Credit Agency Fitch Sees Trouble for China’s Small Developers

Credit ratings agency Fitch has reviewed the recent collapse of a property developer in eastern China, and find that this case represents industry trends that investors should be aware of. The text of the agency’s statement follows.

Fitch Ratings says that news that a China-based homebuilder, Zhejiang Xingrun Real Estate Co., is likely to default on CNY3.5bn in bank and other debt is symptomatic of major themes in the industry – polarisation in favour of larger, better funded homebuilders; oversupply in smaller cities; and significantly slower growth rates and profit margins.

These themes have been examined in detail in Fitch’s previous publications on this industry. We believe there will be further defaults in this industry as these themes will persist, but they will be limited to smaller companies like Zhejiang Xingrun.

Most offshore bond issuers will be able to maintain or, in some cases, improve their financial profiles in the next two to three years due to their larger scale and better funding capability. Further defaults may result in onshore banks becoming more selective when lending to this sector, which would favour larger companies.

Sufficient information is available to deduce why Zhejiang Xingrun ran into trouble.

First, it is a privately owned company, meaning it has limited access to equity funding. Chinese regulations severely limit homebuilders’ ability to use bank borrowings to purchase land, however, larger, publicly listed homebuilders are able to raise equity funding and offshore debt to overcome this obstacle.

But private companies are likely to be more reliant on non-traditional sources like trust funding, which come with high costs. Media reports indicate that Zhejiang Xingrun borrowed directly from individuals.

Second, its core market, Fenghua, near Ningbo in eastern China, shows signs of overbuilding. According to data from China Real Estate Information Corporation (CRIC), Ningbo had saleable inventory of 32 months at end-February 2014, compared with the average of around 15 months in 13 major cities CRIC tracks.

It is not unusual for markets to endure periods of oversupply, which would put strains on profitability and liquidity during the ensuing destocking. Larger homebuilders are able to lower this risk by diversifying into multiple markets, underscoring the importance of scale.

Finally, media reports say that the key shareholders of Zhejiang Xingrun have been arrested on charges related to illegal fundraising. This suggests a significant corporate governance lapse, which is less likely in the case of listed homebuilders issuing offshore debt due to the continued scrutiny by investors.

The manner in which the Chinese authorities resolve these defaults will have important implications on the industry. We believe the authorities will force shareholders and some of the lenders, especially from the non-traditional sectors, to realise their losses.

However, the local governments will likely find means to complete and deliver the homes under construction to avert challenges from buyers who had pre-paid for their purchases. This may include providing incentives to stronger homebuilders to take over the troubled projects.