China Evergrande Group's liquidity strains, restrictive policies in China, and a few recent defaults have shut offshore funding for many developers in the country. S&P Global Ratings views this downturn as policy driven and expects authorities to finetune their measures to manage contagion risk. We believe they will, however, be reluctant to pull back their policies until entities meaningfully deleverage and operate within the authorized boundaries. That won't likely happen until 2023.
This downturn is unlike previous corrections as it has already contributed to developer defaults. Fantasia Holdings Group Co. Ltd. (SD), Sinic Holdings (Group) Co. Ltd. (SD), China Properties Group Ltd. (unrated), and Modern Land (China) Co. Ltd. (unrated) have missed bond payments. China Fortune Land Development Co. Ltd. defaulted on a US$530 million bond in February 2021 (see "China's Contagion Risks Rise," published Nov. 10, 2021, on RatingsDirect). We recently downgraded Kaisa Group Holdings Ltd. and Fujian Yango Group Co. Ltd. to 'CCC-' citing an "inevitable" default scenario, and we have similar expectations for Evergrande, which has more than US$300 billion in liabilities.
Investors are keen to understand what will happen next in this fast-moving situation. Their outlook is unusually negative--in a poll we conducted, 91% said they expected more China developer defaults over the next six to 12 months (see chart 1). Their concerns are largely about controlling their exposure to China property debt, and then how their risks might spread to other industries and investments. Here we address investor questions raised at a recent well-attended forum on the China property sector.
Frequently Asked Questions
How did you arrive at your projection of a 10% drop in residential sales in China in 2022?
We looked at this downturn in the context of the ones that happened in 2008 and 2014. During the 2008 global financial crisis, sales dropped about 20%. In 2014 the decline was 8%-9%. We believe this downturn will hit sales in a slightly more severe way than that seen in 2014, but the effect will still be considerably better than that of 2008.
In our view, a 10% decline is tolerable from the perspective of policymakers. If the decline falls considerably below this level, we anticipate authorities will ease their measures. Until then, they are unlikely to moderate, in our view.
Most of the slippage will be due to a drop in sales volumes. Prices drops should be relatively minor--just 3%--with an increasing number of local governments setting floors on home prices.
As with 2021, policy tightening should largely drive next year's likely drop in residential sales, particularly with regards to mortgage availability. Prospective homebuyers will also want to see how the rollout of trial property taxes will affect valuations.
How can investors understand the volume of debt that a developer might hold off balance sheet?
With difficulty. We ask developers about their joint ventures and incorporate this information into our look-through analysis, using proportional consolidation. However, their disclosure is voluntary. In our adjusted debt, we add back guarantees that usually stem from joint ventures and are held off balance sheet.
Some equity investments reported on developers' balance sheets could turn out to be debt. These securities commonly include an (undisclosed) fixed-return mechanism, and provisions requiring the issuer to buy back the instrument.
From our experience, the risk that minority-interest stakes serve as hidden debt may be higher if the joint-venture partners are not developers but financial institutions, individual investors, or small local firms. They may seek a fixed return since they don't contribute to the projects' operations, as a developer would. Kaisa's default in 2015 and the subsequent audit revealed considerable debt disguised as equity on the balance sheet.
Heavy use of off-balance-sheet debt or other unreported obligations also makes it hard to understand an issuer's true maturity profile. As we have seen in the examples of Evergrande and Kaisa, there may also be off-balance-sheet obligations in the form of wealth management products. Even though these obligations are issued by third parties and may not carry direct and full guarantees from the rated entities, they may have to settle repayments to manage reputational risk.
In addition, private U.S.-dollar bonds are apparent in the cases of Agile Group Holdings Ltd., Fantasia, and Kaisa. The securities can be off or on balance sheet. The market often does not have details on the instruments, similar to wealth management products. This may lead to surprises.
As a rule of thumb, we proportionally consolidate an entity's off-balance-sheet debt and EBITDA to arrive at our look-through leverage. Developers bear extra scrutiny if they get more than one-third of contract sales through joint ventures.
We also care about the quality of the joint-venture partners. If such partners are renowned developers with solid credit profiles, they are more likely to be genuine equity partners. However, stronger partners, such as large state-owned enterprises, may exert more control of the cash at the project level, which presents its own issues (see below).
What are the circumstances for "trapped" cash, or money that an entity declares but cannot use to repay debt?
The key consideration is the accessibility of cash for debt servicing, especially for the cash at the project company level. The unrestricted cash on the balance sheet may not be entirely unrestricted. The ultimate question is whether the developer has control over the project cash flow.
One dimension is how heavily a firm uses joint ventures, and whether the developer controls the venture. If it doesn't, then the developer has limited control of the project cash flows. This limits its ability to upstream cash for purposes including debt repayment.
The second dimension is whether legal or regulatory requirements constrain the developer's access to cash at the project level. Some local governments require developers to put up a deposit, held in escrow. They do this to ensure a project can be completed, and that homes will be delivered to buyers.
In addition, we understand that financial institutions may prioritize repayment of their loans before allowing a project's cash to be upstreamed to the developer.
In our opinion, a firm will have less unrestricted cash accessible for debt servicing if it has a lot of joint ventures, doesn't have control of its projects, and operates in lower-tier cities where governments require a large amount of cash on deposit for construction.
How will the rollout of property taxes in pilot cities affect developers?
The tax will certainly affect homebuyers' expectations and property values. Under a simplified scenario and holding all other conditions the same, assuming a 5% market rate of return and 1% tax rate, the tax would immediately cut home values by about one-fifth. The buyer would need to bear the ongoing cost of the tax. This would affect demand, coolling sales.
The direct effect on developers will depend on their products, and the geographic location of their projects. In cities or regions where homes are commonly bought as investments, the effect of property taxes could be higher.
We need more visibility on the details, such as the tax rate and the exemptions. Moreover, the pilot rollout will likely run for five years before authorities make a decision about whether to extend it to the rest of the country.
Do onshore bonds have a higher priority of repayment than offshore bonds?
Structural subordination means onshore issuers have better access to cash at the project level than offshore issuers, even when both hold senior, unsecured claims.
About three-quarters of our rated developers are "red chips" (Chinese entities incorporated offshore, with key operations in onshore China, and typically listed on the Hong Kong exchange). This means the offshore listed company issued or guaranteed the bonds.
For onshore bonds, developers use an onshore platform that group a number of projects. The platforms are an intermediate holding company. They are in the middle--not quite at the level of the cash-producing assets, but they are closer to the project companies and their cash flows than the offshore issuer.
The U.S.-dollar bonds are subordinate to the onshore bonds issued at the intermediate company level. The project firms get cash first, then the intermediate holding companies, then the offshore companies.
When might a bond exchange be viewed as "distressed"?
If the exchange is a de facto debt restructuring. There are two key questions to that. First, if the issuer doesn't do a debt exchange, would there be a high risk of a conventional default? Second, are investors sufficiently compensated in the exchange with reference to the original terms of the notes?
Secondary repurchases or tender offers also fall under the scope of an exchange offer. However, a below-par repurchase does not automatically mean that it is distressed. We also need to look at whether the company in question will be able to repay at par upon maturity.
If an issuer is rated 'B-' or below with an imminent offshore maturity or an escalated risk of conventional default without the exchange offer, there is a good chance we would view the offer as distressed and equal to a debt restructuring.
What is your latest view on the likelihood of an Evergrande default, given its recent bond payments?
We still believe an Evergrande default is highly likely. While the issuer has managed to cover recent coupon payments, the bigger test will be in March and April 2022, when it will have to make a much larger (US$3.5 billion) repayment of principal for its public U.S.-dollar senior notes.
We believe the government wants to unwind Evergrande in a controlled fashion, or let an orderly debt restructuring take place. Authorities want to maximize the number of presold homes Evergrande completes to protect the interests of homebuyers, and for it to largely repay the contractors and other small businesses that support the firm. Evergrande also has substantial assets that it can sell, and can use the proceeds to settle bonds or other obligations as they come due.
At some point, however, Evergrande's massive debt will catch up with it. The firm has lost the capacity to sell new homes, which means its main business model is effectively defunct. This makes full repayment of its debts unlikely.
How long will the market remain shut for Chinese developers' bond issuance? What could reopen the market?
In our view, government tightening measures are driving the downturn. Some developers' inadequate liquidity management and their reliance on hidden debt have compounded market strains, but investors will likely be focused on when easing may happen.
While we expect Beijing to largely maintain existing policies, it may finetune measures to avoid stress points becoming too acute. Mortgage availability is improving, with authorities potentially reopening the interbank onshore capital market for issuances. It boils down to whether these efforts, if sustainably realized, will be able to stabilize the market. Stabilization of developers' contracted sales performance will also play a part.
What is your expectation for defaults by Chinese property developers over the next six to 12 months?
As we outlined in our recent publications, we expect defaults for Chinese developers to increase over the next six to 12 months. That is reflected in our recent rating actions. We have recently downgraded seven Chinese developers to the 'CCC' level or below, which means we believe there is a default scenario for them. Two out of the seven have already defaulted.
Moreover, according to the sensitivity analysis we conducted recently, about one-third of the rated Chinese developers' liquidity could come under pressure under our most severe scenario stress test. This assumes contracted sales are 20% lower than our base-case projection, a 30% repayment of minority interests, and 30% early repayment of trust loans.
Writer: Jasper Moiseiwitsch
- Kaisa Group Downgraded To 'CCC-' On Depleted Liquidity; Outlook Negative; Rating Withdrawn At Issuer's Request, Nov. 11. 2021
- China Property Watch: Strains In The Key Of 'B', Oct. 27, 2021
- 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
This report does not constitute a rating action.
|Primary Credit Analysts:||Matthew Chow, CFA, Hong Kong + 852 2532 8046;|
|Aeon Liang, Hong Kong + 852 2533 3563;|
|Edward Chan, CFA, FRM, Hong Kong + 852 2533 3539;|
|Esther Liu, Hong Kong + 852 2533 3556;|
|Secondary Contact:||Lawrence Lu, CFA, Hong Kong + 85225333517;|
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