China's three red lines for home developers

Home prices have surged sixfold over the past 15 years, making cities such as Shenzhen less affordable than London.
Home prices have surged sixfold over the past 15 years, making cities such as Shenzhen less affordable than London.PHOTO: AFP

(BLOOMBERG) - The danger lurking in China's debt-laden real estate sector was never so clear as late last month, when word of a possible cash crunch at China Evergrande Group, the world's most indebted property developer, sent investors running for the exit.

With seven more of the 10 most-indebted developers also based in China, policymakers in Beijing have drafted what state-run media is calling "three red lines" - metrics on debt that developers will have to meet if they want to borrow more.

The new approach promises to be a game changer for a sector that accounts for about 29 per cent of economic output.

How will it work?

The People's Bank of China and the Ministry of Housing announced in August that they had drafted new financing rules for real estate companies. Developers wanting to refinance will be assessed against three red lines, or thresholds.

There will be a 70 per cent ceiling on liabilities to assets, excluding advance proceeds from projects sold on contract; a 100 per cent cap on net debt to equity; and they must have a cash to short-term borrowing ratio of at least one.

Developers will be categorised based on how many limits they breach, and their debt growth will be capped accordingly. If all three are breached, the company will not be allowed to increase its debt in the following year.

If it passes all three, it can raise its debt a maximum of 15 per cent in the next year. As the regulator has not announced its official calculations, some definitions are not clear.

Why draw the lines?

A big part is fear of another housing bubble - and a disastrous bust.

Home prices have surged sixfold over the past 15 years, making cities such as Shenzhen less affordable than London.

Chinese builders' debt binge has been an important driver of rising prices, forcing them to charge more to cover a rising interest burden. Potential buyers returned en masse as the pandemic crunch eased, keeping pressure on prices despite the global economic slowdown.

The worry is that China could repeat Japan's mistake in the 1990s of not reining in excessive credit and shutting down insolvent borrowers quickly enough, causing long-term damage to growth.

Even before Evergrande's brief liquidity scare, concern had intensified after Tahoe Group in July became the first large residential developer in the country to default on a bond in five years. Guangzhou R&F Properties and Oceanwide Holdings have also shown signs of stress in recent months.

When will it begin?

There is no timetable yet. But the Economic Information Daily reported that a dozen developers, including Evergrande, China Vanke and Country Garden Holdings, had been picked for a pilot scheme that required them to submit a three-year debt-reduction plan. Full implementation across the residential sector would begin next year, it said.

Xinhua News Agency reported that regulators imposed the red lines and other quantitative limits at an Aug 20 meeting with developers, in another signal that they are moving ahead. The central bank's deputy governor Pan Gongsheng said last month that there would be a "reasonable transitional period" for the policy's adoption.

What's the implication for developers?

In the near term, a developer with a weak balance sheet and sizeable exposure to second-tier cities may need to cut home prices to boost sales and shore up cash.

This is evident in Evergrande's latest campaign to offer discounts of as much as 30 per cent - its deepest cuts ever. It may also spur waves of equity sales and spin-offs of non-core businesses such as property management services.

Over the longer term, it may force developers to devote more resources to non-residential property, such as office and retail.

Which firms will be most affected?

Among the major players, Evergrande and Guangzhou R&F Properties fall short on all three metrics and face the most pressure to cut debt quickly. They may need to cut borrowing by 19 and 21 percentage points, respectively, under the new rule, based on their 2019 finances.

Sunac China Holdings, which meets only one metric, may need to pare back debt by 35 percentage points. Among China's 189 listed developers, 14 were in breach of the three red lines as at early this month.

Among the biggest by market capitalisation were Zhongtian Financial Group, Oceanwide and LVGEM China Real Estate Investment.

More than half of the Hong Kong-listed developers passed all three red line tests, including Country Garden and Vanke.

Will it crush the economy?

Probably not. Developers' debt growth had already been slowing - from 53 per cent in 2017 to 16 per cent last year. That is not far from the caps imposed on firms that pass the red lines test. As China's real estate development investment has grown about 10 per cent in the past two years, there will be room for a mild deleveraging, or debt reduction.