Three Red Lines: Why China Can't Handle the Real Estate Crisis

At the end of November, the heads of leading Chinese banks were invited to a meeting at the People's Bank of China (an analogue of the Central Bank of Russia). The regulator persuaded bankers to lend more actively to development projects and promised to allocate $28 billion by March 2023 for interest-free refinancing of those loans. The Chinese authorities have finally acknowledged that the housing sector, which in the last decade has represented up to 30% of the GDP of the most populous country in the world, is in a deep crisis. Prices and the number of transactions are decreasing. Developers have nowhere to take money for the completion of structures. The irony is that the liquidity crunch suited the Chinese government when it imposed restrictions on lending to developers two and a half years ago. This set of measurements was called the 'Three Red Lines'. Since August 2020, developers, when raising borrowed funds, have had to comply with three conditions: the 'debt-to-assets' ratio must be at least 70%, 'debt-to-equity' - not less than 100%, 'cash and short-term debt equivalents' - not less than one. Since the introduction of this measure, it has been found that the balance sheet of most Chinese developers does not meet at least one of these standards. Liquidity began to dry up. In the first nine months of 2022, developers raised 21% less funds than in the same period of 2021. Construction of millions of apartments across the country has slowed. In response, mortgage lenders began boycotting payments on unfinished housing loans. Construction billionaire The current crisis in the real estate market, which has replaced almost a decade of rallies, is inextricably linked with the Evergrande name. Until 2020, this developer was the second by sales in China. Its revenue in 10 years has grown 10 times and in 2020 reached $77.7 billion (for comparison: the revenue of the largest Russian developer, PIK Group, in 2020 was about $5 billion) . Evergrande's market capitalization on the Hong Kong Stock Exchange in 2017 reached 50 billion dollars, and in 2020 it reached 30-33 billion dollars. The company has concurrently built more than 1,300 structures in 280 cities in China. Chinese business school CKGSB professor Liu Jing in his series of articles 'Problems of China's real estate market' formulates the reason for such a rapid development of the development business. China's urbanization rate rose from 29% to 65% in just 26 years, from 1995 to 2021. For comparison: It took the United States 70 years to increase this figure from 26.8% to 64.5%. , France and Germany have walked a similar path in 73 and 60 years, respectively. On the wave of growth, Chinese developers behaved in much the same way as Russian developers before 2008: they increased their project portfolio, raised funds on the stock exchange (PIK itself was worth 12 billion dollars after the placement of shares in 2007) and launched megaprojects. For example, Evergrande built the 340-hectare Ocean Flower man-made archipelago in the South China Sea with an investment of US$24 billion. Hui Ka Yan, who founded Evergrande in 1996, owns a 77% stake in the developer. Before starting his own business, Hui worked as a technician in a steel mill for 10 years. In 2016-2017 alone, Evergrande paid its owner about $4 billion in revenue, according to Forbes.

In the construction cost of 1 sq. m. m of housing in China, 54% is due to taxes, 30% to building materials, 4% to wages. (Photo by Getty Images) As income increased, so did debt. In 2020, the developer's liabilities exceeded $305 billion, and the total debt of all Chinese developers reached $5 trillion. In August, the Chinese government introduced the 'three red lines' rule. Route change Not immediately, but the market has reacted to the regulator's actions. The severe restrictions imposed by the covid and the increase in the prices of rebar and concrete, equal to around 60%, also had an impact. In January-September 2021, sales of the top 100 developers in China decreased by 36% compared to the same period last year. In the summer of that year, it became clear that Evergrande was in a difficult situation. Rating agencies one after another lowered its ratings to the level of 'possible default'. In September, the company sent a formal letter warning that it would not be able to pay the coupon on the dollar notes, and indeed missed payments. At the time, the number of Evergrande apartments sold but not completed exceeded 1.6 million. By the end of 2021, the developer's market cap was down to $2.7 billion Markets around the world feared the construction giant's collapse would be comparable in consequences to the collapse of Lehman Brothers, but the disaster didn't strike it is verified. While other Chinese developers have also started halting coupon payments, lenders have shown patience. Provincial governments assumed control of Evergrande's sales revenues to oversee the completion of the facilities. Meanwhile, the real estate market rally has been replaced by a crisis. In 2022, real estate prices in China's 70 largest cities began to decline for the first time since 2015 and fell by 5% between January and September. Demand also fell, and in 22 cities, those who bought an apartment with a mortgage decided to boycott the mortgage payments on housing construction, construction of which was stopped. Recognizing the importance of what is happening, the Chinese government has invited banks to lend more actively to builders, ie it has slightly turned on the tap that used to be turned on forcefully by introducing the 'three red lines' policy. The $28 billion pledged in interest-free loans is just one of the measures to support the industry.