Debt troubles at Country Garden threaten global blight

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• China's insolvent property developers and trust companies pose risks to many global businesses.
• The U.S. and Spain offer recent examples of real estate bubbles suggesting China might still be in the early stages of its downturn.
• Restructuring property debt might take years but could eventually unlock attractive investment opportunities.

News of a liquidity crisis at China's largest property developer, Country Garden, has rekindled fears about the scale of the country's real estate problems and potential ripple effects. And Country Garden is not alone. Zhongrong International Trust missed payments to three publicly listed Chinese companies, and its affiliated parent company Zhongzhi's wealth management businesses halted payments to thousands of retail investors.

Another day, another domino

Country Garden is not the first Chinese property developer to face a cash crunch. In September 2021, the country's second-largest developer, China Evergrande, shocked markets when it missed payments on its bonds. Since then, nearly 30 others — representing more than 10% of the 241 publicly listed Chinese developers — have either missed payments, defaulted, or restructured their debt.

The property sector's debt problem early on had involved only external debt (in USD) but has since spread to the onshore market as well. Renminbi bonds are now trading at 20 to 30 cents on the dollar, a level that implies steep losses for local lenders. The sector's ailing cash flows and ballooning leverage appear to justify the bond market's pessimism.

Figure 1: Developers' liabilities have ballooned to US$2T while income has declined to less than US$25B

Aggregate financials (net debt and contract liabilities, operating income) of 241 publicly traded developers in China

Sources: Bloomberg, public financial statements.

Net financial debt for the 241 publicly traded Chinese developers more than doubled from US$386B in 2016 to $831B in 2022, while operating income fell by almost three-quarters, from $86B to $24B. The financial picture is even more alarming when one considers the up-front deposits customers have paid for homes that are still not delivered. This source of borrowing, called contract liabilities, grew from $368B to more than $1T over the same period. With the cash crunch developers are facing, this looks increasingly like unsustainable debt that they will be unable to repay.

The sum of these two forms of liabilities is close to $2T. Much of it now trades at between 10 and 30 cents on the dollar. To put this paper loss in perspective, the entire Chinese banking system has roughly $4T of equity.

Trust, but verify

The $2T unpaid bill of property developers, while hefty, is only part of the problem. Lurking in the shadows are debts in the opaque $3T trust industry, notorious for peddling investment products that promise high returns with limited disclosures on where the funds are invested. One of the biggest players in the industry, Zhongzhi Enterprise Group ($138B in assets), raised alarm bells when its affiliated unit, Zhongrong International Trust ($86B in assets), failed to repay three listed Chinese companies in recent weeks. This followed several weeks of speculation over missed payments to thousands of retail investors in various trust products sold by Zhongzhi and its affiliates.

Many of Zhongrong and Zhongzhi's products had invested in risky assets like property and cryptocurrencies. For example, troubled developers including China Evergrande, Kaisa Group Holdings, and Shenzhen Wongtee had received financing from Zhongrong.

According to the Financial Times, a trust product called "Zhongzhi Shicheng" offered 8% returns to investors with up to RMB 3 million (US$411,280). The presentation materials highlighted Ripple, the U.S. cryptocurrency, as a "classic case," without specifying how much the product allocated to it. In July, Zhongzhi told investors who owned this product that payments would be delayed for 10 days. Several weeks later, they had yet to receive their money.

There's never just one cockroach

China's real estate problem is unlikely to be confined to just property developers and trust companies.

Knock-on effects could have an impact on other sectors, with one of the strongest likely to be felt in the materials sector. China is the largest consumer by far of cement, aluminum, copper, and steel — the key inputs of property construction. For years, the country has accounted for close to half of the world's consumption of these materials despite having only 17% of the world's population.

Figure 2: China's consumption of materials exceeds its needs

Materials consumption, China relative to U.S.

Sources: National Bureau of Statistics of China; U.S. Geological Survey; GMK Center, citing chief analyst at Nanjing Iron & Steel; Statista; Reuters, citing CRU Group; Bloomberg. Data as of 2022.

In his book, How the World Really Works, Vaclav Smil highlights that China consumed nearly as much cement in a two-year period as the U.S. did in the entire 20th century. Perhaps even more remarkable is that they maintained this pace of building for close to a decade. This extreme imbalance has included the construction of proverbial "bridges to nowhere" and apartment buildings that remain unoccupied. The country has long built over 5 times as many homes each year as the U.S. built at the peak of its subprime bubble despite having a household population that is only 3.6 times larger.

Figure 3: China's cement usage has outpaced other nations' historic records

Cement consumption (tons per capita) in China and historical peaks in other countries

Sources: Deutsche Bank, CEIC, United Nations, and CEMBUREAU for non-China nations; Bloomberg, National Bureau of Statistics of China, and author's calculations for China.

While the materials sector could suffer disproportionately if spending evaporates, every industry will feel some effects. Much of the debt issued by property developers, the trust industry, and highly leveraged miners will need to be written down. This will inevitably spread to the banks as well, through both direct and indirect losses. In the late 1990s, when China last went through a big debt restructuring, the commercial banks' non-performing loan (NPL) ratio peaked at almost 35%. Such a level today would wipe out the banking system's equity several times over. When banks write down assets, they are in turn forced to reduce lending to consumers and businesses, which impacts the whole economy. No one can predict where this cycle could lead, but investors should not assume the government will "extend and pretend" forever. And even if policymakers try to choose this path, Japan's experience of the 1990s and 2000s suggests an equally unpalatable scenario, with zombie banks stifling growth for multiple decades.

Workers in many sectors could face job losses due to a real estate downturn

Real estate is also the single most important asset class for employment. The first-order effects would be on construction workers. But real estate's tentacles extend far and wide. Some examples include:

• Trades such as plumbers, electricians, HVAC servicers, and painters
• Manufacturers of furniture, appliances, lighting, carpeting, doors and windows, roofing and flooring, and elevators
• Producers of materials like bricks, cement, and wood
• Miners of metals such as steel, copper, and aluminum

Historically, new home construction and employment have a high correlation.

Figure 4: U.S. example shows housing downturn typically causes large job losses

U.S. housing starts (in thousands) and unemployment

Sources: Bloomberg, U.S. Census Bureau.

Finally, China is the one of the largest trade partners for most countries around the world. A reduction in consumer demand is likely to have effects far beyond its borders.

What inning are we in? Lessons from property bubbles in the U.S. and Spain

The U.S. and Spain offer useful case studies on what happens when countries build too much, too fast. When the U.S. housing bubble ran out of steam in 2007, new home construction fell from a peak pace of over 2.2 million per year in 2006 to less than 500,000 per year at the trough in 2009, representing a -79% decline. It took several years to work off the excess inventory and even today, over 15 years later, home construction remains 30% below the 2006 peak.

Figure 5: U.S. housing starts fell 79% from peak to trough

U.S. housing starts (trailing 12 months) and U.S. unemployment

Sources: Bloomberg, U.S. Census Bureau.

Spain's housing bubble was even more extreme, with a peak of 800,000 homes built per year, more than twice as much on a per capita basis as in the U.S. bubble. Afterward, construction declined for seven years and did not bottom until 2014, after a staggering -96% cumulative decline. Despite rebounding hard off the bottom, Spain housing starts are still 90% below the peak 15 years later.

Figure 6: Spain housing starts fell 96% from peak to trough

Spain housing starts, in thousands, (trailing 12 months) and unemployment

Sources: Bloomberg, Ministerio de Fomento.

China's floor space of newly started houses is down -38% year over year and -59% from the peak. Given the 18- to 24-month lag between the start and completion of new construction projects, the effect on total buildings under construction has been more muted so far. Over time, if new starts do not recover, floor space of buildings under construction will see a steep decline as well.

Figure 7: New housing in China is down 59% from its peak and may lead overall construction down

Floor space of housing newly started (trailing 12 months) in China, in millions of square meters

Source: Bloomberg.

Figure 8: Buildings under construction

Floor space of buildings under construction in China, in millions of square meters

Source: Bloomberg.

In summary, it could be years before China finds its new equilibrium. Stocks in many sectors and markets will feel the effects to varying degrees. If China follows the examples of the U.S. and Spain, construction activity levels might not fully recover. With that said, when the dust eventually settles, a once-in-a-generation buying opportunity could emerge.

Down, but not out

In the long term, we believe investors would be wise not to turn their backs on China. The ongoing property bust will lead to a significant reallocation of resources, but its negative effects will be finite. As the downturn subsides, the innovative spirit of one of the largest, brightest, and hardest-working populations in the world will endure. By freeing up resources away from property into exciting new opportunities in technology, health care, energy, and science, we believe the country will unleash its full potential once again.

There may be bumps along the way, but in our opinion, China's best days lie ahead.

Spencer Morgan is Portfolio Manager of Putnam Focused International Equity Fund and Putnam International Capital Opportunities Fund. The stocks mentioned in this commentary, Country Garden, Kaisa Group Holdings, Shenzhen Wongtee, and China Evergrande, were not held in either fund, representing 0% of assets as of June 30, 2023.

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