China’s government has been talking about deleveraging its economy to reduce systemic financial risks since at least 2015. The policies it has implemented to curb the country’s debt levels, however, have had mixed results at best.
In 2015 Beijing’s reform drive focused on the shadow banking system and on wealth management products that used leverage to juice returns. The result was a massive stock market selloff and a bevy of ill-advised regulatory measures that made matters worse, requiring a partial course correction. By 2018 the government had successfully reformed its securities, banking, and insurance regulators, setting the stage for further financial reform. However, the trade war with the U.S. prompted Beijing to relax its deleveraging campaign amid concerns that excessive tightening might worsen an economic slowdown. At the time China’s total debt accounted for 250% of GDP, little changed from 2017. By 2019, debt-to-GDP had climbed back to 259%, leading to new talk of deleveraging and SOE reform. Then came the 2020 pandemic, forcing the government to loosen monetary policy once more to limit the damage caused by a plunge in economic output.
By the third quarter of 2020, China’s debt burden had grown an additional 30% with total debt reaching 285% of GDP, making China the second most indebted country in the world after the U.S.; credit to the non-financial sector rose to $41.6 trillion, compared to $60.9 trillion in the U.S., according to the Bank for International Settlements (BIS). Once more, much of the credit support engineered by the government found its way to China’s massive and highly leveraged real estate sector. This time, however, Beijing was determined to de-risk it for good.
The Three Red Lines
China’s leverage ratios reached unprecedented levels in the summer of 2020 as land prices skyrocketed and real estate sales boomed, leading to the government’s most far-reaching deleveraging reform ever implemented. Known as the “three red lines,” the program was based on three specific guidelines (“red lines”) to be followed by the country’s 30 to 50 largest property developers. From now on, any growth in their overall debt level would be based on their ability to meet the following rules:
- Liability-to-asset ratio (excluding advance receipts) cannot exceed 70%
- Total debt to total shareholders’ equity ratio must be less than 100%
- Cash-to-short-term debt ratio must exceed 1x
To simplify the guidelines, the regulators created a color-coded scheme, shown below:
|Color Code||Number of Red Lines Breached||Allowable Annual Growth in Debt|
By the end of 2020, according to Standard & Poor’s, only 6% of the real estate developers it rated in China could fully comply with all three red lines; prominent among them given its size, total sales (second largest real estate developer in China by revenue) and overall liabilities (equivalent to around 2% of the country’s GDP) was China Evergrande.
How Big of a Problem are China Evergrande’s Liabilities?
For a company that has $89 billion in total debt and $304 billion in total liabilities (more in this shortly), it seems surprising that the catalyst for the recent global turmoil in risk assets is $118 million in interest payments due by China Evergrande this week. Especially since, as described above, Chinese regulators set their “three red lines” a year ago, credit rating agencies have been downgrading its debt for months, and the company has been in the spotlight for at least a year. Furthermore, the government has given property developers until June of 2023 to comply with the new leverage requirements. The real issue, though, is not with the company’s debt itself, but with its “other liabilities,” which total about $207 billion. These include about $174 billion due to individual homeowners, contractors and various other parties in the form of accounts payable, including almost $55 billion in trade payables (i.e. building costs payable to suppliers).
Considering that, according to the Wall Street Journal, housing accounts for about one fifth of total economic activity in China, a company’s default to its customers (homeowners) and its trade creditors (suppliers) could have a ripple effect that reverberates across wide swaths of the country’s economy. For starters, a massive dump of its unfinished property on the market could have a disastrous effect on home values, decimating a large portion of many households’ largest asset. Defaults to its suppliers could lead to a significant economic slowdown, considering that property related services and downstream goods consumption account for 7.3% and 1.5% of GDP, respectively, according to Morgan Stanley.
Meanwhile, almost 72% of the company’s $89 billion in debt is owed to banks (secured term loans) and only 29% is owed to bondholders. While the complete list of lenders is not entirely known, many of the largest ones (based on the company’s 2020 annual report) are State-Owned Enterprises, who will unquestionably take a capital hit in any restructuring, but whose government backing would ensure containment. Bondholders, on the other hand, are likely to take the biggest haircuts in any workout, but the total debt held by them adds up to less than 9% of the company’s total liabilities. So, what matters most in any government intervention is the extent to which homeowners, suppliers and trade creditors are made whole, mitigating the worst of the damage to China’s economy. Herein lies the opportunity for the government: if it forces the banks to take a hit to capital commensurate with their seniority in the capital structure and bond and equity holders to take the biggest hit in any restructuring, while protecting those who gave the company deposits and are owed unfinished properties as well as suppliers, Beijing can send a powerful signal to all stakeholders that this time it is serious about systemic deleveraging. Furthermore, as the “three red lines” are implemented, any future monetary intervention by the PBOC is likely to have a greater impact across broader areas of the economy rather than resulting in leverage building up again in the real estate sector.
What It All Means for Chinese Equity Investors
At China’s National People’s Congress in March, the government lowered its GDP growth target for 2021 to 6%, giving it room to continue with its deleveraging campaign while focusing on the quality of its future growth. According to the plan’s agenda, its focus is to “promote high-quality development in all aspects, including the economy, environment, and people’s livelihood and wellbeing, and realize the rise of China’s economy in the global industrial chain and value chain.” The fact that the headline GDP growth rate was set 2-3% points below the running annual growth rate tell us Beijing is serious this time about pushing forward with the economic rebalancing that the government has been pushing for years.
Additionally, the government’s annual “Government Work Report” (GWR) for 2021 establishes the areas of the economy that continue to be prioritized, the majority of which support our thesis that China’s growth will continue to come from “new economy” sectors and less from low-value exports and fixed asset investment (including real estate as outlined above). A few key points from the report, presented below, support our thesis (extracted from a summary of the Work Report by Deloitte):
- “The GWR continues an established employment-first policy, addressing hot topics involving people’s wellbeing, such as education, healthcare, housing, basic living requirements, intellectual and cultural needs, and social governance.”
- “The domestic market is the cornerstone of China’s new development pattern. In 2021, it will continuously expand domestic demand as a strategic imperative, increase personal incomes through multiple channels, fully tap the potential of the domestic consumption market.”
- “China will foster a new development pattern in the domestic market. In the 14th Five-year Plan period, it will pursue a strategy of expanding domestic demand and intensifying supply-side structural reform and generate new demand with innovation-driven development and high-quality supply.”
- “Scientific and technological innovation are crucial to the new development pattern. Innovation is at the heart of China’s modernization drive. China will strengthen science and technology to provide strategic support for development.”
- “On the supply side, China will encourage supply for the consumption of big-ticket items, environmental protection and new goods and services. The Report notes that China will encourage steady increases in spending on automobiles, home appliances, and other high value items.”
- “China will strengthen its public health system, improve the system for disease prevention and control and accelerate the development of the healthcare industry.”
- “It will continue to systematically promote centralized purchasing and include more medicines for chronic and common illnesses and high-priced medical consumables into bulk government purchases to lighten patients’ burden.”
- “It will improve the capacity of medical services at the county level, expand trials of national and regional medical centers, and strengthen the ranks of general practitioners and rural doctors.”
More volatility lies ahead as the China Evergrande “saga” plays out. We assume the government will see the current situation as an opportunity to emphasize its focus on an orderly deleveraging of one of its economy’s most important sectors, while avoiding systemic contagion or popular unrest. While equity markets are likely to continue to experience risk-on/risk-off episodes, investors should remain focused on owning quality companies that stand to benefit from the country’s ongoing economic rebalance. We therefore reiterate our “new economy” thesis for Chinese equity owners, who should continue to be watchful of pockets of excessive debt as the government’s deleveraging campaign continues in earnest.
 Source: UBS Asset Management, January 2021
 Source: FactSet
 Source: https://www.wsj.com/articles/what-china-must-do-to-contain-evergrande-fallout-11632234388
 Source: Morgan Stanley Research: Are spillover risks from China’s property sector manageable? September 22, 2021.
 Source: https://www2.deloitte.com/cn/en/pages/public-sector/articles/interpretation-of-the-2021-government-work-report.html