The Three Red Lines Will Trim China's Prosperity Sector Forever

China's central bank says property developer Evergrande Group failed to act judiciously in the face of changing market conditions. However China's three red line rule all but guarantees there will be dozens of defaults. This is because China's biggest real estate developers haven't followed good business practices.

China's consumers put around 75% of their wealth in real estate and it's a ticking time bomb of a shadow based economy.

The problems enveloping Evergrande, which has eyewatering total debts of $305bn -- but that's nothing compared to all the developers that will go bankrupt together in 2022.

It's not complicated. One third of China's property developers will struggle to repay their debts in the next 12 months, according to a new report, as the sector reckons with increasingly serious headwinds from falling sales, restricted access to credit and a wider downturn. This will sour Chinese sentiment around real estate for an entire generation and could in theory lead to a real estate correction globally. Sentiment is contagious in a world of social media.

Contagion is real. The financial contagion sweeping through the sector represents a serious risk for China – and the global economy – as its investment and construction driven model of growth begins to creak under the strain of mind-boggling debts. China's debt-based economy is, in some degree, a house of cards.

Three red lines and China real estate – in sixty seconds

  • China's new 'three red lines' policies for the real estate sector will likely drive a wave of credit reratings for developers and open up opportunities for bond investors;
  • In short, the policies amount to forced deleveraging to improve financial health for the real estate sector;
  • The government is moving to address debt build-up in the sector and there is high confidence in the scope of these policies;
  • Future access to financing will be predicated on developers' adherence to strict criteria including liability to asset ratio (excluding advance receipts) of less than 70%, net gearing ratio of less than 100%, and cash to short-term debt ratios of more than 1x.

With regulations comes a great burden of responsibility for Chinese leaders. Common Prosperity also has a price.

  • China has suffered housing market downturns before but this one is set to be "unusually intense", S&P said.
  • Fears about a fast-spreading contagion in the US$5 trillion property sector have sparked a sell off of bonds from Chinese developers and 2022 will be pretty dire, to be realistic.

Although Evergrande has emerged as the symbol of the debt-laden structure with liabilities of $300bn at home and abroad, the Chinese property sector as a whole owes an estimated $5 trillion, according to analysts at Nomura.

It's not just Evergrande, it's so many others and quite a few of the major ones as well. Real estate and affordable housing has become a global issue for young consumers. Churn of the Middle Class is occurring at an astounding rate. Wealth inequality is the real world GenZ grows up in, not just environmental uncertainty. Chinese GenZ are laying flat for a variety of reasons. The U.S. has no intention of making 'common prosperity' a priority any time soon.

In China, property companies must come up with $92bn as bond payments mature in the next year. There's growing alarm that the liquidity crisis at Evergrande will spill over to other developers as President Xi Jinping maintains measures to cool the property market. Fears of contagion risks intensified this month after a surprise default by Fantasia Holdings Group Co. spurred a dramatic selloff in the offshore market.  The domino effect could be immense since Chinese consumers have been misled to put all their eggs in one basket. It's a massive pyramid scheme.

S&P said: "In the most severe scenario, the liquidity of as much as one-third of rated Chinese developers will come under pressure. The entities most at risk are overwhelmingly rated 'B-' to 'B+'. Over 50% of our rated portfolio of Chinese developers falls into this ratings category."

Capital Economics warned this week that China's manufacturing and construction sectors were "on the cusp of a deeper downturn that could pull down China's growth to just 3% next year". We have to be realistic that the chip sector, supply chain disruptions, Delta plus and China's real estate crisis are not going away any time soon. The equity market bubble won't last forever.

The state of the property market, which accounts for about 25% - 35% (estimates vary) of the Chinese economy, makes for an alarming backdrop to these problems. Since consumers have 75% of their wealth in real estate, a crash could cause social upheaval. The Chinese stock market has already lost much of its value suddenly due to a torrent of regulatory announcements. The barrier to move funds for Chinese in mainland China is significant.

 Home sales by value tumbled 16.9% in September from a year earlier, after a 19.7% drop in August, according to Bloomberg calculations based on official data released last Monday. This doesn't truly blow up until the end of 2021 or sometime in 2022.

Chinese developers are facing a "triple whammy" with dwindling access to offshore financing, "catastrophic" September pre-sales and a limited onshore banking market. Economic karma is quickly arriving for China. You pay to grow too fast in gimmick debt-based ponzi schemes. How does the story actually end? It could put China back ten years.

There are a number of stocks that could be impacted and have already felt the bizarre impact of dwindling sentiment and a dire future in real estate. To pretend that this does not impact the global economy is also naïve. For China, this is only the beginning. This year has seen the longest slump since 2015 in new construction starts, while property sales by floor area dropped 15.8% in September, the third monthly decline in a row. New mortgages are down 9% this year.

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