▪ Triggered by the looming risks of Evergrande defaulting on its debts, China real estate developers have come into the limelight
▪ We are convinced that the situation faced by some property developers will not spiral into a Lehman-like incident as the government takes measures to contain the impact
▪ China banks have consistently maintained high levels of provisions and demonstrated their ability for good balance sheet quality
▪ At 6-7% yield, China large banks are good long-term dividend yield plays
China real estate developers have come into the limelight of late, triggered by the looming risks of Evergrande defaulting on its debts. As at 2Q21, Evergrande has a net debt of CNY483b (gross debt CNY571b) – one of the largest debtors in the sector.
We are convinced that the difficult situation faced by some property developers will not spiral into a Lehman-like incident.
Against the backdrop of growing debt levels and stubbornly high land prices, the government has introduced measures to curb excessive lending to the property development sector and improve the financial health of developers, with the rollout of the “three red lines” guidance in August 2020. We view the criteria as prudent. They include:
- Debt-to-asset cap at 70%
- Net gearing ratio ceiling of 100%
- Cash to short-term debt ratio of above 1x
This is consistent with government efforts to lower risks caused by high debts among the developers. The developers have until 2023 to meet the criteria; currently, some of them have already succeeded. Under this new policy schedule, debt reduction is now among the top priorities of the developers. Similar to many policy implementations, it will take time for the effect to manifest.
In reality, the net debt of the five largest listed real estate developers has been falling since 1H20 as they took steps to manage their balance sheet quality (Figure 1). Their combined net debt, which peaked at CNY700b in 1H20, has been declining after that.
In general, the banking sector’s exposure to the real estate development sector has been limited at a manageable level. Real estate developers’ total gross loans amounted to CNY12.3t as at 2Q21, accounting for less than 7% of the total banking sector’s CNY loan outstanding (Figure 2). This further affirms our stance that this should not become a Lehman-like event.
In order to fulfil the “three red lines” criteria, developers can acquire less land, expedite project launches and presales, as well as asset disposals. China banks’ exposure to Evergrande is manageable and relatively small. Evergrande’s total gross debt outstanding of CNY570b is less than 5% of the total banking sector’s loan to real estate development, and only 0.3% of total banking sector loans.
We believe policymakers are highly supportive of the banking sector and will take steps to
prevent any contagion and systemic risks arising from real estate related issues.
The banking sector has mechanisms in place to guard against unexpected swings in asset quality. Since the middle of the last decade, the sector has consistently maintained loan loss provisions between 180% and 190% (Figure 3). Banks have demonstrated their ability to maintain stable balance sheet quality despite economic volatility.
This backdrop is further enhanced by the sector’s persistently low non -performing loan ratio (Figure 4), allowing the banks more flexibility to extend loans to a larger group of borrowers from a wider range of industries.
Sustainable dividend payout
China banks’ net interest margin (NIM) is expected to face ongoing headwinds given the global low-rate environment and moderating domestic growth outlook. Nonetheless, this should not adversely affect banks’ dividend streams, as evidenced over the years, be it in absolute amount or payout ratio – dividends were sustained despite softening in NIM cycles.
To maintain healthy levels of annual loan growth and moderate level of earnings growth, China banks are shifting their loan deployment to non-property related sectors, like infrastructure, small-and-medium enterprises, services, manufacturing, technology development, and the automotive sector. Banks are also changing the mix of demand deposits to contain funding costs and offer longer tenor loans to protect NIMs.
We expect near-term volatility to persist due to the recent series of events as the markets take time to assess the financial impact to corporate earnings and outlook. Over the mid-to-long term, the policy implementations are positive for the banking sector, as it reduces the concentration of real estate related loan mix and limits asset quality risks that are related to property cyclicality.
Investors should not be demoralised by the recent chain of events as the policy changes are intended to increase the stability of China’s economy. Policymakers are well in control of the situation to prevent a systemic event.
The power of dividend accumulation
At 6-7% yield, China large banks are good long-term dividend yield plays supported by their commitment and ability to maintain healthy levels of dividend distributions. The payout ratio of 30% from net profit after tax is low by any measure and we expect this to be sustainable.
Since 2014, China Financials have rewarded investors with more than 40% of returns from dividend cumulation alone, despite market volatility. The constant dividend distribution secures their role in the income side of the CIO Barbell Strategy.