China: Evergrande’s spillover so far limited, but with a clear focus on private developers and banks overexposed to real estate

Chinese banks have crossed the earning season finish line with a clear rebound in profits. But this piece of good news mainly comes from lower loan provisioning. The overall non-performing loan (NPL) ratio has declined thanks to more loan write-offs. However, the NPL ratio for the property sector has surged from 1.2% in 2019 to 2% in H1 2021. In this note, we analyze the economic and market implications for the stressed grey rhino – a term we have long been using to describe the highly leveraged real estate sector, which is too big and weak to be ignored.

The challenging and deteriorating operating environment of China’s real estate firms is reflected in the poorer sentiment in our big data analysis. From a general perspective, the sentiment for real estate has worsened towards the level of Q1 2020, the peak of Covid-19 pandemic in China. For Evergrande, the chain of credit events, such as delayed interest payments and legal cases from creditors, has damaged investors’ confidence and led to plummeting market view since early 2021.

Such worries can be justified with the financial health of China’s property developers. And the tighter regulations in the light of China’s quest for “common prosperity” and better income distribution will not help. From the demand side, home loan growth is slower and mortgage rates have trended higher, such as the changes in Shanghai. For real estate firms, the focus has switched from rapid expansion to debt control. The share of firms breaching all the “three red lines”, aiming at containing leverage, has declined from 26% in 2019 to 18% in H1 2021.

Given the relevance of real estate in China,  the better corporate health after the pandemic will not be enough stop the surge in credit risks, meaning polarization among safer and riskier borrowers is on the rise. As reflected in bond yields, the spreads for private firms between real estate and other sectors have widened not only in the offshore market but also the onshore, which does not differentiate the property sector much in the past. This shows even onshore investors are worried on the financial health of some private property developers. However, the market view on state-owned enterprises is relatively stable.

For banks, the market reading of the spillover from the stressed real estate sector is still muted. Bond spreads for banks with higher property exposure are stable with slight widening in the offshore. Still, some differentiations are seen for banks with high NPL in the property sector.

All in all, stress is mounting for the most obvious grey rhino in China, namely the real estate sector. Contagion from Evergrande to other developers will be clearer for private and high-yield debtors. Banks with higher property exposure may also be singled out with wider bond spreads. If regulations are tightened further while demand decelerates together with the rest of the economy, China’s property developers and related entitles could be on the way for a bumpy ride.

 Full report is available for Natixis clients.