Why the Evergrande crisis can be contained

Australian banks have more sunk in the domestic property market than their China counterparts – the Evergrande drama is not a risk to broader markets.

A view of the Evergrande Centre building in Shanghai. ‘There is no doubt Evergrande is an important company. But it is a relic of the old high leverage, high growth China model that allowed property developers to aggressively acquire land reserves through favourable bank loans.’ Picture: AFP

Foreign investors have been dumping Chinese stocks throughout 2021 on fears the Chinese government’s recent policy changes will unwind the country’s two decades of economic successes.

Experienced China investors took advantage of the sell-off to accumulate positions in both Tencent and Alibaba, with both stocks rebounding by 15-20 per cent in September.

But just as market sentiment began to settle, rumours quickly spread that the impending collapse of a real estate developer, Evergrande, risked triggering a financial crisis in China. Foreign investors have panicked again, and popular stocks such as Alibaba and Tencent have fallen back down towards August’s share price lows.

But don’t believe the Evergrande crisis is going to lead to a major financial crisis in China.

There is no doubt Evergrande is an important company. But it is a relic of the old “high leverage, high growth” China model that allowed property developers to aggressively acquire land reserves through favourable bank loans.

The company is the second-largest property developer of high-end and mass-market apartments across mainland China. But many of its problems stem from a diversification into new business opportunities, including sports (it owns the Guangzhou soccer team), tourism, healthcare, food and electric vehicles. That investment has diverted vital cashflow away from its property business.

When rumours of a liquidity crunch at Evergrande spread three months ago, locals stopped buying its property developments, placing further strain on its dwindling cash reserves. With substantial short-term loans due, domestic banks then began to call in their loans to the developer, forcing Evergrande to sell assets including its mineral water business and land holdings.

But problems at Evergrande do not reflect problems in the broader Chinese property industry nor policy mismanagement by Beijing.

Recent changes to government policy gave property developers until 2024 to cut their leverage by lowering their total debts and raising cash reserves.

Evergrande’s recent financial results show the company is breaching these new policies, with short-term bank loans of $US37bn ($50.7bn) supported by cash reserves of only $US14bn.

Beijing’s policy moves have also somewhat insulated the broader economy from its property sector, so Evergrande’s woes are also unlikely to spill into a wider economic crisis.

The Chinese property sector contributes up to 20 per cent of GDP. But government policy has limited the risk of financial contagion. It has ensured no single property developer can hold more than a 7 per cent market share. Evergrande market share is 4 per cent, while its outstanding loans make up less than 5 per cent of total Chinese property sector loans.

Recent data from the People’s Bank of China highlights that total banking loans to the property sector is 28 per cent of total bank lending, with mortgage loans 21.4 per cent of lending.

The credit exposure of Australian banks to the domestic property sector is substantially higher.

Westpac, for example, has 70 per cent of its total loan portfolio exposed to the property sector (with a similar figure across all local banks).

China has not only reduced the risk of a property crash affecting its financial sector by managing bank exposure to the property sector, but it has also ensured sufficient loans are available for borrowers in its industrial and consumer sectors.

Amid constant speculation in some quarters that we are facing another “Lehman moment”, which preceded the global financial crisis, it is worth reviewing the Evergrande situation in the context of recent history.

When the US Federal Reserve tried to rein in rising property prices by raising interest rates in 2006, property prices crashed by 30 per cent, triggering widespread home loan defaults.

But we are not seeing a Chinese property price bubble. The government’s property tightening measures since 2017 are working well. Housing price gains have averaged just 5 per cent per year since 2018, a big slowdown from average annual growth of 18 per cent over the period from 2012 to 2017. Maintaining mortgage borrowing rates above 5 per cent and loan deposit requirements of 30 per cent has driven much of this policy success.

Just two property developers, Evergrande and Guangzhou R&F, failed the government’s liquidity test requirements in July this year. Their ability to borrow additional funds has been restricted.

A fall in total leverage across developers from 73 per cent of assets in 2019 to 61 per cent in July this year suggests that risks to the financial sector and the broader Chinese economy remain well contained.

The market’s overreaction to China news again provides experienced investors with the opportunity to increase their exposure to the best listed equites.

When the smoke clears, both offer substantial share price upside based upon past episodes of foreign investor-led selling over the past decade.

In fact, when you look at US interest rates running below 1 per cent for much of the past decade, excessive lending to the property sector (over 50 per cent of total commercial loans) has once again caused runaway US housing prices, which are up 100 per cent over the past 10 years and 21 per cent in the past 18 months.

This begs the question: is there potentially more risk of another property crisis brewing in the US and Australia, than in China?

Tim Davies is director of research at Holon Global Investments