Forced deleveraging has led to a shake-up in the property market
After a 1.3% increase in 2020, Chinese construction output is forecast to grow almost 7% in 2021 and 6% in 2022. Civil construction remains the main driver of growth. Since H2 of 2020, residential construction has been affected by new government rules for the real estate segment. The new rules are designed to make housing more affordable and to curb speculation in a property market characterized by excessive borrowing. Authorities have constricted property developers’ capacity to continue accumulating debt, and banks have tightened lending. Several highly leveraged real estate developers had to offload assets to reduce their borrowings, leading to a shortage of working capital and stoppage of building projects. The default risk of large property developers like Evergrande has sharply increased, leading to elevated credit risk among contractors and suppliers.
Besides the ongoing issues in the Chinese property market, higher global prices for commodities and construction materials will eat into the profit margins of small-and medium-sized enterprises (SMEs) active in all subsectors. In contrast, large state-owned enterprises (SOEs) and listed construction groups are able to pass on higher costs to end-customers. With large working capital requirements, the overall indebtedness of construction businesses and dependence on bank loans are high. Banks remain willing to provide loans to construction SOEs, but are more restrictive towards SMEs.
The credit cycle of the construction industry is very long, and large (mostly state-owned) construction companies with a lot of bargaining power habitually pay slowly. Up to 200-300 days sales outstanding are common, which puts pressure on the working capital of smaller businesses, with many of them facing cash flow issues. Insolvencies of smaller businesses with working capital issues are expected to increase in the coming months.
The default risk has increased for highly leveraged property developers, and subsequently for their contractors and suppliers. However, if Evergrande should default there is still the possibility that the government steps in to support affected construction businesses, by taking care that properties already sold to households, but not yet built, will be completed.