SinoInsight 1
On Aug. 16, CCP ideological journal Qiushi published a piece by China Banking and Insurance Regulatory Commission chairman and Party secretary Guo Shuqing on preventing and resolving financial risks (堅定不移打好防範化解金融風險攻堅戰). Guo noted that China’s banking sector incurred 2.7 trillion yuan (about $390 billion) of non-performing loans in 2019. As for China’s financial system, Guo said that “after the Black Swan of the pandemic, its asset quality will inevitably deteriorate” because current loan classifications are not accurately reflected and banks’ profits are inflated on paper. Guo also warned that recent stimulus measures will create new asset bubbles, with property prices rebounding in some places and capital flowing into high-risk areas.
On Aug. 17, mainland media reported that government regulators plan to introduce so-called “three red lines” to control the growth of interest-bearing bonds issued by real estate enterprises. The various property enterprises will be grouped into four tiers (red, orange, yellow, green) per their financial situation, and will be forbidden from seeking refinancing from financial institutions if they cross the “three red lines”:
- Red line 1: Companies with debt-to-assets ratio of over 70 percent (after excluding unbuilt, pre-paid housing).
- Red line 2: Companies with debt-to-assets ratio of over 100 percent (corporate liabilities exceed the company’s net assets).
- Red line 3: Companies with cash to short term debt ratio of less than 1.0 times (or companies with insufficient unrestricted cash to finance short term debt).
On Aug. 20, the PRC’s Supreme People’s Court slashed the upper limit on private loan interest rates protected by law, ostensibly to clamp down on usurious loans and lower borrowing costs for small businesses. Per newly issued regulations, the upper limit will be capped at four times China’s benchmark loan prime rate (LPR), or 15.4 percent on one-year private loans based on the present LPR. The 15.4 percent rate represents a significant decrease from the previous range of between 24 percent and 36 percent based on the one-year LPR (3.85 percent) on July 20, 2020.
On Aug. 22, Nomura Securities chief China economist Lu Ting said at the China Wealth Forum that the balance of Chinese-issued U.S. dollars bonds has now exceeded $900 billion, a significant portion of which are sold by local government financing vehicles and state-owned enterprises (SOEs), including some very large SOEs.
OUR TAKE
1. The above items indicate that China currently faces significant financial risks and the CCP is rolling out tough policies to curb those risks. However, we believe that the CCP’s de-risking measures will likely exacerbate its financial risks and trigger serious financial problems, including the bursting of the property bubble.
2. We have reason to believe the CCP is indeed greenlighting the implementation of the so-called “three red lines” for Chinese property companies. First, the CCP has not sought to “dispel rumors” in the wake of mainland news reports about the proposed “three red lines,” a move that suggests veracity of the information. Also, the Supreme People’s Court recent lowering of the ceiling on private loan interest rates deters banks from lending to financially risky property companies.
According to financial data company Tianfeng Securities Research Institute, only 12 of the top 50 property companies in China, the bulk of whom are central or state-owned enterprises, will not cross the “three red lines.” Meanwhile, 14 companies have crossed red line 3; 10 are past red line 2, and 14 have broken red line 1. Among the top 10 real estate companies in China by sales in 2019, three companies—China Evergrande, Sunac Holdings, Greenland Holdings—have crossed all “three red lines,” and will not qualify for refinancing under new regulations when they are rolled out.
To secure funding, property companies on the wrong side of the “three red lines” have to find ways to clear their inventory, including selling housing at reduced prices. However, the sale of property at cut prices will in turn trigger another round of financial risks, because China’s real estate sector has long been financialized. Property buyers are unlikely to make purchases when property is going for bargain prices as it means the value of property is also low; when few people are in the market for property, then property companies are unable to sell what they have on hand to finance their operations and prevent the breaking of capital chains (資金鏈斷). Concurrently, property companies will see their debt-to-assets ratio go up, which means that even more companies will find themselves beyond the “three red lines.” Put another way, the CCP’s policies, while meant to curb financial risks and prevent stimulus funds from flowing to the property sector, will end up locking real estate companies in a vicious downward spiral when it comes to refinancing their operations.
We wrote in our China 2020 outlook that “large or prominent (at least well-known at the provincial level) property companies could file for bankruptcy” this year. Our forecast could come to pass should the “three red lines” policy be strictly implemented.
3. The CCP’s effort to derisk the property sector comes as Chinese real estate companies face difficulties moving their inventory. According to financial data company China Index Academy, property transactions in 16 major Chinese cities fell 18.5 percent in July from a year ago. Also in the same period, property transactions fell 27.5 percent in first-tier cities, 9.5 percent in second-tier cities, and 35 percent in third-tier cities. Hence, there is currently a trend of rising housing prices but shrinking property transactions in China.
4. Chinese real estate companies are also heavily saddled with debt, with the second half of 2020 being a peak period for debt repayment. According to financial data firm Beike Research Institute, 558.8 billion yuan worth of domestic and overseas financing bonds issued by property companies will mature in H2 2020, an increase of 58 percent over the previous year. Meanwhile, the scale of real estate credit bonds increased 29.1 percent from a year ago and 86.1 percent from the previous month to 64.2 billion yuan in July, according to data from China Index Academy; Chinese property companies also issued 50.8 billion yuan worth of overseas bonds in July, an increase of 30.6 percent month-on-month. Finally, the average coupon rate of domestic financing bonds issued by property companies was 5.1 percent in July, an increase of 13 percent from a month ago and the third consecutive month of rising rates, according to Beike Research Institute data; the average coupon rate of overseas financing bonds was 8.56 percent, of which eight companies (30 percent of all companies who issued overseas bonds) issued bonds at rates exceeding 10 percent.
Previously, Chinese real estate companies were able to refinance their debt by issuing bonds at high interest rates. The proposed “three red lines,” however, will make it very difficult for property companies to both issue new debt and repay old ones. The inability of Chinese real estate companies to refinance their debt will lead to large-scale defaults and trigger systemic risks in China’s property and financial sector.
5. China’s property sector attracts large amounts of funding from various channels. A burst real estate bubble will inevitably spark a chain reaction and trigger systemic financial risks in China.
The PRC already has a problem with sizable non-performing loans. According to the China Banking and Insurance Regulatory Commission website, the balance of non-performing loans in China at the end of June this year increased by 1.19 trillion yuan from the end of 2019 to 3.6 trillion yuan. The cumulative net profit of banks in H1 2020 decreased 9.4 percent year-on-year to 1 trillion yuan, while China’s banking system plans to dispose 3.4 trillion yuan of non-performing assets throughout the year, or an increase of 1.1 trillion yuan over the previous year.
Should the CCP’s derisking policies burst the property bubble, the scale of non-performing loans will go up sharply. In this scenario, China will not only see economic Gray Rhinos, but political Black Swans.
SinoInsight 2
On Aug. 17, CCP mouthpiece People’s Daily ran a “Zhong Sheng” column titled, “‘Decoupling’ is Misjudging the Situation” (鐘聲：「脫鉤」是誤判大勢的逆動) that criticized “some American politicians” of talking up U.S.-China decoupling. In typical CCP propagandistic fashion, “Zhong Sheng” claims that those American politicians “warp reality,” “block general trends,” are “idiots mumbling in their sleep,” and express “wishful thinking.” Further, “Zhong Sheng” asserts that decoupling is “not a cure for America’s problems” and will “poison the world economy.” People’s Daily uses the “Zhong Sheng” pen name to air its foreign policy views.
In reporting on the “Zhong Sheng” column, several Chinese-language “self-media” outlets ran the headline, “People’s Daily: America Wants to ‘Decouple’? No Way!” (《人民日報》：美國想’脫鉤’？門都沒有！). The headline played up the combative aspect of the “Zhong Sheng” piece in a humorous fashion, and attracted widespread attention and discussion in mainland Chinese circles.
On Aug. 21, some news outlets reported that TikTok is preparing a legal challenge this week against President Donald Trump’s Aug. 6 executive order effectively banning its app if it does not find an American buyer.
On Aug. 23, Trump was asked in a Fox News interview if he would “just decouple, not do business with China,” to which he replied, “it’s something that if they don’t treat us right I would certainly, I would certainly do that.” On Aug. 17, Trump said in a campaign stop in Mankato, Minnesota that “we’ll create tax credits for companies that bring jobs from China back to America and we’ll impose tariffs on countries that leave America to produce jobs overseas.”
OUR TAKE
1. When the Sino-U.S. trade war broke out in 2018, we looked at how ideology and nationalism hampered the CCP’s ability to do propaganda work and limited its options for dealing with American trade pressure (see here and here). Now ideology and nationalism are again affecting and limiting the CCP’s response to an escalation of U.S. pressure across the board.
Take the Aug. 17 “Zhong Sheng” column as an example. On its own, the column is derivative of CCP ideology and the stuff of standard Party propaganda rhetoric, i.e. blame worsening Sino-U.S. relations entirely on the other party (“some American politicians”) so as to cover-up the CCP’s role in provoking the “new cold war” to a domestic audience (cover-ups are a form of deception, a key trait of Communist Party culture). However, when read through a nationalist lens, propaganda aimed more at preserving the CCP by deceiving the public than provoking a quarrel with the U.S. can be interpreted by PRC nationalists to be fuel for further confrontation with the United States. As nationalistic sentiments are inflamed in China, the CCP will be publicly pressured into increasing confrontation with America at a time when doing so runs counter to the CCP’s interests and regime survival.
For instance, TikTok’s parent company, ByteDance, was discussing its sale to an American company just a couple of weeks prior. However, we believe that TikTok’s new decision to challenge President Trump’s executive order is almost certainly due to ByteDance and the CCP being pressured by nationalistic demands at home to save face and/or “defeat” America. TikTok’s challenge, however, will likely reinforce the Trump administration’s notion that the CCP will not deal in good faith with the U.S. despite its multiple requests for reciprocity in the Sino-U.S. relationship, and will result in stiffer U.S. action against the PRC (an outright ban of TikTok cannot be ruled out). Ironically, the CCP’s propaganda efforts to dissuade the U.S. from decoupling, could instead backfire and speed up the decoupling process, due to the CCP-cultivated nationalistic environment inside the PRC.
2. President Trump’s recent remarks about decoupling from China merely confirm what his administration has been working on since he took office in 2017, with the policies only garnering more visibility recently as a result of the Wuhan coronavirus pandemic. Businesses with supply chains in China, investors, and governments must account for Sino-U.S. decoupling if they have not already done so, as well as steeply rising political risks in China.
