Even an orderly unwinding of the highly indebted property sector carries underappreciated risks to foreign investors.
Even an orderly unwinding of the highly indebted property sector carries underappreciated risks to foreign investors.
T he long-anticipated default of China’s most indebted property developer finally came to fruition last week. Evergrande Group will have to restructure some of its $300 billion in liabilities, of which $19 billion are international bonds. While the firm’s bonds have steadily plummeted over the past few months, investors do not appear to be anticipating significant knock-on effects from the insolvency. Indeed, some firms see the default as a buying opportunity.
While an outright collapse of China’s property sector looks unlikely, even an orderly unwinding of the highly indebted property sector carries underappreciated risks to foreign investors. Evergrande’s default — the latest in a series of similar solvency issues at Chinese property developers including Fantasia, Huarong, HNA, and Ping An — could hit local-government bonds and Chinese holdings of U.S. assets.
Local-Government Credit
Although China’s central government has relatively little debt, local governments and related entities owe much more. According to IMF statistics, explicit local-government debt amounted to 25 percent of GDP in 2020. This compares unfavorably to the United States, where $3.2 trillion of state and local debt was just 15 percent of GDP last year.
But in China, debt on local balance sheets is just the tip of the iceberg. As Goldman Sachs reported in October, local government financing vehicles (LGFVs) owed $53 trillion renminbi (RMB) (or 52 percent of GDP) last year. Goldman notes that “LGFVs are technically non-government corporate entities but, as the name suggests, are typically closely associated with local governments.” Goldman Sachs estimates that land sales account for 17 percent of local-government revenue and expects a considerable decline in this revenue source as developers reduce their demand for new plots.
Local-government exposure to the property sector is a problem for foreign bond investors, who have poured capital into Chinese debt at a record pace. Net inflows of funds into China reached a seven-year high in 2021, driven largely by purchases on renminbi-denominated bonds, into which foreign investors have funneled more than $310 billion. That means that the $210 billion of dollar-denominated offshore debt issued by Chinese property developers significantly understates foreign exposure to the sector.
As one researcher explained to Bloomberg, “Chinese bonds are the only major bonds in the world that will actually provide a proper protection in a global systemic event because it’s the only central bank in the world that still has a big bazooka. And Chinese bond yields are trading at a higher level than the European or U.S. bonds.”
Higher yields appear to reflect greater doubt on the part of investors that Chinese authorities will prevent LGFVs and other state-owned enterprises from defaulting. According to Enodo Economics, nine SOEs defaulted on 49 billion renminbi of debt in 2020; the figures for this year should be worse.
Chinese Holdings of U.S. Assets
Troubles at Chinese real-estate firms could spill over to the United States and other international markets as these companies are obliged to retrench and conserve their cash. Creditors just took over a downtown San Francisco property from China Oceanwide Holding Company. Oceanwide had planned to build a two-tower hotel, office, and residential project at 50 First Street, but now there is only a gaping hole in the ground. The company also has troubled projects in Los Angeles, New York, and Hawaii.
On October 31, troubled Chinese conglomerate HNA Group’s U.S. affiliate placed two office buildings into bankruptcy. According to the property manager for the larger of the two buildings, located at 245 Park Avenue in Manhattan, HNA had already failed to deliver the funds needed to carry out the facility’s capital-investment plan and subsequently defaulted on the property’s mortgage.
While Chinese investment in U.S. commercial property has slowed down in recent years, Chinese investment in U.S. residential real estate represents a large, underappreciated risk. A recent Federal Reserve paper finds that China’s net holdings of U.S. residential real estate totaled $344 billion in 2018, at least $100 billion of which is not accounted for in official statistics. The authors find that Chinese ownership of residential real estate has “generated multiple China shocks in the U.S. housing market, with house prices in China-exposed areas having risen significantly faster than those in areas not exposed to Chinese demand.”
Opacity and Lack of Reliable Analysis Could Exacerbate a Downturn
Chinese debt markets, including those for implicit and explicit local-government bonds, are not as transparent as their U.S. counterparts. Consequently, there may be hidden debts that produce negative surprises when they go unpaid. Investors may also lack the information necessary to fully assess debt issuers, and thus secondary market prices may not reflect the true risk of these entities.
In the property sector, Fantasia defaulted on $150 million in bonds that do not appear to have been on the company’s financial statements. Analysts believe that many other firms use joint ventures, offshore private bonds, and retail wealth-management products to hide their reported debt, possibly to circumvent the government’s Three Red Lines policy designed to limit leverage.
Unlike the U.S., China lacks a central repository for the audited financial statements and other disclosures of municipal-bond issuers. State secrecy laws inhibit the publication of budget details, and government agencies’ use of cash-based accounting does not include long-term obligations.
In the absence of adequate public disclosure, bond investors might rely on credit-rating agencies, but Chinese agencies have performed quite poorly — far worse than their much-maligned U.S. counterparts.
China Chengxin International Credit Rating Company (CCXI), the nation’s oldest rating agency, rated Evergrande’s onshore bonds AAA until September 3, nearly a year after the media began reporting on the company’s liquidity issues.
CCXI’s slowness to downgrade is reminiscent of the big three U.S. rating agencies’ reluctance to strip Enron of its investment-grade ratings back in 2001. At the time, it was well known that once Enron fell into junk territory, the company would be obliged to repay loans with money it did not have, forcing a bankruptcy filing. Enron filed for a Chapter 11 petition just four days after Moody’s downgraded the firm.
In the case of Evergrande, AAA status meant that its bonds could be pledged as collateral for repurchase agreements on the Shanghai and Shenzhen stock exchanges. We have to wonder whether CCXI maintained Evergrande’s inflated rating out of fear that a downgrade would close the window on further borrowing. While such concerns may be understandable, they should play no role in a rating-agency action.
Evergrande is not the first case of a dubious CCXI AAA rating. The agency rated Yongcheng Coal & Energy Holding Group AAA when it defaulted on $153 million of short-term debt last November. That rating failure earned CCXI a three-month suspension on rating new bonds imposed by the National Association of Financial Market Institutional Investors, a self-regulatory organization overseen by China’s central bank.
Previously, regulators had meted out an even more severe penalty to another Chinese domestic-rating agency, Dagong. In 2018, the firm received a one-year suspension due to conflicts of interest and rating inflation. It returned to the market only after selling a 58 percent stake to a state-owned investment firm, ceding whatever independence it may have had.
Rating-agency problems in the United States have illustrated the need to manage conflicts of interest by walling off analysts from the influence of salespeople and managers trying to maximize rating fees and consulting revenues. Unfortunately, these lessons do not seem to have been learned in China.
While Evergrande’s insolvency is unlikely to represent a “Lehman moment” for China, declining real-estate prices could impair the values of assets as far-flung as U.S. homes. More broadly, the frequent failures of China’s rating agencies point to the possibility of hidden risks throughout the country’s financial markets.
Marc Joffe is a senior policy analyst at Reason Foundation. Daniel Tenreiro is the Thomas L. Rhodes Journalism Fellow at the National Review Institute.