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Why hidden debt is a big problem for China developers

Why hidden debt is a big problem for China developers
Turmoil in China’s junk bond market has been testing investors’ nerves, with property developers having lots of opaque liabilities that may or may not be reflected on their balance sheets. (Photo: AFP)

Turmoil in China’s junk bond market has been testing investors’ nerves - and that’s just concerning the debt they knew about.

It turns out that property developers including China Evergrande Group, Kaisa Group Holdings, Fantasia Holdings Group and Agile Group Holdings also have lots of opaque liabilities that may or may not be reflected on their balance sheets, making it hard to assess the companies’ true credit risks.

A spate of defaults - most notably by Evergrande and Kaisa - have undermined confidence in China’s economy and led to mounting pressure on developers to reveal their hidden leverage. At least one has committed to no longer issuing this type of debt. 

1. How do developers obscure debt?

There are several ways, including:

Relatively short-term, high-yield obligations known as wealth-management products sold to retail investors, homebuyers and sometimes even developers’ own employees. Unlike wealth-management products offered by banks, those issued by developers are loosely regulated, if at all. Public details are sparse on the value of products outstanding and their due dates.

Evergrande’s late payments on its wealth products sparked protests in September, prompting worries of social unrest. Kaisa’s bonds and shares plunged in November after the company missed payments on its wealth products.

Privately placed bonds, often issued by special-purpose companies with obscure names. One tactic to keep the debt off balance sheet - and off the radar of regulators - is to provide guarantees for the bonds that apply on all days except Jun 30 and Dec 31, when the developers compile their financial statements.

Joint ventures. These allow property companies to invest in projects without consolidating them onto their own balance sheet, creating potential for hidden liabilities, according to Moody’s Investors Service.

2. What’s the scale?

It’s difficult to know the true extent of these off balance sheet obligations, though there are some clues. HSBC analysts estimated in October that Chinese developers had at least US$2.7 billion of private placement notes due in the following 18 months.

Bloomberg-compiled data shows at least US$852 million of private bonds will be coming due through the first quarter of 2022. There could be a lot more out there. Many investors were shocked to find out earlier this year that Evergrande had privately guaranteed a US$260 million note issued by a company called Jumbo Fortune Enterprises.

Fantasia disclosed it had US$150 million of private bonds only after it ran into repayment trouble, according to Fitch Ratings. Evergrande, Kaisa, Fantasia and Agile didn’t respond to requests for comment.

3. Why do they do it?

Developers have always relied heavily on borrowing to fund growth, but in recent years they’ve come under pressure from regulators worried about the risk of financial meltdown.

The “three red lines” introduced in 2020 - metrics developers have to meet if they want to borrow more - likely exacerbated the problem. With huge liabilities and refinancing needs, the industry appears to have increased hidden debt to retain access to funding without breaching the red lines.

4. What’s the private bond market and who are the issuers?

Private placement bonds are usually issued by shell companies and guaranteed by developers. Shell issuers of such opaque debt include Wuyi Mountains, Rainmakers Solutions, Better Hai Investment and Green Force Investment, among many other names, according to Bloomberg-compiled data. Some of them were only used to issue debt once. 

5. What’s the reaction been?

Earlier this year, Chinese authorities banned local over-the-counter exchanges from issuing WMPs with real estate as the underlying assets, according to people familiar with the matter. But they’ve yet to take much action on private bonds. Even so, demand for the debt is waning as investors grow increasingly concerned about the risks.

Bondholders have also become savvier about identifying red flags at developers, including large exposure to joint ventures. Agile told investors in October it plans to refrain from issuing private placement bonds going forward.

6. Why does this matter now?

Hidden debt exacerbates concerns about a credit crisis among Chinese property firms caused by declining sales and refinancing difficulties. The selloff has dragged down a Bloomberg index of Chinese junk bonds by about 23 per cent this year through Dec 13.

More broadly, financial stress in China’s property sector threatens to worsen the country’s economic slowdown. Even the Federal Reserve has warned that the sector’s woes could “strain global financial markets”, “pose risks to global economic growth and affect the United States.”

Source: Bloomberg/ic


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