(Bloomberg) — Just weeks ago, Wall Street analysts and central bankers were quick to assure investors that a collapse by China Evergrande Group wouldn’t be a Lehman moment. Regulators in Beijing said that the crisis would be “contained.”
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Now that a bond selloff has spread to China’s entire real estate sector and beyond, concern is growing about the potential risk to the global financial system.
The U.S. Federal Reserve made that link explicit in a report on Monday, warning that what happens in China’s property industry could impact financial markets and threaten world economic growth. Underscoring the risks of a potential spillover, the Hong Kong Monetary Authority asked banks to disclose their exposure to Chinese real estate, according to a local media report.
At the heart of the bond market rout is concern that developers may have far more debt than disclosed on their balance sheets. That’s after some companies struggled to pay public and hidden debt despite appearing to have sufficient capital. Making matters worse is developers’ inability to roll over maturing debt due to surging borrowing costs that effectively shut them out of the dollar bond market. China’s 10 largest developers by sales owe a combined $1.65 trillion in liabilities.
“China appears to be stress-testing its financial system,” said Larry Hu, head of China economics at Macquarie Group Ltd. “Only under stress do you know how much off-balance sheet debt there is and how much pressure the system is able to handle. But the danger is that China decides to ease off too late.”
The cash crunch is worsening by the day. The yield on a Bloomberg index of Chinese junk dollar bonds — dominated by property firms — has surged toward 24%. Kaisa Group Holdings Ltd., which said last week it missed payments on wealth products, was downgraded further into junk by Fitch Ratings on Tuesday.
The selloff has spread to higher-grade issuers such as Country Garden Holdings Co., while even a company controlled by China’s government has seen its bonds slump. Spreads on the nation’s investment-grade bonds over Treasuries widened the most since April on Tuesday.
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Shares are also plunging. A Bloomberg index of Chinese developers is at the lowest level in more than four years after losing 33% in 2021. Shareholders of companies such as Evergrande, China Fortune Land Development Co., China Aoyuan Group and Yuzhou Group Holdings Co. are sitting on losses exceeding 70%. The gauge is valued at just 0.3 times book value, showing traders are assigning a significant discount to developers’ reported assets.
There are few signs policy makers will ease curbs on the property market, despite the risks to the economy. Guo Shuqing, the head of nation’s banking regulator, a year ago called real estate “the biggest gray rhino” for China’s financial stability — referring to a large yet overlooked threat. President Xi Jinping appears determined to confront the challenge as he seeks to bring “common prosperity” and secure a third term to extend his indefinite rule.
Cities including Beijing and Tianjin have tightened supervision over the use of proceeds from property pre-sales to ensure projects are completed, China Business News reported. That will worsen the cash shortage for developers, making it harder for them to repay their debts.
The stakes are high. Chinese banks had more than 51.4 trillion yuan ($8 trillion) of outstanding loans to the real estate sector as of September, an increase of 7.6% from a year earlier. The exposure was more than any other industry, and accounted for about 27% of the nation’s total lending, according to official data. About 41% of China’s banking system assets were either directly or indirectly associated with the property sector at the end of last year.
“We expect most of Beijing’s property curbs will remain in place for a while, with the worst likely yet to come for both China’s property sector and macro-economy,” Nomura International HK’s economists Ting Lu and Jing Wang wrote in a note published Monday. “Beijing’s policy makers may opt to ramp up support to prevent worsening defaults in coming months.”
Some see the selloff as an opportunity. Goldman Sachs Asset Management has been adding a “modest amount of risk” through high-yield dollar bonds issued by China property developers, said Angus Bell, a member of Goldman’s portfolio management team. The market is overestimating the contagion risk, Bell said in an interview last week.
Yet central bankers are starting to sound the alarm. Hong Kong banks will be required to disclose their loans and credit issued to mainland developers, treasury units’ securities holdings as well as the proportion of their exposed assets, the Hong Kong Economic Journal reported, citing unidentified people.
“Financial stresses in China could strain global financial markets through a deterioration of risk sentiment, pose risks to global economic growth, and affect the United States,” the Fed said in its twice-yearly Financial Stability Report released Monday.
The warnings go both ways. Policy makers in China this year blamed post-pandemic liquidity unleashed by central banks elsewhere for inflating prices. The banking regulator in March said asset bubbles in overseas markets posed a risk to the global economy and could burst soon.
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For now, limited signs of contagion in mainland financial markets give Chinese authorities room to maintain their curbs on the property industry, meaning the likelihood of some of kind of Lehman moment remains remote.
The economy is still projected to grow 8.1% in 2021, while the Shanghai equity benchmark is less than 6% away from a six-year high. Money market rates are subdued as the People’s Bank of China ensures there’s sufficient liquidity in the banking system. The yuan is near the strongest versus the dollar since 2018.
But how Beijing manages its crackdown on the nation’s real estate industry may have far-reaching consequences beyond its borders.
“Even if systemic risk remains low for now, the contagion risk is very real,” Macquarie’s Hu said. “I would say China needs to act if onshore markets panic and the economic risk grows so big they can’t defend 5% growth next year.”
(Updates to add Kaisa downgrade in sixth paragraph.)
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