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The Transparency Problem in China’s Credit Markets

It is well understood that the expansion of China’s residential property market over the past two decades was driven by the country’s rapid urbanization and funded with astonishing amounts of leverage. What is perhaps less understood is the transparency problem in China’s fixed income markets as defaults rise in this grossly over-leveraged sector, necessitating workouts and restructurings. Considering the large role that real estate plays in China’s economy, the increasing number of property developers in financial trouble is concerning, but none more so than China Evergrande Group. Chinese regulators need to orchestrate orderly restructurings for Evergrande and others while maintaining stability in the broader financial system and limiting the impact on economic growth.

That said, there is no clear precedent in China for debt restructurings of these magnitudes; Evergrande has total liabilities of approximately 300 billion U.S. dollar (USD)-equivalent.1 Evergrande’s publicly-traded debt has been issued both onshore (denominated in renminbi (RMB)) and offshore (denominated in USD); the difference in how these bonds are priced and trade illustrate a real transparency problem in China’s credit markets. How creditors in this sector are treated in their all but inevitable restructuring processes will be a good indication of how China’s bond market will be allowed to mature. A key issue to monitor is differential treatment of onshore versus offshore creditors to Chinese corporates.

Large Role of Property Sector

Property plays an outsized role in the Chinese economy. China’s real estate sector creates construction and finance jobs, infrastructure projects, and is a major factor in the banking system. It is, by most accounts, the dominant form of collateral within a banking system that is not known for its cash-flow based lending acumen. Large portions of China’s economic output, household wealth, consumption, and government finances all trace back to the health of the country’s real estate sector. Credible research states that real estate-related activity accounts for at least 25% of China’s total gross domestic product (GDP), a much higher percent than most large economies around the globe.2 China’s savings rate, while notably high at close to 35% of total disposable income, is nonetheless problematic given that more than 40% of this savings is tied to housing and real estate investments.34

Also of concern is that as much as 38% of China’s national government revenues are contributed by the sale of state-owned land use rights.5 China is heavily reliant on the property sector as a driver for economic growth and source of government funding – a sudden shock across the sector could induce enormous and far-reaching changes to the structure of the Chinese economy. It is no wonder that housing policy is a central part of Xi Jinping’s “Common Prosperity” campaign, including such measures as ridding the property market of speculation and making housing more affordable.6 Given the large role that property plays in the economy, there is a clear incentive for property developers to remain on stable footing, or at least stable enough to finish projects paid for but not yet delivered to the Chinese home buyer.

Imperatives for Orderly Restructuring

Beyond the importance of this sector to the overall health of the Chinese economy, another motivation for orderly restructurings of the many troubled property developers is the extensive and opaque web of their liabilities. Stakeholders in the restructuring process (roughly in order of payment preference) include contractors and suppliers, banks, homebuyers, wealth management product investors and finally, bondholders. There are also off-balance sheet liabilities and other hidden debts to consider. Investors, rightly concerned over the lack of disclosures, struggle to understand some of these off-balance sheet (and largely heretofore hidden) debts. These concerns are further compounded by property developers’ failure to file audited annual results with the relevant authorities.7 Hasty or ham-fisted restructurings might require write-downs by holders of these lesser-understood obligations, which could have unforeseen consequences in other parts of the Chinese economy. It seems that China’s regulators know this and are taking a careful and measured approach to property sector restructurings, particularly the big ones.

The Chinese government has prioritized the delivery of homes under construction to individual buyers, likely with the primary motivation of maintaining social stability.8 The protracted and carefully calculated workout at Evergrande and other large property developers could signal a huge shift in the way that China’s economic model works. Some developers are effectively being nationalized before our eyes, selling stakes to state-owned entities as they face financing needs for upcoming bank and bond maturities.910 The restructurings of China’s troubled property developers could have profound implications for China’s position as the locomotive of global economic growth. With webs of liabilities that are far and wide and not terribly transparent, an orderly restructuring process could go a long way in the development of China’s financial markets.

Hopefully the restructuring in this sector will not only be orderly, but reasonably market-oriented. Allowing distressed bonds to trade in the open market, honoring the terms of the bond indentures (including adherence to covenants and change of control clauses), and respecting creditor claims on assets in order of seniority would all be key aspects of an orderly, transparent and market-driven restructuring process. One glimmer of hope is that the term “marketized default” has surfaced in government documents as financial authorities and regulators manage large and highly complex defaults, like that of Evergrande.11 Another glimmer is a rare instance of a Western lender seizing assets and taking control of projects after a property developer defaulted on secured loans.12 Offsetting these small market-oriented victories are the facts that creditor committees in China remain opaque and exclusive, and provincial and/or national authorities can become involved unexpectedly. Such moves strongly suggest that Beijing exerts control over private developers as needed.13

Onshore versus Offshore

All eyes are on onshore versus offshore creditor treatment. While trading volumes are not readily visible for all of Evergrande’s bonds, the available evidence indicates that the onshore (RMB-denominated bonds) have essentially stopped trading and continue to be marked at the last market prices – even as those prices are stale, and do not properly reflect Evergrande’s financial distress, likelihood of full default or ultimate recovery values to creditors. This may be due to a circuit breaker mechanism in China’s local bond market, but whatever the reason, it is not healthy. The company’s RMB-denominated bonds have a last traded price that is much higher than the USD-denominated offshore bonds, which now trade at just cents on the dollar. Figures 1 and 2 show the price and yield trends for the company’s benchmark 2024 onshore RMB-denominated (red) versus offshore USD-denominated (blue) bonds.

Figure 1. Quoted Prices Evergrande Bonds, 2024 Maturity (USD and RMB denomination)
Source: Bloomberg. Data as of 12/22/22.
Past performance does not guarantee future results.
Figure 2. Implied Yields to Maturity, Based on Quoted Prices Evergrande Bonds, 2024 Maturity (USD and RMB denominations)
Source: Bloomberg. Data as of 12/22/22.
Past performance does not guarantee future results.

These charts illustrate that while onshore (RMB) bonds have been essentially suspended from trading, offshore (USD) bonds continue to trade, allowing for price discovery among market participants. These USD-denominated bonds serve as a reflection of the evolving risks associated with this very complicated restructuring. Conversely, RMB-denominated bonds offer little or no indication of the changing risk profile of this restructuring. While only the authorities who are managing Evergrande’s workout know for sure, there is growing sentiment in the market that offshore (USD) bond holders will likely stand behind their onshore (RMB) peers in order of payment seniority, as evidenced by how these bonds are being quoted.

Furthermore, offshore (USD) bondholders elsewhere in the sector are encountering obstacles in their efforts for rightful claim on assets, such as backroom deals that give priority to undisclosed private lenders, unfavorable extensions and payment delays, especially to offshore lenders.14 Despite the introduction of defaulted corporate bond recovery guidelines in December 2019, Chinese bond issuers continue to ease or postpone debt repayments by issuing rollover debt, seeking repayment deadline extensions, or cancelling features such as early redemptions.15 Some issuers have avoided default by undertaking private negotiations with individual creditors, often persuading bondholders not to exercise put options, deferring interest payments on perpetual securities, forcing debt exchanges, or even repaying bondholders outside the proper clearing channels some days or weeks late.16

Bond markets prefer certainty and transparency; essential to these aims are standardized resolutions, in which creditors within each class are treated equally, and creditors across classes are treated fairly in relation to their respective contractual rights. If regulators continue to tolerate the opaque tactics that are prevalent in this sector, investors will remain hesitant, and China’s bond market development will be stunted.

Conclusion

Considering the large role that property plays in China’s economy, a great deal hangs in the balance with respect to restructuring in the property sector.17 The details of how onshore and offshore creditors fare – in absolute terms, and relative to one another – matters a lot for the future health of China’s bond markets. Hopefully the restructurings will consider corporate governance and the rights of creditors. Lack of ready access to international capital markets will take a toll on this sector. While it is increasingly clear that the days of housing driving the Chinese economy are likely over, the big question is: where do the funds come from to keep the economy on an even keel?

Author’s note: On November 12th 2022, Beijing circulated document #254 to the country’s financial institutions and policymakers. This document contains a wide-ranging series of measures aimed at boosting liquidity in the sector and thereby hopefully stabilizing this critical pillar of the Chinese economy. Document #254 outlines multiple financing measures for China’s property sector, including temporarily easing lending caps to developers, extending loans and encouraging banks to treat private developers and state-controlled developers equally.18 While this announcement may offer temporary relief to some of China’s most troubled developers, I believe it is a tacit admission that the property sector is in trouble. This dramatic shift in property sector policies may stave off a slew of developer bankruptcies in the near term, but I think it is only prolonging the pain and further exasperating the transparency problems in China’s credit markets.

Kate Jaquet
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 December 31, 2022, the Seafarer Funds did not own shares in the entities referenced in this commentary.
  1. Source: Bloomberg. Data as of most recent audited financials, last published 31 December 2020.
  2. “Measuring the Universe’s Most Important Sector,” The Economist, 26 November 2021.
  3. Thomas Hale and Tabby Kinder, “What Happens if Chinese Household Wealth is Unleashed on the World?,” Financial Times, 4 July 2021.
  4. “Household Savings,” OECD. Data as of 31 December 2021.
  5. Kate Jaquet, “China’s Indebted Residential Property Development Sector,” Seafarer Capital Partners, June 2020.
  6. Jonathan Cheng, “To Achieve ‘Common Prosperity,’ Xi Jinping Seeks to Scale China’s ‘Three Big Mountains’,” The Wall Street Journal, 3 February 2022.
  7. Thomas Hale and Tabby Kinder ,“Big Four Under Growing Pressure as Chinese Developers Delay Audits,” Financial Times, 29 March 2022.
  8. Clare Jim and Xie Yu, “China Vows Timely Home Deliveries in Wake of Property Protests,” Reuters, 14 July 2022.
  9. Pearl Liu, “Agile Group Becomes Latest Debt-Ridden Chinese Developer to be Rescued by State-Owned Company,” South China Morning Post, 24 January 2022.
  10. Clare Jim, “Chinese State-Owned Property Firms Step in to Rescue Cash-Strapped Developers,” Reuters, 25 January 2022.
  11. “What are the Systemic Risks of an Evergrande Collapse?,” The Economist, 23 September 2021.
  12. Thomas Hale and Tabby Kinder, "Oaktree Takes Control of Sprawling Evergrande Building Project near Shanghai,” Financial Times, 29 January 2022.
  13. Clare Jim, “Evergrande Seeks More Time from Offshore Creditors for Debt Restructuring Plan,” Reuters, 24 January 2022.
  14. “China Credit Investors Face Billions in Losses, Waning Power,” Bloomberg Law, 18 March 2022.
  15. Molly Dai, “China’s Corporate Bond Defaults Unveil Hidden Blind Spots,” Bloomberg, 1 July 2020.
  16. “China’s Corporate Bond-Market Stress May Persist in 2021,” Fitch Ratings, 16 November 2020.
  17. Hudson Lockett and Thomas Hale, “Evergrande Crisis Locks Chinese Developers out of Global Debt Market,” Financial Times, 25 March 2022.
  18. Clare Jim and Xie Yu, “China’s ‘Most Comprehensive’ Rescue Package for Property Sector Lifts Stocks, Bonds,” Reuters, 14 November 2022.