Country Garden's Death Spiral Nears Point Of No Return

Can China Avoid Its "Lehman Brothers Moment"?

When last we looked at Chinese developer Country Garden metastasizing financial problems, the question of the moment whether this would be China’s “Lehman Brothers Moment”.

Has China's "Lehman Brothers" Moment Arrived?

With Country Garden having made a last minute debt service payment just as the 30-day grace period about to expire, the question is less whether this will be a Lehman Brothers moment but how can China hope to escape such a scenario.

Chinese developer Country Garden Holdings Co. has paid coupons on two dollar bonds within grace periods, avoiding its first default and bringing some respite amid a liquidity crisis that’s shaken the nation’s financial markets.

While Country Garden until now had seemed certain to fail to make the necessary debt service payments within the 30-day grace period to stave off debt default, at the very last minute the developer also appeared to have secured an extension from other bondholders, thereby kicking the default can down the road….for now.

Country Garden (2007.HK) has won approval from its creditors to extend payments for an onshore private bond, two sources said on Saturday, in a major relief for the embattled Chinese property developer as well as the crisis-hit property sector.

Country Garden was seeking approval from its creditors to extend the maturity for a 3.9 billion yuan ($540 million) onshore private bond in a vote that ended on Friday night.

China's largest private property developer had proposed to repay the debt in installments over three years instead of meeting its obligations by Saturday. The bond is not publicly traded.

The development buys time for the firm to avoid default in what will likely be a major relief for financial markets and the Chinese government, which has announced a raft of measures to support the indebted property sector.

While the extension avoids further defaults for now, it does nothing to improve China’s deteriorating real estate sector and little to improve Country Garden’s deteriorating financial prospects. Country Garden still has to service some $2.5 Billion in interest and maturing debt by the end of the year—and still does not have nearly enough cash to service that debt.

The Lehman Brothers scenario seems to be bearing down on China. China has avoided this outcome thus far, but the outlook is still getting worse and not bettter.

How bad will Country Garden’s collapse be?

That a Country Garden collapse would be a major body blow to the Chinese economy seems almost inevitable. Not only is the developer the largest in China, but default on its debt would further erode the value of developer debt in China, debt which has already lost some 87% of its value since Evergrande first defaulted on its debt obligations.

The market for Chinese developers' dollar-denominated bonds has seen a meltdown over the past two years,  losing a staggering 87% of value. The rout has wiped out $135.5 billion of value from $154.9 billion of outstanding notes, according to an analysis by Debtwire. 

"The average price on the notes is now only a tad above 11 cents on the dollar," Debtwire co-managing editor Chaim Estulin wrote in an accompanying LinkedIn post.

Additionally, like many Chinese developers Country Garden has extensive ties to China’s “shadow banking” firms, such as Zhongrong International Trust and its parent company Zhongzhi Enterprises, which also has missed required payments on wealth management products, raising the possibility that Country Garden has missed more than just the offshore bond payments.

The authorities have also directed two of the country’s bigger financial firms to inspect the books of one of the larger trust companies, Zhongrong International Trust Co, after it missed payments to an estimated 150,000 investors on of a raft of investment products in recent weeks.

Zhongrong manages more than $210 billion of funds, largely from wealth investors, and Beijing appears concerned that its connections with property developers and other financial institutions represents a risk to the wider financial system and economy.

Zhongrong and a number of its peers are said to have bought into a number of large property projects last year, betting that the market would stabilise and then rebound. Instead, sales numbers and value have kept falling and the losses would have kept mounting.

With over 3,000 projects underway, a Country Garden collapse would almost certainly send a fresh shock through China’s beleaguered real estate market.

A major part of China’s dilemma—and Country Garden’s financial distress—is the steadily shrinking size of the real estate market.

Since 2021, new home sales have been steadily less and less and less.

So bad has it been that the sector experienced negative growth throughout most of last year.

After a nascent attempt at a recovery, China’s accumulated growth rate is about to turn negative yet again.

With real estate contributing as much as 30% of China’s overall GDP, further decline in real estate (which seems almost sure to happen now) will only further exacerbate the deflation which recently began to be seen in the Middle Kingdom.

Deflation Has Arrived In China

As it stands, Chinese real estate has already seen overall investment decline by 10% in 2022, and is on track for even further decline in 2023.

Driving the decline has been a steady drop in new home prices. Although home prices had been staging a small recovery during the first half of the year, in recent months prices have resumed their downward spiral.

Collapsing home prices have created a sort of “doom loop” for Country Garden, as declining prices cut into its revenues, which cuts into its ability to service its mounting debt obligations, which cuts into its ability to deliver housing projects, which cuts into Chinese homebuyer confidence, which cuts into housing prices.

Country Garden’s troubles leaves Beijing on the horns of a dilemma. On the one hand the size of the real estate sector within the Chinese economy very much makes it “too big to fail”, meaning at some point Beijing will have to step forward with significant fiscal stimulus to stabilize the market—which could result in an even worse property bubble and lead to an even worse crisis down the road.

Still, given the scale of China's property market, policymakers may need to step in with fiscal stimulus to avoid catastrophe. That, however, can make asset price bubbles bigger and drive up debt, according to William Hurst, deputy director for the Centre for Geopolitics at the University of Cambridge, told Insider. 

"If we think about the 2008 collapse in the US property market, driven by excessive wealth plowed into real estate, versus what's happening in China with much higher amounts of wealth in that sector, the scale and severity of the crisis is potentially much much worse than what happened 15 years ago in the US," Hurst said.

Yet failing to provide some form of relief risks consigning 30% of China’s Gross Domestic Product to further chaos, and accelerating the contagion effect, as developer insolvencies begin to impact both the regular banks and the “shadow banking” sector.

Further complicating the issues is that, while Country Garden is struggling to pay its debts, it is itself, along with other developers, a debt many local governments in China, mainly through various Local Government Funding Vehicles, are themselves struggling to pay.

Local governments in some Chinese cities owe property developers 1 billion yuan ($137 million) to 2 billion yuan each in unpaid bills, according to a local media report, with pressure building on the authorities to pay their debt.

The outstanding amounts owed to the property firms include tax rebates and promised reimbursement of land sale fees, Economic Observer reported late Monday, citing unidentified executives at developers.

Beijing is pushing local governments to resolve these outstanding debts, but, in a collapsing real estate market, the land sales local governments rely on for revenue are also cratering. Without revenue, it is likely many LGFVs and their sponsoring local governments will need assistance from Beijing to resolve their debts and themselves avoid debt default.

Local government finances are under pressure after revenue from land sales, a major source of income, plunged. That’s limited their ability to spend and boost economic growth. Data on Monday showed China’s broadest measure of the fiscal deficit — the so-called augmented shortfall — shrank by more than a third so far this year compared with the same period in 2022.

Thus Country Garden and other developers are on both sides of the contagion equation. The more developers fail or default on their debts the more various finanancial entities such as the LGFVs encounter liquidity stress, which in turn limits their ability to spend and thus pay their debts to those self-same developers, thereby magnifying the problem.

Ironically, it is this governmental aspect of China’s real estate crises that tends to make some analysts doubt the unfolding of a Lehman Brothers scenario.

"Trying to compare what's going on with China now to the US in 2008 is like comparing apples and oranges," Nicholas Spiro, a partner at macroeconomic consultancy Lauressa Advisory, told Insider. "It's unhelpful but it's made its way into the narrative, which is worrying. It's not a Lehman moment. You're not going to have a comparable banking crisis because of the simple reason you have a state-owned financial system."

That said, Spiro said it's unlikely China can return to the boom-times of decades past.

"There isn't going to be a sudden sharp shock or dramatic loss of confidence or financial stability," he said. "Rather, it'll be a slow-moving, structural economic crisis that could last for years. We are seeing a deep-seated, economic malaise which will be very prolonged."

However, the ongoing debt challenges of LGFVs, which are implicitly backstopped by their sponsoring local governments, are a potential monkey wrench that could get thrown into the works.

Already two of China’s larger banks have posted sub-par results, and one even pointed an accusatory finger at a region’s LGFVs.

Two of China’s biggest banks on Wednesday posted sluggish profit growth as the economy struggles to bounce back after the lifting of pandemic restrictions, with one saying local government financing vehicles (LGFV) had defaulted, hitting asset quality.

Industrial and Commercial Bank of China Ltd (ICBC), the country’s biggest lender, and Bank of China (BoC) posted in exchange filings first half profit growth of 1.2 percent and 0.78 percent, respectively, from a year earlier.

Chinese lenders are battling headwinds such as lower lending rates and pressure from the government to prop up the economy – which has been buffeted by weak demand both at home and abroad – as well as bad debts related to property developers and LGFVs.

This is where the Lehman analogy gains traction. With potentially unknown connections between property developers, local government financing vehicles, banks, and “shadow banks”, at a time when most if not all property developers are facing some level of liquidity stress, the potential for a major debt default anywhere in that web of interconnection to reverberate and trigger liquidity crises and even debt defaults throughout that web is simply not possible to determine.

Will a Country Garden collapse trigger an outright debt default by one LGFV or another? That is unknown—but it is not impossible.

Could Beijing step in even at the eleventh hour and backstop developers and LGFVs alike to head off any contagion effect? Yes, but the longer Beijing waits the more expensive the backstop becomes.

Barring a miracle, Country Garden days as a going concern are numbered. Barring a miracle, Country Garden is going to tip into formal debt default and ultimately tumble into bankruptcy. It will take a financial miracle for these outcomes to not happen.

How much contagion will erupt from that collapse remains to be seen. It is certain there will be some, but how far it will spread beyond real estate and potentially some banks is an unknown at this time. Equally unknown is whether Beijing will find a way to respond assertively to head off that contagion.

The stage is set for what could very easily become China’s version of a Lehman Brothers moment. Whether that moment materializes when Country Garden at last collapses into default is a question as yet unanswered, a question that will remain unanswered until Country Garden’s denouement reaches its conclusion.