Over the past year, the Chinese property sector has faced unprecedented stress, as Chinese authorities enforced deleveraging in the sector, pushing bond issuers such as Evergrande to default. Given stress in such an important sector, there have been concerns about spillover to other sectors and growing fears of a “hard landing.” Yet, to date, Chinese credit markets continue to be relatively stable and Chinese investment grade spreads have even tightened in the past year.
Why such resilience? We believe important contributors have been the broad deleveraging among financials and corporates, as well as reforms implemented in recent years. While the reforms have been broad-based, we will look at the banking and materials sectors as key examples.
Since the financial deleveraging campaign started in 2016, banks have improved their capital ratios and risk management; considerable progress has been made in de-risking their wealth management product (WMP) operations to comply with the new asset management rules introduced in 2018, which has improved transparency and reduced financial interconnectedness. As a result, when Evergrande and other developers defaulted on WMPs, there was no damage to bank reputation and earnings.
Supply-side reforms since 2015 have also dramatically reduced excess capacity in sectors like steel production. These production curbs are ongoing, declining enough to offset demand loss from weaker construction activity. China has also been restricting output in other energy-intensive industries, such as aluminum, translating into stronger-than-expected earnings and improved balance sheets for most Chinese materials companies.
The importance of the property sector to the Chinese economy should not be understated. We expect subdued GDP growth of 4.9% in 2022, partly due to weakness in the sector. However, during this “live stress test,” it is it is undeniable that most Chinese sectors have fared well and have shown some decoupling from property. We think this decoupling is likely to continue as credit flows into more productive sectors, allowing for continued positive evolution of the Chinese credit markets.
For Chinese property bonds, we see unique opportunities as the market has already priced in a high degree of stress and we expect the sector to stabilize following elimination of the weakest developers and policy easing measures. On the latter, one of the strongest signals that policymakers are looking to stabilize the sector is the recent news of plans to loosen developers’ access to pre-sales escrow accounts which has been a major contributor to the cash crunch.