A look at the impact of a default in Country Garden
A look at the impact of a default in Country Garden
Writer: Klinsmann Lee
What is Country Garden:
In 2022, Country Garden was one of the largest private-sector real estate developers in China. According to Real Estate Information Corporation, Country Garden was the largest real estate developer with the largest sales contract in 2022. [1]
Country Garden’s success is built on high-volume and low-margin business strategies focusing on developing properties in third and fourth-tier cities in China.
The company was founded in 1992 and publicly listed on the Hong Kong Stock Exchange in 2007. Country Garden Services is the property management arm of Country Garden.
In August 2023, Country Garden did not pay two “dollar bonds” coupons totalling US $22.5M. This signals a strong liquidity issue within the company, given the size of the interest payment. [2]
Main Factors Impacting China’s Real Estate Developer Business Environment:
China’s deleveraging effort: [3]
In 2020, China introduced the “three red lines” for real estate developers in China with the purpose of:
Stabilises property prices in China
Deleverage the real estate industry to improve the financial health of the industry.
Reduce the systematic risk given the importance of the real estate industry in China.
The criteria for the “three red lines” include:
Liability-to-asset ratio (excluding advance receipts) of less than 70%
Net gearing ratio of less than 100%
Cash-to-short-term debt ratio of more than 1x
When developers fail to meet one, two or all of the “three red lines”, regulators would place limits on the extent to which the company can increase their debt. Although with good intentions, the “three red lines” also create liquidity issues for many real estate developers in China that are highly leveraged. The “three red lines” mean that real estate developers cannot borrow from banks and financial institutions to continue financing their operations.
Regulatory Effort and Macroeconomic Factors: [4]
Real Estate prices in China have been growing over the past 15 years driven by strong demands. These demands are due to factors such as urbanisation, rising consumer wealth and investment speculation.
To prevent house prices from rising, the regulator has introduced the “houses are for living in, not speculation” policy.
To prevent real estate from hoarding land, the regulator also charged a levy of 20% on land that has not been developed for over a year.
Macroeconomic factors in recent years such as slower economic growth in China, lockdowns during COVID-19 and a high unemployment rate have weakened the demand and market sentiment for property prices.
These factors have not only impacted the sales of properties in China but also created difficulty for real estate developers to raise capital due to poor outlook.
With a deteriorating real estate business environment, Country Garden’s revenue and cash flow have been materially impacted and resulted in a liquidity issue within the company.
Analysis of the potential default impact on the Chinese economy:
Market Confidence:
The real estate sector is one of the most important sectors of the Chinese economy, accounting for about 30% of the GDP. [5]
The default of Country Garden will have a material impact on the market confidence for the following reasons:
As one of China’s largest private-sectoral estate developers, the default can strongly signal to the market the possibility of default of other real estate developers in China.
The houses that are being built by Country Garden will likely be suspended, impacting the confidence of future home buyers.
Given the importance of the real estate sectors, the systematic risk created by the possible default in Country Garden will lead to a depressed confidence and outlook in the Chinese economy.
Contagion Events:
The default of Country Garden will impact many stakeholders including:
Suppliers: As the liquidity risk grows with Country Garden, existing suppliers will likely either stop delivering materials or demand a faster payment period on delivery. If Country Garden is defaulted, existing suppliers and construction workers will be left with unpaid bills.
Buyers: Homebuyers, who have often made hefty down payments, will be impacted the most as a result of unfinished homes. As Country Garden properties are built in third and fourth-tier cities, many residents do not have high incomes. The depressed real estate market will also mean that owners cannot sell their homes in the secondary market. This will lead to some home buyers suspending their mortgage payments, defaulting and further reducing demand and overall confidence in the real estate market.
Government: Local government in China relies heavily on real estate revenue as their income. In 2021, the share revenue from land sales accounts for 30% of the total local government revenue. [6] At the same time, these local governments are also heavily in debt. The default of Country Garden and other real estate developers will impact the ability of local governments to manage and finance their loans. At the same time, depressed consumer and business confidence will impact other tax revenue for local governments, increasing the risk of default for local governments.
Investors: Debt and equity investors are already impacted by the liquidity risk in real estate sectors, both the pricing of the current bond and the stock market of publicly listed real estate developers. Country Garden has lost over 67% of its share price since the start of 2023 at a historical low of HK$0.89 per share. [7] This is also impacting other financial institutions that have offered construction loans to developers. In 2023 Q1, about 1.13 trillion yuan of trust funds were invested in the real estate sector. [8]
Summary:
Country Garden’s liquidity risk has been fuelled by a depressed real estate market and growing interest-bearing debt.
The default of Country Garden will pose a systematic risk to the overall economy in China given the size of the real estate sector. This impact will affect suppliers, home buyers, governments and investors.
The result will likely lead to depressed market confidence and impact consumer spending and business investment.
Whether the Central government will provide financial support or Yang Guoqiang's family (the largest shareholder) will inject additional support into the company is to be seen. However, one certain thing is that this case study is something worth studying and reflecting on.
Other Information:
Recommendation: This article is not an investment recommendation.
Copyrights: Please do not repost or translate my work without my permission. It takes time to plan, research, analyse, write and review each blog post. Feel free to reference this article in your work.
Reference: Please see the “references” section to acknowledge the sources used in this article. For any mistakes made in this article, feel free and let me know.
References:
[7]Share price as of 31/08/2023 – 1:31 pm HK Time
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