High downside risk.   The property sector is largely driving China's high downside risk. This was the focus of our Credit Conditions Asia-Pacific Q4 2023 report, "China Downside Risk Is High," published Sept. 26, 2023. Residential property sales have been falling hard since April, reversing a small revival earlier in the year on easing restrictions on mortgage and purchase limits. The situation is most severe in the lower-tier cities, but even tier-one cities saw a 29% decline year on year in property sales in August 2023 (driven partly by a high base in Shanghai the previous summer).

This is hitting property developers' cash flows and also hurting land sales, a key source of revenue for local and regional governments (LRGs). That diminishes the fiscal strength of these LRGs and their ability to support state-owned enterprises (SOEs).

Meanwhile, China has rolled out easing measures to stem declining sales in the richest cities. While the top-down approach could be more effective in stabilizing the property market, it means lower-tier cities could see the recovery pushed out further. We believe China's property sales will track an extended L-shaped, with sales declining in 2024 as a whole (see "China Property Watch: A Slow, Sequential Recovery In 2024," on Oct. 16, 2023)

China's former no.1 property developer in trouble again.  Symptomatic of the troubles in the sector, Country Garden, once China's largest privately owned property developer, said on Oct. 10 that it may default on offshore debt obligations given cash flow pressures. This potential default, which comes after a string of property company defaults since 2021 (most notably, Evergrande, another former no.1), highlights deepening stress for real estate and related sectors.

The resulting hit to business and household confidence is also affecting China's post-pandemic economic recovery. These weak economic conditions prompted us in September to shave our projection for China's real GDP growth in 2023 to 4.8%, down from 5.2% previously (see "Economic Research: Economic Outlook Asia-Pacific Q4 2023: Resilient Growth Amid China Slowdown," Sept. 24, 2023).

Why China's property sector matters

Overbuilding and overborrowing.  In the first three decades (1980s-2000s) of China's economic reform, investments were directed toward advancing the economy in terms of manufacturing, infrastructure and housing. In the fourth decade (2010s), signs emerged that too much money was going into real estate. Local governments needed to sell land at higher prices to sustain public services while private sector real estate developers, confident of supportive housing sale prices, borrowed heavily to expand at a fast pace.

One-fourth of economic activity.   On paper, the real estate sector directly makes up around 13% of China's GDP. However, the overall footprint is around twice as large. Consequently, a stressed real estate sector affects the Chinese economy, financial system, and local government fiscal profiles.

A strict COVID lockdown and weak homebuyer confidence saw China's national property sales fall sharply in 2022 and 2023 (see charts 1 and 2). We anticipate 2023 sales will drop to about Chinese renminbi (RMB) 11.5 trillion-RMB12 trillion, a decline of 10%-15% over the prior year. 2024 sales should decrease a further 5% to RMB11 trillion–RMB11.5 trillion (see "China Property Watch: A Slow, Sequential Recovery In 2024," Oct. 16, 2023).

Chart 1

Chart 2

State Of Play

Housing sales down, land sales down.  With the weak economic recovery and would-be buyers' doubts about the ability of property developers to deliver new apartments on time, demand for new properties has fallen. We observe the following:

• Declining fiscal revenues. Land sales and property tax contribute significantly to the fiscal revenue of local and regional governments (LRGs), especially for lower-tiered cities. With this important source of income gone, LRGs' ability to support heavily leveraged local government financing vehicles (LGFVs) or stimulate the local economy is hampered.
• Revenue hit for upstream and downstream real estate segments. Weaker new property sales will mean reduced demand for products and services from related industries such as building materials, steel and engineering, and construction. In the face of a protracted real estate slowdown, earnings contractions would hit credit quality.
• Declining house prices. With sales dipping, property developers could lower prices in a bid to speed up turnover. For individuals, this means a devaluation of their assets or personal wealth. For banks, a devaluation to underlying collateral for mortgages point to higher provisions for loans. Correspondingly, lower demand for mortgage loans would further hit banks' profitability.

Local government financing vehicles are struggling amid heightening liquidity pressure.  LGFVs have long been able to operate with weak credit profiles, propped up by LRG support. These financing vehicles are heavily reliant on debt to support various infrastructure-related projects.

Unfortunately, many of these projects are loss-making (see "Global Debt Leverage: China's SOEs Are Stuck In A Debt Trap," Sept. 20, 2022), so refinancing is key for them to stay afloat. With LRGs' ability to support LGFVs coming into question, and a stringent central-government policy stance around LGFV debt risks, funding access of these entities could narrow significantly. The consequence is growing default risk for LGFVs. We believe policy measures to alleviate the most imminent repayment risks in some regions are insufficient to solve the sector's debt problem. Particularly, a surprise default by a major LGFV could risk contagion to its peers or even local governments.

Concurrently, banks are the largest financiers of LGFVs. They provide funding through direct loans and owning bonds issued by the LGFV. The deterioration of LGFVs' credit profiles would mean investment write-downs and higher provisions for nonperformance, hitting banks' capitalization (see "LGFV Strains May Inflict A RMB2 Trillion Hit On China Regional Banks," Oct. 18, 2023).

Major government stimulus unlikely.  To stimulate the population's confidence over the real estate market, the central government eased measures across major cities (such as Beijing, Shanghai, Guangzhou, and Shenzhen). This includes relaxing home purchase rules, and lowering downpayment and mortgage rates. However, we believe these measures fall short of what the market expected. In our view, the authorities will not provide significant stimulus. Indeed, property sales across 50 major cities declined 8% year on year during the recent Golden Week holiday (Oct. 2 to Oct. 8) (see table 1).

Table 1

Other than real estate, exports.  Beyond domestic issues, a global slowdown is hurting exports. For manufacturers, slowing demand from key export markets means reduced incentives to invest and expand.

Parts of consumption constrained.  In the face of high youth unemployment at 21.3% in June 2023 (more than double the pre-pandemic rate in May 2018), souring employment prospects are weighing down consumption. Meanwhile, increasingly cautious behavior as indicated through slower investments and a lack of appetite for big ticket consumption items could mean further weakness is in store for the Chinese economy.

Downside scenario assumptions: Property sales fall further

Scenario.  Assessing the real estate sector, we estimate a 1-in-5 chance of a downside scenario as follows:

• 17.3% decline in 2023 sales over 2022. Monthly average sales could go down to RMB800 billion per month for the rest of the year. This translates into RMB11 billion in sales for 2023, a 4%-8% decline from our current base case (10-15% lower than 2022) (see table 2). New starts will continue to fall, resulting in national property sales declining to RMB10 trillion in 2024 and stay flat onwards.

Table 2

• Lower-tiered cities are affected more. The decline in value and average selling price (ASP) for lower tier cities is more pronounced than those of higher-tiered cities due to weaker economic fundamentals and demand. Consequently, the share of property sales from higher tier cities will rise to 45% in 2023 and 50% in 2024 (2021: 40%; 2022: 43%).
• Lower land purchases. Developers' top priority will focus on completing pre-sold homes for on-time delivery. Therefore, they will likely hold back on land investment to preserve cash.
• No government stimulus. No discretionary fiscal or monetary stimulus from the authorities, amid efforts to contain leverage and financial risks.

Macroeconomics: Growth could slow to 2.9% in 2024.  China's deepening property crisis will slow growth momentum further, given the large economic footprint of the property sector, and no apparent growth replacement (of the same magnitude) in sight,. With 2023 already in its final quarter, the impact of the downside scenario will show up substantially more in 2024. Our downside scenario would imply GDP growth of 4.4% in 2023 and 2.9% in 2024 (see table 3).

This downside contraction would come on top of our recently adjusted baseline growth forecast for China in September 2023 (see "Economic Outlook Asia-Pacific Q4 2023: Resilient Growth Amid China Slowdown," Sept. 25, 2023) where we now expect whole-year growth of 4.8% this year, from our 5.2% forecast in June; and 4.4% next year, from 4.7% in June.

Key assumptions and takeaways regarding the downside scenario are:

• Real estate as the starting point. Real estate activity is significantly weaker than in the baseline September forecast, reflecting lower housing starts and construction. Specifically, we assume real estate investment momentum is another 5 percentage points (ppt) weaker in 2024 than in the baseline; housing prices will also be lower.
• First-order GDP impact. The large economic footprint of the property sector, including via backward linkages to sectors such as steel and forward linkages to sectors like white goods, implies a drag of around 0.3 ppts on GDP growth in 2023 and 1.1 ppts in 2024.
• Second-order GDP impact. In addition, the impact of further housing weakness on confidence, especially among consumers, would imply a further hit on GDP growth of 0.1 ppts in 2023 and 0.4 ppts in 2024, in our assessment.
• Tax revenues. We assume that additional negative spill-over is offset by "dilution" via lower imports and tax revenue. Indeed, we assume that policymakers will not try to offset the reduction in tax revenue by cutting expenditures or raising tax rates (as in, they will let automatic stabilizers work).
• No stimulus. We presume no discretionary fiscal or monetary stimulus. This reflects our assessment that, amid efforts to contain leverage and financial risks, policymakers currently have little appetite for macroeconomic stimulus. That is especially the case for the kind of local government-led fiscal stimulus that China has relied on in the past.
• Interest rates. On the monetary side, the room for significant reduction of the policy interest rates is limited, in our view. Policymakers remain keen to keep banks' net interest margins at a level that ensures the big banks are sufficiently profitable. Elevated U.S. interest rates are another constraint, especially given the depreciation of the renminbi this year.

Overall, the downside would imply 0.4 ppts less GDP growth in 2023 than in the September baseline and 1.5 ppts less GDP growth in 2024 (see table 3).

Table 3

Probability.  Such a downside is consistent with the results of our statistical model. This model suggests that the probability of a downside to GDP growth of this size or worse--compared with the baseline--is 20%.

More on investment, less on consumption.  Reflecting the large role of the property weakness in this scenario, we expect the hit to investment to be larger than the one to consumption. Relatedly, we think the drag on industrial production would exceed that on services output. Consumer-price inflation would be 0.7 ppts lower in 2024 than in the baseline. The impact on producer price inflation would be higher, since commodity and heavy industry prices would be hit heavily by the larger property downturn. Our forecast unemployment rate on average would be 0.5 ppt higher in 2024 in the downside scenario.

Downside scenario impact on sectors

We illustrate some of the linkages of the property market to the wider economy in the flow chart below (see chart 3).

Chart 3

We discuss the downside scenario's impact on the following industry sectors:

1. Real estate

2. Local and regional governments (LRGs)

3. Local government financing vehicles (LGFVs)

4. Engineering and construction

5. Commodities

6. Banks

7. Capital goods

8. Auto

9. Ports, toll roads, and utilities

10. Technology

11. Consumer products

12. Insurance

13. Structured finance

14. Sovereign

1. Property: More developers to default and further extensions sought for restructured debt

With the divergent trend between higher- and lower-tier cities, developers with higher exposure to the former will fare better. In addition, developers with good funding access, especially those that are state-owned, should be able to weather this difficult period. Despite weaker sales prospects, their liquidity should remain adequate with continued funding support; but we expect their leverage to rise due to slower asset turnover.

On the other hand, developers with restrictive funding access, particularly privately owned ones, may need to liquidate assets on hand to speed up cash collection. That would hurt their profitability and further weaken leverage. These developers, particularly those with higher exposure to lower-tier cities, could face significant cash flow pressure. We perceive the honoring of debt obligations will be secondary; completions and delivery of properties will be their top priority. This means more debt restructuring could occur.

Meanwhile, distressed developers who have completed debt restructurings could seek further debt extensions to beyond 2024 in hopes for sales recovery.

2. LRGs: No easing in debt-swap program amid rising deficits

In our downside scenario, LRGs' deficits could widen to 18%-19% in 2023 and 17%-19% in 2024. This implies a further delay to achieving fiscal consolidation and debt burden remaining a drag for the sector. Furthermore, the uneven property correction in lower-tiered cities will widen the gap between city and county governments--ensuing even more divergent GDP growth across Chinese cities. This deterioration in fiscal and economic performance will translate into weaker credit profiles for the already highly indebted LRGs.

Such a downside would spill over to state-owned enterprises and LGFVs. With limited resources, local governments would prioritize the most important SOEs and LGFVs. This would put other SOE or LGFV debt at risk.

3. LGFVs: Contagion fears could risk surprise defaults

Default risk among LGFVs will be exacerbated, amid worsening fundamentals and liquidity strains (see "China Policy Patches Alone Won't Fix LGFVs' Fraying Liquidity," Sept. 7, 2023). Concurrently, with LRGs' weakening capacity and propensity to support, credit access to LGFVs could be further curtailed. More critically, fears of contagion could intensify, prompting demands for higher risk premia by investors and lenders; this would compound funding woes and result in a domino effect of distress situations.

Furthermore, shrinking LGFV capex and stalled projects could lead to stagnant growth in certain development zones, posing further drags to China's economic outlook. To stem contagion fears, a large-scale restructuring of debt might need to take place. This could intensify burdens on the banking sector and capital markets. That said, the recently announced debt swap in some regions, and likely tighter coordination among central and local governments and banks, may give the market a temporary and small boost to confidence.

4. Engineering & construction: Earnings squeeze and slower cash collection thins ratings headroom

China's engineering and construction (E&C) sector could see revenue declining in 2024 in a downside scenario. This compares to modest growth in our base line. Concurrently, slower cash collections from project owners would result in higher receivables impairment--squeezing earnings.

Weaker profits and slower working capital turnover will weigh on operating cash flows, pushing up the industry's debt and leverage. For the small private E&C companies, cash flow and liquidity pressure will intensify. For the rated universe, about one-in-three credits will see thinner financial headroom, foreshadowing negative rating actions.

5 .Commodities: Survival of the fittest

It's no surprise that a substantially weaker real estate sector would further dampen demand for steel and building materials industries. The knock-on effects would be felt by upstream material providers, including iron ore, coal and some base metals. This will entail deeper financial duress for already loss-making and small companies in these sectors.

In our base case, we already assume the smaller players with obsolete or less efficient facilities will likely be phased out as new and sizable production capacities come onboard in 2023. Likewise for smaller commodities chemicals companies. A downside scenario would hasten this consolidation.

6. Banks: Credit losses to spike, asset quality pressure intensifies, and some banks in trouble

We expect the nonperforming asset (NPA) ratio of Chinese commercial banks to increase to 6.1% in 2023, 7.0% 2024, and 6.0% in 2025, compared to our July 2023 estimates of 5.4%, 5.0% and 5.0%, respectively. This will push up annual credit losses to Chinese renminbi (RMB) 2.9 trillion over 2023-2025, 18% above our previous estimate of RMB2.4 trillion.

Concurrently, slower economic growth in our downside scenario over 2023-2024 would likely lead to a spike in forborne loans, before a recovery in 2025 alleviates pressure on asset quality. Our NPA metric includes estimates of forborne and other problem loans, in addition to nonperforming and special-mention loans.

We forecast weaker real estate activity will press on loan growth in property development and increase the proportion of developer loans that is troubled to 55% from 40%. This pushes up our NPA estimate for property development loans to 17.3% at end-2023, compared with our previous expectation of an improvement to 11.5%, from 14.3% at end-2022. This segment's NPA ratio would stay higher for longer in our downside scenario.

Meanwhile, the spillover from lingering real estate woes could strain LGFVs' debt situation. We anticipate the NPA ratio of LGFV loans would increase to 10% in our downside scenario, from our previous forecast of 5%.

On a related note, banks' 2024 NPAs (as a proportion of loans) could fall back to 2020 levels in the downside scenario. Higher credit costs (a gauge of loan losses), and lower net interest margins from lost or lower interest income due to restructuring, could drag on profitability and increase some banks' reliance on external capital replenishment.

We believe China's banking sector in general has reasonable financial buffers and the system's credit profile will remain sound compared with that of key global peers (including Brazil and South Africa). However, some aggressive and weak banks will face heightened financial risk and could fail (or recapitalize with the government's help if they threaten regional stability).

Meanwhile, worsening operating conditions for the distressed asset management companies will further delay their earnings recovery.

7. Capital goods: Souring business sentiment hits demand and financial metrics

Like the E&C sector, revenue declines will hit the capital goods sector in 2024. Shrinking demand, amid slowing business activities, will intensify competition and hurt margins despite potentially lower input costs. While we expect capex and investment appetite to diminish in a bid to preserve cash, leverage could still trend up due to narrowing operating cashflows. Among the rated names, about half of the credits may see meaningful deterioration in financial metrics and be subject to rating downgrade or outlook revision.

8. Auto: Reduction in discretionary spend on big-ticket items to slow auto sales

With propensity to spend on big-ticket items curtailed, light vehicle sales in China may drop by low single digits in 2023 and mid-to-high single digits in 2024 (compared with our base case of 0%-2% growth). Weaker demand would entail more price competition among automakers and suppliers. Rising electric vehicle sales will further heighten margin pressure, despite lower raw material costs.

Lower profit and slower inventory turnover would hurt operating cash flows. Companies would be reluctant to invest. We would expect them to cut capex and suspend dividends to preserve cash. Under such a scenario, about 20% of the covered credits could see rating downgrades due to narrower margins and higher leverage. For the wider industry, loss-making small players with limited funding channels may see liquidity crunch.

9. Ports, toll roads and utilities: Slowdown hits revenues, coupled with inelastic investments means increasing leverage

A downside scenario for 2024 GDP means weaker revenues for power and natural gas operators, given their consumption is closely correlated with economic performance. However, we consider the risk of high fuel prices diluting margins as limited, in light of easing prices and an ability to pass through to end-customers. Leverage will stay elevated amid persistent capex investment to meet long-term energy transition targets and the government's push on green development as an economic growth driver.

Concurrently, toll utilization could dip from lower traffic volume. Like utilities, capex for toll developers is inelastic, given ongoing spending needs to prop up the economy (particularly if under a slower economic outlook). Furthermore, the regulator could require larger discounts on toll rates, a move that would likely squeeze profitability by 5%-15% than otherwise. Consequently, leverage could rise beyond our base case.

In our downside, China port throughput could contract more than 10% year on year due to the slower economic outlook. Yet, for pivotal port operators, throughput would remain well above breakeven levels (covering operating expenses and financing costs) in our view--even with a downside GDP hit. For port operators, leverage trends will depend on the capex outlook.

10. Technology: Low debt leverage and good free operating cashflow underpin resilience against weaker demand

The potential impact of lower GDP in our downside would be modest for technology credits. The number of affected credits would be in the low-single digit percentage. Most technology companies have been focusing on improving their profitability and cash flow over the past 18 months and longer. This will enable the vast majority of outlook and ratings to withstand a more severe and temporary slowdown in demand for consumer and business products.

11. Consumer products: Weak credit fundamentals expose vulnerabilities

After years of expanding operations and geographical footprints, high leverage and still-subtle revenues expose consumer products sectors to credit vulnerabilities. Reductions in discretionary spend by households could further hamper credit headroom. In the downside scenario for China, we expect that 7%-9% of our ratings under the consumer product portfolio could be subject to outlook or rating change.

12. Insurance: More "national service" to support capital markets to hit capitalization

The significant economic slowdown in 2024 in our downside scenario could lead to declines in insurance premium growth, amid a shrinking propensity for businesses and households to acquire protection. Furthermore, insurers may be asked to undertake more "national service" to support capital markets (see "Revised Regulatory Standards Could Be Credit Negative For Insurers in China," Sept. 13, 2023). Meanwhile, low interest rate and persistent market swings will continue to weigh on investment return and overall profitability.

13. Structured finance: Higher unemployment

While the potential pick-up of unemployment to 5.9% in 2024 (under the stress scenario) will contribute to increasing delinquency rates, it is unlikely to have a rating impact on rated auto loan asset-backed securities (ABS). The same goes for consumer-finance ABS and residential mortgage-backed securities (RMBS).

Our view is based on observations from past periods with similar unemployment rate levels. During those periods, with the unemployment rate hovering at around 6%, the arrears of securitized pools rose modestly for the auto-loan ABS and RMBS that we had rated then, and led to just a dip in rating headroom.

Furthermore, the transaction features of rated securitizations also contribute to rating stability. For amortizing transactions, their credit enhancements in percentage terms continue to increase over time as the notes are gradually paid down. For transactions that are still in the revolving period, usually there are amortization events linked to the performance of the underlying pools. Should the delinquency rates of the securitized pools rise and breach the amortization triggers, the transactions would enter into an amortization period and as a result start to deleverage.

Meanwhile, we continue to monitor the magnitude of a potential second-order impact from the prolonged downturn of the residential property market. Amid a property downturn, more time may be needed for banks to sell properties associated with defaulted mortgage loans.

14. Sovereign: Prolonged economic underperformance could prompt aggressive stimulus and higher debt levels

Despite the significant underperformance in 2024, in the downside scenario, China's economic performance should remain above peers on a trend comparison basis, particularly with the rebound in 2025.

However, a sustained downturn could compel policymakers to introduce more aggressive measures, such as much higher fiscal deficits and larger bond quotas for local governments, to bring the economy back on track. This could further delay our expectations for fiscal consolidation and increase general government debt, thereby weakening credit support for our sovereign rating on China (A+/Stable/A-1).

Related Research

• LGFV Strains May Inflict A RMB2 Trillion Hit On China Regional Banks, Oct. 18, 2023
• Global Debt Leverage: What If Chinese Corporate Earnings Further Decline?, Oct. 18, 2023
• China Property Watch: A Slow, Sequential Recovery In 2024, Oct. 16, 2023
• China's Reforms Need A Confidence Booster, Oct. 9, 2023
• China Still Has More Policy Tools To Stabilize The Higher Tier Property Markets, Sept. 26, 2023
• Credit Conditions Asia-Pacific Q4 2023: China Downside Risk Is High, Sept. 26, 2023
• Economic Research: Economic Outlook Asia-Pacific Q4 2023: Resilient Growth Amid China Slowdown, Sept. 24, 2023
• Revised Regulatory Standards Could Be Credit Negative For Insurers in China, Sept. 13, 2023
• China Policy Patches Alone Won't Fix LGFVs' Fraying Liquidity, Sept. 7, 2023
• Credit FAQ: Will Country Garden's Woes Further Hobble China's Property Market?, Aug. 16, 2023
• China Property Watch: Peripheral Pain, May 22, 2023
• Global Debt Leverage: China's SOEs Are Stuck In A Debt Trap, Sept. 20, 2022