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Ana Swanson: Kaisa's woes may be only the beginning for China property

Chinese property developer Kaisa Group Holdings was little known outside the country before 2015. But in the last two months, the company has come to symbolize investors' worst fears about China's heavily indebted real estate industry.

     After Kaisa missed a $23 million interest payment in early January, many people thought the company would go under. Kaisa's domestic creditors applied to local courts to freeze the developer's assets, banks froze its accounts, and investors initiated a sharp sell-off of its Hong Kong-listed shares.

     At the last minute, however, Tianjin-based property developer Sunac China Holdings swept in and saved the day by agreeing to buy a 49.25% stake in Kaisa for $587 million, according to a filing with the Hong Kong Stock Exchange on Feb. 5.

     But not even this was enough. On Feb. 16, Kaisa announced that its debt load had doubled to $10.4 billion. It didn't explain the figure's dramatic rise from June to the end of December 2014, but analysts speculate that it moved debts from "nontraditional Chinese lenders" -- the shadow banking sector -- onto its balance sheet.

     As China's property market slows and profits fall, there is growing concern that many developers will struggle to make payments on their debts. Investors also fear that Chinese property developers are more exposed to off-balance-sheet debt through the shadow banking sector than they'd thought.

     The poorly regulated shadow banking industry accounts for roughly a third of China's outstanding debt. Even excluding off-balance-sheet debt, the debt load of the Chinese property sector is huge. A recent report from consulting firm McKinsey & Co. shows that almost half of China's nonfinancial sector debt -- some $9 trillion -- is tied to real estate.

     Investment and debt in the property sector have helped push China's overall debt load to massive and unsustainable levels. China's total debt now equals 282% of gross domestic product. That's far higher than the average for developing countries, and higher than the U.S. and Germany. And the rise is accelerating, quadrupling in the last seven years to $28 trillion in mid-2014. All this raises concerns: Rapid increases in debt are almost always followed by financial crises.

     The property sector is the most likely trigger. China has some 89,000 property developers, many of which have taken on heavy debt loads in recent years.

     The latest official data shows that sale prices of new residential properties in the top 100 cities stopped falling in January after eight consecutive months of decline. But no recovery is expected amid the slowing economy. Kaisa and others have also been hit by unexplained sale bans in Shenzhen and Hangzhou.

     Some of these developers may default on their loans, sending a wave of bankruptcies through the property sector, in turn damaging the finances of local governments, which have invested heavily in property and the regular banking sectors. A lot of legitimate companies and even households will suffer as well.

Bailout of last resort

The central government has the financial resources to step in and bail out the property sector before contagion really sets in, but it is unlikely to dip into its massive foreign exchange reserves to fund an intervention. It would have to convert foreign currency into yuan, pushing up the domestic currency and negating the reason for accumulating reserves in the first place. It could issue a large amount of yuan-denominated bonds -- a massive and unprecedented expansion of the Chinese bond market, but still an option.

     The Chinese government rarely lets big companies default, and most Chinese investors give little thought to default risk. This is one reason Sunac China was willing to buy Kaisa's debt: It didn't think the Chinese government would let the company fail -- and, given the state of the property market, they were probably right.

     The hand of the Chinese government isn't always apparent in a bailout. Often, local governments with close ties to property developers push other developers to take over troubled companies, or direct banks and financial companies to temporarily cover payments for floundering developers. And if a property company does go under, the government may allow it to compensate bondholders retroactively. This sets a dangerous precedent but is preferable to political instability, bankruptcies and financial contagion.

     If the property market stays lukewarm, more developers will struggle in the months ahead. The Chinese government must be praying that these defaults will not pose a systemic threat. This is likely why the Chinese central bank lowered short-term interest rates for commercial lenders on March 4, just days after it cut policy interest rates for the second time in four months. If these expansionary efforts don't succeed in keeping property developers out of the red, the central government will likely be on the hook.

Ana Swanson is a Washington-based writer and analyst at JL Warren Capital, a China-focused equity research firm.

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