HONG KONG -- China's crackdown on overextended property developers has led to a surge in loan losses, raising fears of contagion across the nation's $50 trillion financial sector.
Developers enjoyed a return to pre-pandemic profit levels in the first half of the year, buoyed by the nation's economic recovery. Now, however, they are contending with a slew of tougher rules, including curbs on borrowing, leverage and land purchasing, that has sparked a liquidity crisis and missed debt payments.
Nonperforming loans to the real estate sector, which has for years been the backbone of growth for the world's second-largest economy, surged 30% across the five largest banks to 97 billion yuan ($15 billion) in the first six months of the year, according to filings.
A similar story is playing out at smaller banks. Bad loans at Ping An Bank, which is majority owned by Ping An Insurance, tripled while those at Bank of Shanghai rose 26%, filings show.
Real estate was the second-largest source of NPLs, behind only the manufacturing, wholesale and retail category, filings by Industrial and Commercial Bank of China, China Construction Bank, Bank of China, Agricultural Bank of China and Bank of Communications showed.
"The property sector may once again be at center stage, testing the nerves of both China's government and global investors," said Ting Lu, Nomura's chief China economist. "Markets should be prepared for what could be a much worse-than-expected growth slowdown, more loan and bond defaults, and potential stock market turmoil."
Mainland listed banks are trading at a historical low of just 0.4 times the value of their net assets, compared with 0.75 times earlier this year and 1.2 times in 2019.
Bond investors are taking notice, too. The premium that investors demand for high-yield debt, which is dominated by developers, has surged 300 basis points in three months over risk-free yields, while that of similar notes in Europe and U.S. has declined, Thomson Reuters reported.
While absolute NPL figures are still small and bank's direct exposure to real estate stands at about 5% to 6% of total assets, investors fear a teetering sector may cause hardship for others, such as home buyers and suppliers.
More importantly, the total exposure of banks to the sector is higher.
Late last year, Guo Shuqing, chairman of the China Banking and Insurance Regulatory Commission, called property the biggest risk to China's financial system. According to him, property loans including mortgages stood at 39% of total outstanding loans, or 70 trillion yuan.
So far this year, 230 property developers have gone out of business, according to state-owned publication People's Court Daily, an increase of 10% over last year.
Evergrande, a bellwether for China's leveraged property sector, warned last month it may fail to repay its debt unless it can attract new investors or sell assets. The company, which has almost $305 billion in total liabilities, has been forced to suspend some projects due to non-payment to suppliers and contractors.
It counts 20 banks, including the nation's four largest, as its principal bankers, according to its website.
"Authorities have imposed new rules to thwart high-profile risk events, and that should in some way go towards safeguarding the banking system," said Shujin Chen, an analyst at Jefferies in Hong Kong. "Going forward, challenges are set to increase for the bank though with property sector worsening , the economy set to slow and more regulation expected across sectors which can increase NPLs."
China is clamping down on sectors ranging from big tech to steel as President Xi Jinping sets ambitious targets to curb emissions, ensure a more equal spread of wealth and prevent any systemic shocks to the economy.
This clampdown has brought a wave of new regulations that has limited developers' funding options. Late last year, authorities announced that property lending should make up no more than 40% of banks' total lending forcing banks to slow advances to developers.
Developers were also hit by a "three red line" policy last year that assesses their financial soundness and assigns a color -- green, orange, yellow or red -- based on how many of the "lines" they cross.
Under the policy, regulators evaluate three ratios -- liabilities to assets, net debt to equity, and cash to short-term debt -- before deciding whether a developer can borrow further. For each of the three criteria it successfully meets, a developer can expand its debt by 5% annually, for a maximum of 15%. Just five of 52 large developers were in the "green" zone, investment bank UBS said in January.
With borrowing drying up, developers are stretching out payments to suppliers and relying on pre-funding projects, which require buyers to deposit part or all of the money for a home that is being built. Such projects have become the largest single source of real-estate developer funding, according to filings by the property companies.
These deposits are in turn funded by banks as mortgages.
Investors, however, say banks have bolstered their defenses as the scale of their exposure became clearer.
Loan loss provisions, they argue, were expanded last year as the pandemic raged, which means they have room to write off bad-debts. Total NPLs, moreover, have trended lower as the economy improved.
Commercial banks had set aside 5.4 trillion yuan in loan loss provisions, up 174.6 billion compared with the previous quarter. The NPL ratio across the sector declined 0.05 point to 1.76%, according to regulatory data.
The provision coverage ratio was 193.23%, up 6.09 percentage points, the data showed.
"The exposure to developers is a risk and one that can get bigger," said Mark Dong, co-founder of Hong Kong-based Minority Asset Management, which manages $2.5 billion, including Chinese banks. "But banks have been preparing for a long time and have built sizeable provisions [so] that it will be manageable. The market concern for now is on banks' ability to maintain profits and growth."