China’s Evolving Property Crisis and Stress Test Scenarios

Deterioration in the credit profiles of the largest and most leveraged of China’s real estate companies threaten to send the world’s second largest economy into a downward spiral. That has the potential to create a vicious cycle where declining credit profiles weigh on economic growth, which could subsequently compound deterioration of the property sector.

China Evergrande Group recently publicly reported losses of 812 billion yuan for 2021 and 2022, while fellow property developer Country Garden, the largest in China, is on the verge of a bond default. Following is a high-level timeline of key events since December 2021.

Key Events

The Extreme Event/Factor Scenario

The Hang Seng Mainland Property Index (HSMPI) has declined by close to 20% month over month in August 2023 considering Country Garden’s recent troubles. Should Country Garden default, the HSMPI is expected to decline further, with the default having further ripple effects on financial markets.

While China’s banking system is largely controlled by state-owned players such as the Big 4—ICBC, CCB, BoC, and ABC—the property sector presents the most prominent risk, owing to its deep integration into the national economy, accounting for as much as 30% of China’s GDP. As such, China’s current property woes bring back memories of the US subprime loan crisis and the subsequent collapse of Lehman Brothers between 2007 and 2010.

The following factor stress test scenarios consider three orders of impact on risk factors arising from the China property crisis: the first order being the property sector; the second order being the financial sector; and the third order being the wider impact on China’s GDP.

A best-case scenario would represent the distress in the property sector being a long-drawn affair, with no sudden or severe shocks, weighing mildly on the economy sector. Government intervention to mitigate any further growing distress is also likely.

The base-case scenario assumes that Country Garden subsequently defaults, but its impact is limited on the second and third order risk factors owing to the Chinese government stepping in to provide aid.

Lastly, the worst-case scenario assumes wider contagion, with little to no government intervention, or government intervention failing. This scenario poses a potential for a global ripple effect. FactSet’s multi-asset class models consider the various stressed risk factors and their correlations with other risk factors to determine the overall impact on a client’s portfolio.

For FactSet clients who wish to implement the stress test scenarios, existing subscribers to PA3 and accompanying risk models may reach out to their regional/local consultants or APS specialists for assistance in the workstation. (Path: PA3 > Stress Testing > Client/2020 – 2023 China Property Crisis)

Application

This scenario can be part of a larger stress test involving the property sector, China financials, or China. It is most suitable for bonds or REITs in the property sector, or equities in financials, specific to China markets.

The stress tests were applied to a mix of China equity (S&P Greater China BMI) and fixed income (ChinaBond Composite Index) indices. For a more macro view, these were tested against the S&P 500 as well. The results are as follows: 

S&P Greater China BMI

Source: FactSet

ChinaBond Composite Index

Source: FactSet

S&P 500

Source: FactSet

Across stress test scenarios, Chinese equity markets are hit hardest by an anemic and declining property sector. Chinese bond markets show a small upswing in returns, reflecting the inverse relationship between equities and bonds while US markets appear to benefit from a downturn in Chinese fortunes.

There does not seem to be any strong correlation between the China property crisis and US markets, however. The best-case scenario projects the best returns for the S&P 500, while there is a small inflection point between the base-case and worst-case scenarios. This may be attributable to more negative returns for heavier weighted securities in the base-case scenario, arising from factors/returns being sorted on an event-weighted basis and closest to the quantum of the shocked factors.

This blog post is for informational purposes only. The information contained in this blog post is not legal, tax, or investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.