After signs of stabilization in the first quarter of 2023, China's property market now faces another unsettling stress event. Country Garden Holdings Co. Ltd. (Cogard; unrated), one of China's largest and most successful private developers, has missed interest payments on two offshore bonds and suspended trading on nearly a dozen onshore bonds. In our view, this raises the prospect of a disorderly default, and could dampen the country's slow-healing property market.

In this report, we address questions on the company's financial and operational situation. We also look at what a potential default could mean for industry-wide property sales, financing environment, project completion, and related issues. Finally, we address queries on whether other sectors, such as suppliers or constructors, are increasingly vulnerable to property-sector fallout.

Frequently Asked Questions

Is Cogard at risk of defaulting on its offshore debt obligations?

Yes, we see default risk on the offshore bonds. This is given:

• Cogard still hasn't paid US$22.5 million in interest on two U.S.-dollar-denominated bonds with a total outstanding amount of US$1 billion.
• Nonetheless, the 30 consecutive-day grace period has not expired on the payment, which was originally due on Aug. 6, 2023.
• If Cogard fails to pay the coupon payments within the grace period, then that will be a default, and it would trigger cross-defaults (e.g., based on the offering memorandum for the U.S.-dollar bond due January 2024, a cross-default can be triggered if an outstanding principal amount of US$20 million of borrowing is in default).
• Subsequent to its missed payment, Cogard suspended the trading on 11 of its 19 outstanding onshore bonds. This action, in our view, reduces the likelihood that Cogard will pay its U.S.-dollar coupon.

Cogard's onshore obligations also face default risk. This is given media reports that the company is seeking an extension of up to three years for its onshore bond due on Sept. 2, 2023, with outstanding principal of Chinese renminbi (RMB) 3.9 billion (about US$538 million). If this onshore bond defaults, it could also trigger cross-defaults on the company's offshore bonds.

Cogard will likely opt for a maturity extension or restructuring for its other bonds that are coming due (be it coupon or principal payments). While we no longer rate Cogard, we would generally classify such an extension or restructuring as a distressed transaction, which is an equivalent to a default; we'd classify it as such even if the maturity extension or debt restructuring were successful.

Why is Cogard in this situation--with missed coupons on offshore bonds and suspended trading of onshore bonds?

In a nutshell: Falling sales, exposure to lower-tier cities, and a depletion of its best assets.

After signs of stabilization earlier in the year, China's property sales are softening again, with particularly tough figures for June and July (see table 1). Moreover, Cogard's sales have underperformed the industry so far this year:

Table 1

Why is Cogard underperforming the industry average?

In our view, this is because of its significant lower-tier city exposure. Some 61% of Cogard's landbank was located in third-and fourth-tier cities at end-2022 (see chart 1a). China's lower-tier cities tend to be less economically developed, with shakier housing demand (see "China Property Watch: Peripheral Pain," published on RatingsDirect on May 22, 2023).

We believe that Cogard tried to sell its highest-quality landbank as a first reaction to China's property downturn. Last year, Cogard's sales slightly outperformed the market's, with sales of RMB357.5 billion: this was a -35.9% year-on-year decline, better than the -41.6% fall for the top-100 developers. This outperformance may have come at the cost of a depletion in the stronger assets.

The company's efforts to replenish its landbank in higher-cities was too little, too late to move the needle, in our view. Last year it spent about RMB6.09 billion in land premiums, to acquire nine projects with an estimated attributable gross floor area of 980,000 square meters (sqm) in higher-tier cities. And in January to June 2023, Cogard paid RMB6.93 billion for six projects with estimated attributable GFA of 640,000 sqm. This compares with Cogard's annual sales of 44.5 million sqm in 2022.

Chart 1a

Chart 1b

If Cogard went into distress, its sales could plunge even further.   There are plenty of such examples. For example, China Evergrande Group (unrated) was one of China's largest developers by contract sales in 2020 before going into distress in 2021. In the first seven months in 2023, Evergrande rank dropped to 23rd.

Table 2

What other factors may be depleting Cogard's liquidity?

A couple issues stand out:

(1) More restrictive access to cash. 

When bank lenders and local governments see deteriorating operations, we believe they may require the developer to put more cash into escrow accounts. This is in order to protect the repayment of bank loans, and help to ensure project completion--given that developers are required to keep escrow accounts for paying the construction expenditure on presold projects. Cogard's weakening sales likely would lead to more restrictive access to cash.

This phenomenon has a history. When Chinese developers have gone into distress in recent years, the amount of cash in presale escrow accounts actually increased, a sign that company's cash was stranded. For example, Shimao Group Holdings (unrated) had RMB18.6 billon cash in presale escrow as of end-2020, out of unrestricted cash of RMB61 billion. By end-2021, when it was on the brink of falling into distress, its presale escrow account rose to RMB25.5 billion, out of unrestricted cash of RMB47.8 billion.

(2) Cogard still has to complete and deliver on its presold projects. 

We estimate Cogard will be generating negative cash flow if its monthly contracted sales sustains at its July 2023 level of RMB12 billion. This is given its ongoing project development obligations:

• Cogard has completed and delivered 278,000 units totaling 34.38 million sqm in first-half 2023. Its targets to complete and deliver 700,000 units in 2023, the same number of units as in 2022. However, if we annualize its first-half 2023 completion for the full year, we get 556,000 units.
• We estimate Cogard will spend around RMB130 billion on construction. This compares to our estimated RMB160 billion-RMB180 billion in 2022 and reflects its likeliness to miss its annual completions target; as well as some effective cost-cutting.

What are the key differences between Cogard's situation and Evergrande's distress situation?

Evergrande's problem was more related to potential "hidden debt." Its previous auditor, PricewaterhouseCoopers, cited the possible existence of off-balance sheet wealth management products and other off-balance sheet liabilities.

Whereas Cogard's problems are tied to the deteriorating operating environment, particularly for lower-tier cities.

However, the hit to homebuyer and investors' confidence could be even harder in Cogard's case.  We think this is because Cogard is regarded as higher quality than Evergrande. Cogard is one of the few privately owned developers that benefit from government-backed onshore bond issuance designed to shore up the market. The company has been able to issue RMB5.2 billion in such bonds since the second half of 2022. Another sign of perceived quality: Cogard had access to external financing; just last month, it was able to obtain an offshore syndicated loan (equivalent to RMB6 billion) from banks in Hong Kong (led by Bank of China Hong Kong). However, if Cogard does go into distress, we believe its existing banking relationships will be put to the test.

Could there be insolvency risk for Cogard?

Yes, we think there's a chance that Cogard's inventory may get further impaired. Why? The developer may need to make bigger discounts to clear its inventory at low-tier cities. Even so, the demand for such inventory may not be there.

We calculate insolvency risk if:

• Cogard's inventory gets written off by about one-third or by RMB309 billion.
• The company wrote off RMB23 billion of inventory 2022, and announced expected further impairment for first-half 2023, in its profit warning announcement on Aug. 10, 2023.

If Cogard fails to meet its debt repayment obligations, how would that affect S&P Global Ratings' sales forecast for 2023 and 2024?

It's a negative. Cogard's delayed payment is already likely exacerbating confidence and a default would only worsen matters. We are increasingly thinking our forecast of an "L" shaped recovery--with flat sales after last year's plunge--could shift into a "descending staircase" figure.

Below are some details on our existing forecasts and potential further adjustments:

• Our house forecasts is for national property sales to fall between 3%-5% this year from 2022. In absolute numbers, that is equivalent to RMB 12 trillion-RMB13 trillion in 2023. This now looks challenging, despite moderate sales growth in the first five months.
• Sales in June and July were deteriorating rapidly, a sign that more buyers could be adopting a wait-and-see approach for any potential release of policy easing measures in the sector, in our view.
• By September, we'll know if Cogard has defaulted on its offshore bond, and the coming weeks could bring more clarity--and potentially bad news--on its onshore obligations as well.
• Assuming no significant policy to roll out over the next one to two months, 2023's sales growth may turn south again and also pressure 2024's sales outlook. This is because homebuyers' confidence could further deteriorate, in our view.

In sum, we think the chance of 2023 industry sales approaching our bear case of about RMB 11 trillion is getting higher.  In our bear case, 2024 industry sales could even drop further to RMB10 trillion.

Given Cogard's difficulty in managing sales, would developers stay away from the property market in these lower-tier cities?

Yes. The outlook is poor, as Cogard's stats alone show. The developer recorded only RMB12 billion in sales this July 2023, down 60% from a year ago. A widening divergence between sales performance in lower- versus higher-tier cities will exacerbate the situation, in our view.

China's property firms will be even more risk averse from development in lower-tier cities, given low margins, high cash control and slow sales. Given tight liquidity, property firms will offer more and more discounts to speed up sales. This could further squeeze margins, adding to impairments. Poor performance can lead to tighter restrictions on the use of pre-sales proceeds, adding another reason for property firms to stay away from these areas.

Cogard is not among the developers that defaulted on offshore bonds last year. Now it might join the group. Does this suggest that all other developers without a default record could be experiencing the same liquidity crunch?  No. But Cogard's problems could make a tough situation worse--especially other privately owned enterprises.

Many developers are likely subject to varying degrees of liquidity problems given the recent sales decline from the end of the second quarter 2023. That means that financing cash inflow is becoming more important with operating-cash inflow shrinking. And here, state-owned enterprises (SOEs) have an advantage.

The SOEs have been able to get tap domestic markets, making up for last year's effective collapse in the offshore bond market for Chinese developers. For instance, China Resources Land Ltd. and Poly Developments and Holdings Group Co. Ltd. have both issued sizable onshore bonds each totaling over RMB12 billion in first seven months of the year.

Selected mixed-ownership developers have also found market access--e.g., China Vanke Co. Ltd.issued RMB10 billion in onshore bonds during the same period. However, issuance is down this year for private developers, including Seazen Holdings Co. Ltd. and Longfor Group Holdings Ltd. Moreover, Cogard's woes will likely make banks more wary about lending to developers, especially the non-SOEs.

What about the "three arrows" support to open funding options to China's eligible ("better managed") developers. Is this policy, which seemed to stabilize things when first introduced in November 2022, still effective ?

Not completely. For example, Cogard benefitted from the second arrow--it was able to issue bonds supported by government-backed credit enhancement. Yet it's still in trouble and overall, the amount of bonds issues in this program is below targets.

Here's our assessment of where the three-arrows scheme is helping, or not:

First arrow is a big support.  China's banks agree to extended RMB4.8 trillion in loans to about 100 developers. We believe these lines will remain in place until a firm recovery is in place. The program has already been extended to the end of 2024. And property firms can apply for a one-year loan extension for construction loans or trusts maturing before the end of 2024.

Second arrow less so.  If developers are getting a break on bank loans, they still need to repay public debt but the second arrow's implementation is ineffective. Developers have so far issued RMB24 billion under the program, well below the RMB140 billion-RMB150 billion in quota applied last November. The challenge lies in the issuance structure. It requires property firms to give assets, most preferable investment properties or high quality residential assets for pledges under the bond issuances. However these property firms, even the better managed ones, do not have much sound but unpledged quality assets for issuances under the second arrow scheme.

Third arrow is slow to advance equity funding.  So far only China Merchants Shekou Industrial Zong Holdings Ltd. was able to raise equity onshore in share placement of RMB8.9 billion. This is despite the fact that numerous firms in the sector have applied for the equity placements since late last year.

What would a Cogard default mean for the supply chain?

It would spell more trouble for suppliers which have already suffered from a string of developer defaults over the past two years. While Cogard's trade payables dropped noticeably from RMB285 billion in end-2021 to RMB192 billion by end-2022, we see heightening uncertainties in future trade-payment collections from the developer. Engineering & construction (E&C) firms, as well as other material & equipment suppliers, most likely will have to take additional write-offs from Cogard, given uncertainty in recovery prospects.

In terms of rated Chinese E&C companies and equipment suppliers, we believe the impact should be manageable. This is given their large scale, diversified customer base and solid financing capability supported by their SOE status. By our estimates, their revenue exposure to private property developers should be less than 10% in general. Our current forecasts have factored in a relatively high level of receivables impairment (as compared with historical levels before the property market stress).

Smaller construction contractors and suppliers are in a much weaker position, with their heavy reliance on selected customers, such as Cogard. With sharp drops in activity and scale in the property market and heightened difficulties on cash collection, many may be forced to exit the market or even face liquidation.

Companies along the property supply chain have tightened controls on the acceptance of commercial bills, etc., given the various troubles in the past couple of years. And in some cases, these companies even require advanced cash payment before construction or product delivery. This further complicates developers' efforts to ensure home delivery, as they continue to bleed cash with slowing pre-sales, construction obligations and debt maturities.

Related Research

• China Property Watch: Peripheral Pain, May 22, 2023