Chinese bonds and equities are flashing warning signs that suggest the booming mainland property sector is heading for a bust – a development that would send shock waves through financial markets worldwide.
A sector that was until last year the darling of international investors is turning into a horror show as traders have started to digest evidence that real estate prices are falling and developers are losing access to funding.
Fears are most stark in the international bond markets, where Chinese property developers have sold $19-billion (U.S.) of debt in recent years. Prices of these bonds have plunged by an average 22 cents on the dollar in the past two months alone, causing yields to jump.
"You're seeing yields now above 20 per cent, which implies significant default risk," says Owen Gallimore, Asia credit strategist at ANZ. He warns that at least half a dozen developers are in serious danger of defaulting on their bonds.
Equity markets are also delivering a brutal verdict. Since the start of the year, Chinese property stocks listed in Hong Kong have tumbled 40 per cent, compared to a 22 per cent decline in the benchmark Hang Seng index.
"People are worrying about default risk, and the implications for property companies themselves, for the banking system and for the overall equity market," says Agnes Deng, head of China equities at Baring Asset Management.
On a recent fact-finding trip to the Pearl River Delta, Ms. Deng said she saw many developers reducing selling prices by 5 per cent or more amid a decline in transaction volumes, even though September and October are traditionally the strongest months for mainland property sales.
According to government data, Chinese property prices have risen 60 per cent since the end of 2006. However private sector estimates suggest that in many areas the jump in prices is several multiples of the official figures.
Partly as a result of the dearth of accurate, comprehensive data on supply and demand for housing in China, there is a wide array of opinions about whether the market is a bubble, and if it is, whether it has started to burst.
What is without doubt, however, is that Chinese property developers took on enormous amounts of debt in recent years as they pursued aggressive expansion plans, leaving them little room for manoeuvre if property sales do fall.
Making matters worse, developers are losing access to funding, having been frozen out of public bond markets for the past three months. Meanwhile, state-owned banks are following government orders to restrict lending to all but the most powerful developers.
According to Chinese media, the government this month told the trust company sector, part of the country's fast-growing shadow banking system, to stop lending to certain developers. "The trust companies were the lender of last resort, which is why it's so serious for that tap to be turned off," says Mr. Gallimore.
Standard & Poor's, the rating agency, this week conducted a stress test to determine how the 30 Chinese developers that it rates would perform in a downturn. For bondholders, the results were sobering.
Most developers could withstand a 10 per cent decline in property sales in 2012, S&P found. But more than half of the companies, including several large operators such as Evergrande, would struggle to meet debt repayments if contract sales fall by 30 per cent.
In January, 2010, when bullish sentiment about China was running high, Evergrande sold $1.35-billion of five-year bonds to U.S., European and Asian investors with a coupon of 13 per cent. Those bonds are now trading at 73 cents on the dollar, giving a yield of 26 per cent. Meanwhile, Hong Kong-listed shares in Evergrande are trading at a multiple of just four times its forecast 2011 earnings.
While prices like these may appear attractive, analysts warn they could fall much lower. In 2008, when there were only a few Chinese property bonds in the market, bond prices slumped to below 50 cents on the dollar as the mainland housing market started to implode.
Investors were bracing for a wave of defaults but they never materialized because Beijing allowed the state-owned banking system to go on an unprecedented lending spree that saved the housing market and resulted in China's M2 money supply almost doubling since the start of 2008.
Now, however, with inflation running at elevated levels and expectations that bad debts will start to emerge in the banking system, few think China will choose to implement another stimulus package on the same scale, even if the global economy faces another crisis.
One fund manager who remembers China's property crash in the 1990s says yields on property bonds would need to rise much higher before he was confident that the market was adequately compensating for the risks.
"The government doesn't want the whole industry to go bankrupt but it probably doesn't mind the market calming down if that means one or two go bust and have to be consolidated into bigger entities," he said.