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China's property market is known for its boom and bust cycles, but the current, contagion-tinged downturn is unusually intense. Contracted sales are faltering as authorities tighten funding. Measures that restrict credit to the property market are hitting developers' liquidity. The likely default of the country's most indebted property firm, China Evergrande Group, threatens to shut out many speculative-grade names from offshore capital markets. S&P Global Ratings believes that defaults will rise as firms enter a prolonged down cycle, amid heightened refinancing risk and steep maturity walls coming due this year and next.

Our scenario analysis shows that, in the most severe scenario, the liquidity of as much as one-third of rated Chinese developers will come under pressure. The entities most at risk are overwhelmingly rated 'B-' to 'B+'. Over 50% of our rated portfolio of Chinese developers falls into this ratings category. The entities have also made heavy use of funding via joint ventures and trust loans, given they have been largely shut out of more conventional funding. New regulations and weak sentiment are squeezing these capital channels. The idea that entities may be abruptly deprived of such funding, threatening refinancing plans and potentially triggering defaults, is a large part of our scenario analysis.

The risk of default among Chinese developers is real, as was recently apparent in missed bond payments by Fantasia Holdings Group Co. Ltd.(SD), Sinic Holdings (Group) Co. Ltd. (SD), China Properties Group Ltd. (unrated), and Modern Land (China) Co. Ltd. (unrated).

A Long Downward Journey Ahead

We forecast a 10% drop in residential sales in 2022. This trend should continue into 2023, where we project another 5%-10% decline. Sliding unit sales and an up-to 3% drop in prices will drive the downturn. Some local governments are starting to set price floors on residential sales as regulators seek to stabilize the market.

We believe regulatory measures restricting borrowing for mortgages, and capital for developers, will last at least through 2022. Officials will finetune their measures to avoid a drastically adverse effect, in our opinion. This may include making mortgages more available.

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The policy turning point will likely arrive when the major Chinese developers meet the "three red lines" rule (regulations that cap lending to developers that don't meet thresholds on leverage and liquidity). Once major developers are operating within these boundaries, there should be more room for policy relaxation, including liquidity easing.

The Signs Point To Liquidity Strains

Our analysis tests four scenarios. In scenario one, we assume sales are 10% below our base case. In scenario two, they miss by 20%.

Scenarios three and four assume the same sales underperformance, falling 10% and 20% below our base case, respectively. However, we incorporate an additional assumption of repayment of 30% of de facto debt to minority interests, as well as of 30% of trust loans outstanding within a 12-month period. The stress tests gauge the effects of fixed-term obligations due to minority interests, largely through the use of joint ventures.

While the funding arrangements in joint ventures are private, investors believe they often comprise hidden debt owed to minority interests. We have highlighted this risk in a previous report (see "High Stakes: Analyzing The Risks Of China’s Property Joint Ventures," published on RatingsDirect on June 14, 2021).

Likewise, we expect that trust firms can ask for early repayment of trust loans that back a project, if the credit standing of the developer behind the project is slipping. We believe these scenarios present important risks to the liquidity standing on developers.

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The liquidity profiles on most rated developers can absorb a sales drop that is 10% below our base-case projection (scenario one). Our recent rating actions have already addressed entities with the slimmest liquidity buffer. The rest have slightly more buffer, and can withstand a more moderate sales decline in this scenario.

In the more severe sales decline assumption of scenario two, four out of the five developers that would see the liquidity profile become less than adequate are rated 'B' or 'B+'. Those four players are geographically concentrated to a varying extent, and they have a smaller scale. This adds to the sales risks.

Scenario three would mean the liquidity profile on 22% of our rated portfolio would be less than adequate or weak. We expect the liquidity profile on 37% of our rated portfolio would be likewise hit in the most severe case (scenario four).

Less than adequate and weak are specific terms we use to gauge the liquidity profiles on companies. As general rule, less than adequate means the ratio of liquidity sources to uses is less than 1.2x. Weak means liquidity sources fall below uses. These are not fixed parameters, since the analyst will use judgement on how they will be applied.

A 'B' Category Phenomenon

We expect that 85%-90% of the developers that would come under liquidity pressure in these scenarios are rated 'B-' to 'B+'. The entities' need for funding is rapidly outpacing their revenue base as they grow quickly. They are also relatively less established, and are more likely to use alternative financing, such as trust funding, which is quickly falling out of favor with investors. Alternative financing makes up 27% of the debt capital of developers rated 'B+' or below.

For those entities that heavily use joint-venture structures, there is a higher risk of hidden debt, in the form of obligations to minority partners.

There are a few 'B-' to 'B+' names for which liquidity looks more resilient than peers' in our stress test. This is partly because the entities do a better job of managing their maturity profile and cash balance. Such names include KWG Group Holdings Ltd. (B+/Stable/--) and Radiance Holdings (Group) Co. Ltd.(B+/Stable/--).

For developers rated 'BB-' to 'BB+', just one to three of the entities would fall into a lower liquidity category under the four stress scenarios. Their weakness mostly shows up only in the most strained conditions: scenario four. One or two of the entities have a history of aggressive expansion, partly through the use of joint ventures. They may also have concentration risk, with sales highly dependent on a particular region.

We also gauge the number of developers that would see a significant drop (over 30%) in the ratio of liquidity sources to liquidity uses under each scenario. The results are broadly the same as our analysis above--it's mainly the 'B-' to 'B+' developers that would be affected. In addition, five of the entities that would see their liquidity ratio drop by more 30% in scenario four have breached two or more of the three red lines.

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Last but not least, the maturity wall in 2022 may amplify liquidity risks in our scenario analysis. Rated developers face repayment of US$40 billion over the next five quarters in offshore debt. Issuers rated 'B+' or below will face their first peak in debt payments due in January 2022, with more than US$3.7 billion due in the month.

It's a similar picture in China's domestic bond market. Funding conditions here are equally unsupportive. Rated developers are facing a maturity wall of US$44 billion onshore, before the end of 2022.

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The Known Unknowables

Developer pressures are playing out in a fraught external environment. We cannot quantify all these risks in a scenario analysis, but they do bear discussion. For example, Chinese developers may find it hard to access onshore cash to service offshore debt. A substantial amount of their cash could be trapped at the project level, due to their wide use of joint ventures.

This scenario has indeed played out in recent defaults. Joint-venture partners, trust companies, or other creditors have put hurdles on companies to upstream cash from projects. We believe banks could also limit the transfer of funds away from projects, to ensure project completion and loan repayment. This would be consistent with the central government's aim that prepaid homes are delivered to buyers, even after a developer defaults. Other qualitative factors might also include a developer's willingness to pay, as an entity might opt for default and debt restructuring in a difficult environment.

The unravelling of commercial bills.   In our view, developers' increasing use of commercial bills to pay suppliers and service providers is a byproduct of the current tight financing and restrictive regulatory environment. The risk to developers is manageable at this point, in our view. No entity has heavily used such bills, other than Evergrande. That said, potential liquidity disruption arising from developers' rising credit risks may spread. Simply put, the suppliers and service providers may stop accepting developers' bills, halting building work.

Indeed, in a more extreme scenario, nonpayment risk of developers could cause construction suspension, putting a hard stop to developers' cash flows. Project delivery and revenue booking would deteriorate rapidly, hitting the credit metrics of developers. The affected general contractors and suppliers may then stop paying their own suppliers, or stop work for other property developers, causing spillover effects.

We estimate the total outstanding commercial bills of our rated developers grew by more than 30% to about Chinese renminbi 125 billion in 2020. Even with that increase, the sum only represented about 6% of total trade payables and 3% of reported debt. In 2021, we are expecting slower growth in the use of commercial bills. Evergrande's recent troubles have made suppliers more selective about accepting commercial bills.

Lower-rated developers rely more on commercial bills as they typically use a high gearing, fast-churn model. Their funding channels are also usually limited. They are also incentivized to utilize more commercial bills to meet at least one of the red lines quicker. Although we do not include commercial bills in our adjusted debt as they are not interest-bearing debt liabilities, we capture such exposure through our cash outflow projection and liquidity assessment.

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Possibility of national property tax weighs on outlook.  China's "common prosperity" campaign aims to ensure greater social equality. This includes common access to affordable housing. We believe it is possible that property holding tax may be used to limit ownership of multiple homes, with greater income redistribution from wealthy property owners.

Although a property tax has been discussed for years in China, only two pilot cities (Shanghai and Chongqing) have adopted such schemes since 2011. We believe such a tax will soon spread to more cities and regions as the government is contemplating selecting more pilot cities. We hold off on speculating too much on the effects of this tax as it ultimately depends on the specifics of the rates and exemption criteria. However, we see the possibility for the introduction of a property tax regime that may gradually go nationwide and is stricter than the ones now applied in Shanghai and Chongqing.

Editor: Jasper Moiseiwitsch

Digital Design: Halie Mennen

Related Research

• Sinic Holdings Downgraded To 'SD' On Missed Bond Payment, Oct. 19, 2021
• Fantasia Holdings Downgraded To 'SD' On Missed Principal Payment, Oct. 5, 2021
• Credit FAQ: Evergrande Default Contagion Risk--Ripple Or Wave? Sept. 20, 2021
• China Developers Battle Tight Liquidity And Plummeting Profitability, Sept. 6, 2021
• High Stakes: Analyzing The Risks Of China’s Property Joint Ventures, June 15, 2021