In a bid to curtail China’s freewheeling real estate sector, policy makers introduced debt metrics in 2020 that set limits for developers seeking to borrow more. Called the “three red lines” by state-run media, they have become a game-changer for an industry that accounts for about a quarter of economic output. But with more and more real estate companies now sinking into a worrying liquidity crisis, regulators are now tweaking the rules to engineer a soft landing.
1. How does it work?
Developers wanting to refinance are being assessed against three thresholds:
• Their liabilities shouldn’t be more than 70% of assets, excluding advance proceeds from projects sold on contract.
• Net debt shouldn’t exceed equity.
• Cash must be at least equal to short-term borrowings.
Under the rules, property firms are being categorized based on how many limits they breach and their debt growth is capped accordingly. If a company passes all three, it can increase its debt a maximum of 15% in the next year, according to an August report in the Securities Times and an earlier one by China Central Television in 2020. As regulators haven’t announced their official calculations, some definitions aren’t clear.
2. What’s been changed?
One way for distressed developers to raise badly needed cash without borrowing is to sell assets to healthier firms. But the rules made that difficult because potential buyers ran the risk of breaching the metrics by taking on more debt to fund purchases. So in December 2021, regulators were said to have quietly issued guidance that borrowing by property firms used to finance mergers and acquisitions won’t be counted toward the red lines.
3. 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 new cities such as Shenzhen less affordable than London. The debt binge by Chinese builders has been an important driver of rising prices, forcing them to charge more to cover a swelling 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 in the world’s No. 2 economy.
The danger has become clearer since September 2020, when signs of a cash crunch emerged at industry giant China Evergrande Group. The world’s most indebted property developer eventually defaulted at the end of 2021 and now faces a massive restructuring. As 2022 began, distress was still spreading in the nation’s $870 billion offshore bond market as more property firms missed payments and record refinancing costs effectively blocked them from rolling over borrowings.
4. What’s the implication for developers?
In the near term, developers with weak balance sheets may continue to slash home prices to boost sales and shore up cash. This was evident in Evergrande’s campaign back in 2020 to offer discounts of as much as 30% -- its deepest cuts ever. It may also spur waves of asset sales and spinoffs of non-core businesses such as property management services. Those that survive the downturn may need to devote more resources to non-residential property, such as offices and retail.
5. Will it crush the economy?
Hard to say. Developers’ debt growth had already been slowing -- from 53% in 2017 to 16% in 2019 -- before the rule was introduced. That’s not far from the caps imposed on firms that pass the red lines test, according to Bloomberg Intelligence. However, China’s economy has taken a knock in recent months from the property market slump that was triggered by developers’ liquidity scare. Residential property sales and housing starts have dropped, dragging down the pace of investment spending. Beijing has recently shifted its focus to stabilizing growth, with the central bank easing monetary policy and the Communist Party ordering more fiscal spending early in 2022.
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