China's largest developer by sales, Country Garden (HK:2007) (CTRYY) , has this week made payments on its bonds that stave off default, an unexpected move that demonstrates the company will fight to stay afloat.
That's giving its penny stock a boost, and as a result property stocks led the way on the Hong Kong market Wednesday. Together with a boost from changes to mortgage rates, these are additional signs of life to China's moribund property industry, which would experience a Lazarus-like return from the dead if the Beijing government's efforts to resuscitate the sector work.
Dollar bonds from companies such as Country Garden used to be exceptionally popular with overseas investors as a way of delivering very high yields at a perceived low rate of risk. But all that changed in August 2020 when the Chinese government introduced its "three red lines" aimed at forcing the property sector to deleverage.
Country Garden last month failed to pay the US$22.5 million coupon on two bonds worth US$500 million each, and due in February 2026 and August 2030, as I explained at the time. It had a 30-day grace period to make the payments before technical default.
It has now done exactly that, hours ahead of Wednesday's deadline, according to multiple sources. It has also reportedly asked to extend by three years the repayment period of eight onshore bonds worth US$1.48 billion.
Country Garden, specializing in massive city-size developments of mass-market apartment towers, was in much better financial shape than China Evergrande Group (HK:3333), which with US$340 billion in obligations as of the end of 2022 was the highest-leveraged developer in the world. So a default for a well-regarded property builder would shake what little faith remains in the sector and potentially cause a cascade of defaults as bondholders and other creditors chase their money.
All eyes are now on the leadership in Beijing, which precipitated the crisis but has also taken recent steps to ease the worst of the pressure on developers. However, the Chinese Communist Party top brass have only tweaked policy, fearful of provoking another asset bubble in home prices if they unleash large-scale stimulus. There's both the issue of moral hazard if they bail out developers that managed their own finances badly as well as the proscription by Chinese President Xi Jinping that "homes are for living in, not for speculation."
In fact, speculating on property has been the primary way to get wealthy in China. The process also encouraged developers to sell apartments as quickly as possible, recycle the capital into land purchases, and ramp up both operations and leverage.
Financial regulators and the central People's Bank of China last week cut mortgage down-payment ratios as well as mortgage interest rates for both new loans and existing mortgages. They also made the changes effective nationwide, in a country where cities have typically been left to set their own rules on homebuying.
Even in cities that had existing home-purchase restrictions, buyers can now put down 30% on a second home, reduced from 40%, and 20% on a new home, down from 30%. That brings top-tier cities such as Shanghai and Beijing, where prices remain solid, in line with cities that have not had restrictions on home purchases, normally smaller cities.
"These measures may provide a brief respite to housing markets, especially in large cities," Nomura writes in a note to clients. "However, the impact could be small and short-lived, as other restrictions on home transactions and land supply remain in place in large cities, and contracting exports, geopolitical tensions and weak confidence in the private sector may continue to weight on the economy in general and sentiment of potential homebuyers in particular."
Beijing is clearly concerned about the negative effects to wealth and to consumer confidence provoked by declining property prices, which discourage future home purchases and thereby become a self-fulfilling prophecy that prices will continue to decline. That loss of faith in the market is transferring into the broader economy, coupled with concern about rapid, Maoist-tinged changes in regulation that targeted the private sector.
Officials are desperately attempting to rekindle "animal spirits," most recently announcing the formation of a new bureau within the National Development and Reform Commission designed to oversee the development of the private sector. It will track and analyze the state of the private economy, as well as drafting policies to promote growth. It will seek to promote the 31-point guideline issued in July, also designed to promote the development of private business.
The approach is typical of a centralized, top-down Communist-style dictatorship, attempting to "order" growth. In fact, many private businesses in China would like to see far less government involvement, regulation and red tape interfering with their operations. Recent government statements have stressed that private business should be viewed on par with the government's state-owned enterprises, but the private sector accounts for 60% of China's economy and 80% of urban jobs, by far the largest portion of both.
By some counts, the property sector alone represents around 25% of China's GDP. Whether real-estate developers can recover is therefore key to any efforts to spur an economic rebound. The stop-start recovery from China's costly, but failed attempt to stamp out Covid-19 has been disappointing, and now export demand overseas is lackluster while China faces geopolitical tensions on multiple fronts, in particular with the United States heading into the election cycle.
Country Garden's bonds have recovered slightly on word of the repayments but are still trading at highly distressed levels, around 13 cents on the dollar. With the Hong Kong market closed on Friday due to a typhoon, the company's shares have risen from HK$0.90 at Thursday's close to HK$1.20 Wednesday.
Its property-management subsidiary Country Garden Services (HK:6098) (CGSHY) led the Hang Seng Index with a gain of 5.8% Wednesday. Other developers such as Longfor Group (HK:0960) (LGFRY) (up 4.6%) and China Overseas Land & Investment (COLI) (HK:0688) (CAOVY) (up 2.1%) also got a boost.
The smart money is betting that the winners out of the property market's downturn will be state-backed developers such as COLI, China Resources Land (HK:1109) and China Vanke (HK:2202). Morningstar likes CR Land and COLI best, "given their presence in wealthy cities and outstanding financial strength." While top-line sales are down even for the best-positioned developers, margins are starting to improve. Nomura favors COLI, Longfor and KE Holdings (HK:2423) (BEKE) among the developers it covers.
Chinese regulators have begun investigating collapsing or collapsed developers, which may lay bare problems that the troubled property companies had disguised in their financials. For instance, Shimao Group Holdings (HK:0813) (SHMAY) in late July revealed the findings of an independent investigation into its finances that sharply raised its total debt obligations, particularly on short-term debt.
"The wraps are coming off China developers' books," S&P Global Ratings credit analysts Fan Gao and Edward Chan write in the report China Developer Probes Expose Governance Risk. The ratings agency "believes Shimao's practices are not an isolated case."
Shimao has already defaulted on its debt, so it is already undergoing last-ditch attempts to restructure its obligations.
The unraveling of the Chinese property industry started with the problems faced by China Evergrande, which preceded Country Garden as China's largest developer by sales before running aground.
China Evergrande's subsidiary inside mainland China, non-listed Hengda Real Estate Group, said in mid-August that it has been notified by China's stock watchdog, the China Securities Regulatory Commission, that it is suspected of violating disclosure requirements.
There has also been a string of resignations by auditors that are no longer comfortable with signing off on the books of developers. The situation has delayed necessary disclosures while also provoking trading halts on the Hong Kong Stock Exchange. So, while skeptics say many Chinese companies keep two sets of books in any case, with a sanitized version shared publicly, we have had even less official material to go on than normal.
New auditors have delivered a verdict that it is questionable whether a string of developers can continue as a viable "going concern." They have cast doubt on the future of not only Evergrande and Shimao but also Kaisa Group Holdings (HK:1638), China Aoyuan Group (HK:3883) and Fantasia Holdings Group (HK:1777).
S&P says auditors are now pushing back against what can politely be called "aggressive" accounting practices among developers, which points to weak corporate governance among some of those companies. Companies such as Shimao and Kaisa set up joint ventures that borrowed on their behalf, with the developer guaranteeing the debts, often without disclosing that debt.