announced home purchase subsidies for migrant workers are two meaningful and supportive recent developments.¹⁶ Other policies that the authorities have employed to cap and support housing prices in different regions include resale time restrictions, presale price restrictions, down payment requirements and the key step of further loosening hukou restrictions in certain markets.¹⁷¹⁸ Add in the government’s “unwavering” support for the private sector, and it is hard to dismiss the potential power of such levers and the ability of the government to quickly employ property-related policy shifts.

Conclusion

The Chinese government has indirectly raised capital by selling land bank to developers at robust prices. Developers have taken on substantial debt to acquire this land bank. Based on the percentage of government revenues related to the sale of state-owned land use rights, the fiscal position of local governments does seem rather dependent on continued land bank sales. Furthermore, the use of USD funding by many developers means that this leverage is at least partially funded from outside of the Chinese financial system. I wonder, have some portion of the proceeds gone to support government-directed stimulus in the economy? If land bank sales decline, what will be the consequences for China’s ability to engage in fiscal stimulus? With urbanization now in a later stage, when will the consequences arrive? In the meantime, as China’s currency comes under pressure due to trade-related tensions and the fallout from the global Covid-19 pandemic, the property development sector’s ability to refinance its USD-denominated debts may come under increasing strain, perhaps ultimately testing Xi’s resolve to follow through with “unwavering” support.¹⁹

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

As of March 31, 2020, the Seafarer Funds did not own shares in the entities referenced in this commentary.

1. “China Developers Were in a Weakened Position Even Before the Virus Hit,” Bloomberg News, 8 April 2020.
2. “Xi Vows ‘Unwavering’ Support for Private Sector After China Rout,” Bloomberg News, 21 October 2018.
3. “China’s Private Economy to Thrive in Better Business Environment,” The State Council of The People’s Republic of China, 22 December 2019.
4. “China Vows More Support for Private Sector to Stabilize Growth,” Bloomberg News, 22 December 2019.
5. As of April 2020 there were 202 publicly-listed property developers in China with market capitalizations above 250 million USD-equivalent. It is this group of companies that I have used to assemble the data for the listed property developers in this market commentary. Market capitalizations for this group of companies range from 250 million to 41 billion USD-equivalent. Data referring to “listed property developers” does not incorporate the thousands of smaller, unlisted property developers in China.
6. Seafarer, Bloomberg, Wind Information, National Bureau of Statistics. Data as of 6 April 2020.
7. Seafarer, Bloomberg. Data as of 6 April 2020.
8. The recently issued bonds by Evergrande through a special purpose vehicle named Scenery Journey Ltd are just one example of this bond issuance structure. See Prospectus.
9. “中国金融稳定报告 (2018) (People’s Bank of China’s annual China Financial Stability Report 2018),” The People’s Bank of China, November 2018.
10. “中国金融稳定报告 (2019) (People’s Bank of China’s annual China Financial Stability Report 2019),” The People’s Bank of China, November 2019, page 35.
11. “China’s Forex Regulator Improves Rules to Facilitate Foreign Trade, Investment,” The State Council of The People’s Republic of China, 14 April 2020.
12. Wind Information. Data as of 6 April 2020.
13. “People’s Republic of China: 2018 Article IV Consultation,” International Monetary Fund, 26 July 2018.
14. “People’s Republic of China: 2019 Article IV Consultation,” International Monetary Fund, 9 August 2019.
15. Wind Information, Bloomberg. Data as of 6 April 2020.
16. “China Property Monthly,” CLSA, 7 April 2020.
17. “China to Ease Urban Residency Restrictions to Boost Urbanization,” The State Council of The People’s Republic of China, 9 April 2020.
18. “Access to Urban Residency Made Easier,” The State Council of The People’s Republic of China, 4 Feb 2020.
19. A clear example of refinancing strain in the sector is a bond issuance by Evergrande on 31 October 2018. This three-tranche bond deal has interest rates of up to 13.75%, well above the 8.75% for similar bonds issued by the company just last year. In a further sign of strain, the Chairman of Evergrande, Hui Ka Yan, purchased more than half of the overall 1.8 billion USD-equivalent issuance. Source: Lucy Hornby, Gabriel Wildau, and Robert Smith, “Evergrande chairman props up $1.8bn bond,” Financial Times, 31 October 2018.