By Stephen Chang, portfolio manager, Annisa Lee, Asia-Pacific credit research, and Jingjing Huang, credit product strategist, at PIMCO
Earlier this year, we published our views on the China property sector, noting that we expected the government’s credit tightening to partially offset resilient demand in the physical housing market. We also highlighted three themes to watch under the “Three Red Lines” policy, idiosyncratic risks being one of them. Over the past few months, we have seen examples of this idiosyncratic risk emerge, with Evergrande being the most notable. Given recent developments, we have updated our outlook for China real estate and its potential impact on the banking sector.
Physical property market: tight policy and softening demand
We expect the Chinese government to maintain tight property policies that impose greater control on developers’ total debt growth, on banks’ exposure to the property sector, and – through the centralized land auction system – on land price. In addition, with the pandemic continuing to create uncertainty and a slower economic recovery, demand for housing has softened. Despite robust sales growth in 1H 2021, we believe the outlook will be challenging over the next six months.
However, we do not expect systemic risk across China’s real estate sector. Real estate directly contributes 10%-15% of China’s overall GDP growth, making it systemically important to the Chinese economy. Furthermore, most local governments rely on the property market as their largest revenue source. That said, the property development sector is a fragmented market with more than 20,000 operators and we also expect the government to implement selective easing measures to restore homebuyer confidence in order to stabilize nationwide property and land sales if required. While we may see more defaults in the sector, we expect them to be more idiosyncratic in nature and do not anticipate widespread contagion risk.
Looking beyond the 12-month cyclical horizon, several factors should provide some downside risk mitigation for the property sector. Progress toward urbanization continues to create long-term fundamental demand for housing. In addition, the loan-to-value (LTV) ratio for the residential sector is relatively low in China compared with most developed countries. With currently tight housing and monetary policy, there is significant room for the government to relax these settings.
China real estate: the investment implications
Our China real estate exposure continues to focus on more resilient developers that are unlikely to come under refinancing pressure in the next six to nine months. We consider this focus prudent since access to capital markets has become further constrained. We remain cautious regarding smaller companies that focus on rural areas, as well as those most vulnerable to a continuation of tight regulation.
In light of recent developments, we are closely monitoring several indicators that may give us confidence to consider increasing exposure to the sector. Weaker macroeconomic data, such as in golden week holiday spending, housing fixed asset investment data, or consumption data might indicate the likelihood of increased government support for the sector. This could include a relaxation of mortgage quotas, or increasing developers’ access to the onshore bond market.
In our view, in-depth bottom-up research and prudent credit selection remain crucial for investors in the sector. Government policy measures and idiosyncratic risks will create short-term volatility and drive performance divergence between developers.
Stress testing the banking sector: Systemic risk unlikely
As idiosyncratic property company events made the headlines, investors have been increasingly concerned about potential spill-over effects, particularly for Chinese banks. We have conducted stress tests to assess both the direct and indirect implications for the Chinese banking sector, noting that global banks generally have immaterial holdings of China real estate loans and thus are only likely to be affected indirectly by broader China macro developments, rather than directly from the property sector.
Three key questions in our stress test framework include:
- How bad can the property sector get?Based on listed developers’ cash/short-term debt ratio as of 1H 2021, we analyzed the potential for loans to transition into nonperforming (NPL) status in a tail-risk scenario, while taking into account the direction of government policy.
- How exposed are banks to the property sector? Our in-depth analysis assessed banks’ exposures to property developers through loans, as well as other on-balance-sheet and off-balance-sheet items.
- How much buffer do banks have to absorb the credit shock?Based on the above assumptions, we estimate that Common Equity Tier 1 (CET1) and capital adequacy ratio (CAR) metrics for the sector would still be above regulatory requirements even in our stress scenario.
In addition, we believe the distribution of losses will be uneven, with select mid-sized and regional banks under more pressure than the larger banks.
Overall, while further deterioration across property developers, if not contained, would surely give rise to increased NPLs and weigh negatively on banks’ earnings, we think it would not likely be a systemic issue but more of a profitability hit. Only 6%–7% of Chinese banks’ direct lending relates to developers, and banks have built substantial loan loss reserves in the past few years. In addition, they have a relatively healthy capital base to absorb the potential losses, barring a widespread collapse of the industry, or material correction in property prices, which is not our base case.
The bar is high to ease policy in the property sector where the Chinese government wants to keep prices stable and avoid speculation. However, China can ease policy through infrastructure investment and banking policies, all of which can help offset contagion.