China's banks are extending their exposures to the property sector amid a real estate slump. This is policy-driven and, in the event of a major correction, would leave banks holding rapidly declining collateral.

S&P Global Ratings anticipates that financial institutions will retain some selectivity as megabanks lead the effort with plans to disperse more than Chinese renminbi 1.8 trillion (US$256 billion) in fresh loans (see "Real Estate Funds, A First Aid To China's Property Slump," published on RatingsDirect on Aug. 18, 2022). This selectivity could help rein in some of the risk for banks. For developers, it means survival of the fittest, since the stronger ones will get favored treatment.

Fresh credit infusions, alone, won't be enough to restore homebuying sentiment. By our forecasts, national home prices will decline by up to 8% in 2023. The declines will be larger in lower-tier cities, and tier-two cities with large inventory overhang (see chart 1). More visibility on the end of "zero COVID" policies would be a bigger impetus in reviving home sales, in our view.

Do China's Conservative LTV Ratios Provide A Sufficient Cushion?

Property development loans remain a top risk for banks. But they aren't holding back; we now see loan extensions and fresh loans to support market stability. One justification is strong collateral coverage to ensure loan recoverability should projects turn sour--or in some cases, sour again.

We estimate loan-to-value (LTV) ratios on property development loans average about 50% at the national level. This implies ample room to absorb the circa 6% home price decline this year and up to 8% next year, as per our estimates. Yet lower-tier cities may see sharper drops in valuation changes, thereby reducing the safety offered by the collateral. Also, some small regional banks have been more aggressive in granting these loans, with higher LTV ratios.

The LTV ratio in China summarizes these considerations: (1) the amount of leverage that can be safely added; and (2) the buffer needed to absorb for further potential price depreciation (see chart 1).

Chart 1

Banks with vigorous revaluation processes will have steadier asset quality

Risks look set to emerge sooner for banks with infrequent collateral revaluation, giving property prices have been and are still heading south. At the same time, leverage is increasing, This is because restructuring typically focuses on debt extension, not debt reduction (see "China Property Is Heading For A Transformation, And Maybe A Turnaround," Nov. 21, 2022).

By our calculations, even projects that are more than 80% completed could see LTV ratios exceed 100% from revaluation if the market correction is steep (see table 1). The LTV ratio is typically lower at the start of a property development project because banks are secured by the full value of the land use rights. This ratio climbs throughout the life of a project as banks lend more for the construction of the building, being a smaller share of the overall collateral value.

Table 1

A Kick-The-Can Strategy Will Increase Leverage For Borrowers

We expect real-estate nonperforming loans (NPL) to remain elevated in 2023 after doubling in 2022. The reported ratios would be higher if not for forbearance policies allowing banks to classify credit stress among developers as normal or special-mention loans (SMLs). The can is kicked down the road, with fresh loans adding to leverage for borrowers (our wider nonperforming asset (NPA) metric captures some of the broader risks--see "Global Bank Country-By-Country 2023 Outlook: Greater Divergence Ahead," Nov. 17, 2022 ).

Chinese banks typically prefer loan restructuring to fire-selling collateral. This reflects their state-owned backgrounds and the priority of systemic price stability. It also reflects market realities. Selling collateral at steep discounts may not be in the best interest of creditors, given the market for unfinished projects is quite narrow. As shown in table 1, the areas shaded pink and red denote the loss zone on loans if banks fire-sold the collateral, assuming a further 50% discount on the original expected market value of the project.

Thinly traded markets can yield price discovery surprises, even with price floor guidelines set by the authorities. For prudency, regulators or auditors may push banks to use more conservative valuations of collateral. However, moving from a market-based to a cost-based approach in a down market could push LTVs beyond 100% (see table 2), accentuating risks on already problematic loans. We calculate market based in this circumstance as expected sales determined at project inception, less remaining construction costs.

Table 2

If LTV ratio is near or exceeds 100% on already problematic loans, we'd normally expect banks to classify the loans to nonperforming.  However, the latest rules grant one-year forbearance. The delay in recognizing NPLs and the provisions should embellish short-term profit and asset quality indicators for banks; although we expect a fair share of such loans would eventually become nonperforming if forbearances do not help borrowers recover.

Also, as banks transition to an expected credit-loss model under recent regulatory guidance (as opposed to general 150% provision coverage of NPLs), there is a less of a profit hit from reclassifying a reasonably collateralized loan.

It's Still Survival Of The Fittest For Developers

We anticipate loan support for property development will increase in the fourth quarter of 2022 compared with the previous quarter, and for this momentum to continue into 2023. Big banks are likely to take the lead in this policy push. However, the support won't be blanket. The strongest developers will find it easier to obtain new bank lines. Credit divergence thus will widen. Industry consolidation will increase at the project level with banks making more loans for mergers and acquisitions.

Recent policy initiatives give relief to homeowners waiting on pre-sold units to complete. Real estate rescue funds and other related special-funding targets are not designed to bail out troubled developers. Moreover, this new financing will get repayment priority--at the expense of existing secured creditors.

Bigger Price Drop In Smaller Cities

We foresee bigger price squeezes in lower-tier cities, where average selling prices will drop by a low-teens rate versus 8% nationally. Regional home-price differences and varied underwriting standards will thus widen credit divergence between big and strong banks and small and weak banks (see "Banking Industry Country Risk Assessment: China," Sept. 13 2022).

Our analysis shows that property loans with concentration in these certain cities (see chart 2) face heightened asset quality pressure. This is because price declines expose vulnerabilities with real estate expansion prior to China's anti-speculative crackdown over the past few years. Due to data availability, we use city-level retail sales growth to gauge consumption and investment appetite from residents in our chart below.

Chart 2

Risk Is Bigger Than Reward For Banks

The recent slew of supportive measures, including a 16-point plan to stabilize the property market, could work for the greater good of China's real estate sector and for broader stability. Banks and developers can together resolve urgent issues such as completing stalled projects. This should prevent a deeper fallout in home prices.

A greater-good scenario could reward banks in the long run. The chance of a hard landing for banks is remote at this stage considering collateral buffers and China's collective stability mindset. Still, as real estate rescue funds and other related special funding come in, project leverage will increase and collateral safety buffers wane. Pockets of regional sensitivities could chip banking sector health at the fringes. In a remoter scenario, policy missteps could lead to property risks becoming systemic.

Ultimately, the property ecosystem needs a buy-in from end-customers. Recent supports have not yet ushered in a rebound in homebuyer confidence. This, in our view, is because China's strict COVID stance and sporadic restrictions creates uncertainty on household income, lowering the willingness to take out a mortgage. A 'L' shaped recovery is more likely than a dramatic rebound.

Editor: Cathy Holcombe

Digital design: Evy Cheung.

Related Research

• China Property Is Heading For A Transformation, And Maybe A Turnaround, Nov. 21, 2022
• Global Bank Country-By-Country 2023 Outlook: Greater Divergence Ahead, Nov. 17, 2022
• China Cities Diverge To Navigate Property Slowdown, Nov. 1, 2022
• Banking Industry Country Risk Assessment: China, Sept. 13, 2022
• Real Estate Funds, A First Aid To China's Property Slump, Aug. 18, 2022
• China's Banks Face A Doubling In Real Estate NPLs, Dec. 15, 2021