What China’s Three Red Lines Mean for Property Firms
(Bloomberg) -- With eight of the 10 most-indebted property developers based in China, policy makers have drafted what state-run media are calling “three red lines” -- metrics regarding debt that developers will have to meet if they want to borrow more. The new approach promises to be a game changer for a sector that accounts for about 29% of economic output.
1. How will it work?
The People’s Bank of China and the Ministry of Housing announced in 2020 that they’d drafted new financing rules for real estate companies. Developers wanting to refinance are being assessed against three thresholds:
- a 70% ceiling on liabilities to assets, excluding advance proceeds from projects sold on contract,
- a 100% cap on net debt to equity,
- a cash to short-term borrowing ratio of at least one.
Developers will be categorized based on how many limits they breach and their debt growth will be capped accordingly. If a firm passes all three, it can increase its debt a maximum of 15% in the next year. As the regulator hasn’t announced its official calculations, some definitions aren’t clear.
2. Why draw the lines?
A big part is fear of another housing bubble -- and a disastrous bust. Home prices have surged sixfold over the past 15 years, making new cities such as Shenzhen less affordable than London. The debt binge by Chinese builders has been an important driver of rising prices, forcing them to charge more to cover a rising interest burden. Potential buyers returned en masse as the pandemic crunch eased, keeping pressure on prices despite the global economic slowdown. The worry is that China could repeat Japan’s mistake in the 1990s of not reining in excessive credit and shutting down insolvent borrowers quickly enough, causing long-term damage to growth in the world’s No. 2 economy. The danger was never so clear as in September 2020, when word of a possible cash crunch at China Evergrande Group, the world’s most indebted property developer, led to a brief liquidity scare. Concerns over the conglomerate’s financial health resurfaced in mid-2021, causing its stock and bonds to tumble.
3. What’s the implication for developers?
In the near term, a developer with a weak balance sheet and sizable exposure to second-tier cities may need to cut home prices to boost sales and shore up cash. This was evident in Evergrande’s campaign last year to offer discounts of as much as 30% -- its deepest cuts ever. It may also spur waves of equity sales and spinoffs of non-core businesses such as property management services; Evergrande is already disposing of assets and spinning off affiliates. Longer term, it may force developers to devote more resources to non-residential property, such as office and retail.
4. Will it crush the economy?
Probably not. Developers’ debt growth has already been slowing from 53% in 2017 to 16% in 2019. That’s not far from the caps imposed on firms that pass the red lines test, according to Bloomberg Intelligence. As China’s real estate development investment has grown about 10% in the past two years, there will be room for a mild deleveraging, or debt reduction.
The Reference Shelf
- Bloomberg Intelligence looks at how the three red lines will impact developers’ earnings.
- Bloomberg Opinion’s Shuli Ren examines the creative ways that developers are trying to meet the debt metrics.
- A Bloomberg FFM looks at Evergrande and other developers testing the limits.
- A profile of Evergrande’s billionaire founder, and why his company is running out of room to beat short sellers.
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