The policy crackdown on China's residential housing market has bottomed. The down cycle has further to go. S&P Global Ratings anticipates it will take several quarters, at least, for regulatory easing to feed through to the physical market.

In the meantime, another tough year awaits. Residential property sales will be rocky. Financing conditions are dire, and stricter escrow requirements are adding to cash strain. Another layer of strain is coming from delays in audited financial reports and sudden changes of auditors has added to uncertainties. In our view, more defaults are in the pipeline.

When China's residential market emerges from this correction, it may be changed forever. We anticipate fewer developers will be able to employ the highly leveraged, fast-churn strategy that brought past success. Over the long term, policy will be guided by the principle that "housing is for living, not speculation." The new business models will, at least to some degree, need to fit that objective.

Policy Bottomed But Not The Market

We see March 16 as a turning point for property tightening, based on signaling from Vice Premier Liu He in a specially convened meeting of the central government's financial and development stability board. Later that same day, the Ministry of Finance announced it would postpone a planned rollout of a property tax, citing market conditions.

In our view, the upcoming housing supports will focus on the "demand" side. Central-government easing will carry more weight than the recent relaxations and incentives introduced at local levels by city and provincial governments.

Nonetheless, restoring confidence will likely be a gradual process, given sentiment is at such a low ebb. In the first two months of the year, mid- and long-term loans to households shrank for first time since 2007, despite lower mortgage lending rates and down payment requirements (see chart 1). Over the first three months of the year, residential property sales plunged 50% year on year for the top-100 developers.

Chart 1

The Sales Situation Remains Tough

Our new base case assumes national sales will shrink by 15%-20% in 2022, a downward revision from original base case of a 10% drop. Most of the pressure (10-15 percentage points) will be on volume, and around 5 percentage points of our forecast is based on a drop in home prices.

We expect an "L-shaped" pattern recovery, with the biggest fallout in the first half. This is because COVID outbreaks, city lockdowns, and flagging homebuyers' confidence will interrupt project launches (see chart 2). By the second half, the declines will be smaller, in part due to a lower base, and because we expect sales to gradually recover from March onwards.

Home prices should start to stabilize in 2023. Our projected 3% drop in sales for next year is mostly based on volume, or area sold. In our view, the cash crunch this year means many developers can't easily develop new resources for future expansion. Supply may be limited even if sentiment improves. Furthermore, the increase in government-funded affordable housing supply will gradually eat into the commercial housing market.

Chart 2

Swing factors that could alter our forecasts include wider policy loosening on the upside, and COVID-19 risk and external market uncertainties on the downside.

A Crash In Cash

The liquidity crunch for developers has deepened since the second half of 2021, spurring investors to brace for liquidity and even insolvency risk. Cash is scarce for numerous reasons: falling sales, the recent halt to nearly all financing channels, and cash trapped in escrow accounts to ensure developers can deliver pre-sold units (see "As The Escrow Flies: China Developers Navigate Convoluted Rules On Presales," published on RatingsDirect on Jan. 20, 2022).

The receding tide of liquidity has revealed the weaker swimmers. Recent auditor resignations or delay in releasing audited financial statements, coupled with the previously unreported debt issues, is hampering transparency and governance and spooking investors. We suspended ratings and downgraded some developers to reflect this in our transparency and governance measures (see table 1 and "Auditor Resignations Flag Governance Risk For China Developers," Feb. 15, 2022).

A trading halt on the shares could prompt early redemption of convertible bonds, adding to liquidity strains (see chart 3)

Further governance concerns could lead to a prolonged weakness in capital markets, especially for 'B' rated peers. Offshore bond issuance is down -94% in the first two months of the year, reflecting fallout for speculative-grade issuance. Bank loans and trust financing is also much harder to get.

Table 1

Chart 3

Past obligations to deliver presold properties will likely tie up resources in the next 12-24 months, leading to persistent financial pressure and potentially more insolvency cases (see section below on stress tests).

Chart 4

Our analysis shows that the late-reporting developers also are facing higher restrictions on cash (see chart 5).

Chart 5

The restrictions on upstreaming presale proceeds from project companies are meant to protect the project-level lending as well as to ensure completion. The risk to developers nonetheless causes a dilemma for local governments and central authorities. Some cities may take longer to loosen such restrictions. This is due to the political risk if presold homes are not delivered. We test various assumptions of escrow requirements in our sensitivity analysis (see below).

Coming This Year: Incremental Contagion Risk?

Last year's big event—defaults by the country's largest developer, China Evergrande had limited contagion effect (see "Evergrande Default Contagion Risk--Ripple Or Wave?," Sept. 21, 2021). In part, this is because the developer did not have numerous joint-venture (JV) partners. In recent years, however, many developers have turned to JVs to reduce stress on their balance sheets (see "High Stakes: Analyzing The Risks Of China's Property Joint Ventures," June 14, 2021). JVs exacerbate contagion risk in a downturn.

For our rated developers, the average attributable sales ratio is 70%--meaning a significant proportion of sales are via partnerships and not consolidated in their financial statements. This raises counterpart risk when a developer's liquidity deteriorates. Banks or trust companies might lock up the money in the project company if one party faces a crisis, hence spreading stress automatically to other project participants.

For example, about 12% of market share (in terms of national sales) face liquidity risk— defined here as announcing extension of due dates; exchange offers; or missed payments on onshore or offshore notes. Given the JV model is so prevalent, we expect this means at least another 4% of market share is in the same boat (see table 2). And keep in mind that this data is based on companies we rate or used to rate. The contagion metrics could be greater than this back-of-the envelope estimate in table 2.

Table 2

In the coming 12 months, rated Chinese developers face a US$18 billion maturity wall. This number dropped significantly from about US$40 billion at the end of last year. In the past stressful year, with ratings downgrades, requests for ratings withdraws have tended to occur ahead of large maturities (see chart 6).

Chart 6

Our Sensitivity Analysis: Some Developers Have Limited Room For Further Stress

We tested various degrees of stress, based on sharper declines of sales and bigger amounts of cash trapped in escrow. As to be expected, the lower-rated companies have limited capacity to absorb shocks if conditions worsen. Our results show inaccessibility of cash is the most drastic factor leading to liquidity crunch. The higher the cash trapped ratio, the most drastic crunch. This could partially explain the sudden drastic defaults and rapid deterioration of credit profile of some developers.

Table 3

Ratings are resilient to a 20% sales decline in 2022 (scenario 1)   because most of our recent rating actions have already addressed entities with the slimmest liquidity buffer.

Scenario 3 suggests the liquidity profile on 34% of our rated portfolio would decline   to less than adequate or weak --mainly those rated in the 'B' category, while 'BB' category start to feel the strain.

In scenario 4, the liquidity profiles on 76% of our rated portfolio would be hit,   and even some 'BBB' category names would feel the pain. That said, we believe this scenario is highly unlikely to hit the stronger companies; this given the investment grade names usually have fewer restrictions in presale escrow accounts and hence more accessible cash for debt repayment than our stress assumption of just 20% of total cash.

Chart 7

For Some Developers, Liquidity Risk Could Turn To Insolvency Risk

Declining sales, tight liquidity, and cash trapped in escrow or joint venture partners all point to rising defaults. The larger the amount of unfinished pre-sold units, the higher the risk. Companies that have higher average selling prices, meaning better asset location or quality, can absorb more shock.

In our most extreme scenario (see chart 8), about 20% of developers would face insolvency risk. This assume all pre-sold obligations are completed with cash on hand and proceeds from asset sales. It does not count the cash that would be needed to repay debt. We further assume a third of minority interest as debt, on the assumption that some of this is "debt disguised as equity" that will need to be repaid.

Chart 8

The 20% developers likely to be insolvent in this are mainly rated 'B+ or below. If landbanks and assets have to be sold at 30% discount, this ratio goes to 40% and would also include 'BB' category ratings (see chart 9).

Chart 9

The New Market Won't Be The Same As The Old

"Housing is for living not for speculation." This motive will continue to guide long-term policy. As China's property market gradually recovers, it will also likely change shape. Secular change is afoot.

For starters, we expect a sizable increase in government-funded affordable housing, which would nudge the Chinese market toward models in Germany and Singapore. China has committed to add 8 to 9 million units of public-sector housing by 2025. This is equivalent to about 10% of the private commercial property market by our estimates, contributing to changed dynamics. Looking at the market as big pie, we will see the government slice getting bigger, and the commercial market portion coming down.

Over the past two decades, with volumes and prices appreciating in most years, high leverage worked. More funding from debt translated into higher returns on equity and ready financing allowed developers to rapidly deploy new investment as they wrapped up the old. The new model could mean lower industry profitability and thus be less attractive to external financiers.

Chart 10

Writing: Cathy Holcombe

Digital Design: Halie Mustow

Appendix

Table 4

Related Research

• Auditor Resignations Flag Governance Risk For China Developers, Feb. 15, 2022
• As The Escrow Flies: China Developers Navigate Convoluted Rules On Presales, Jan. 20, 2022
• Evergrande Default Contagion Risk--Ripple Or Wave?, Sept. 21, 2021
• High Stakes: Analyzing The Risks Of China's Property Joint Ventures, June 14, 2021