Why is China's Property Market Crashing?

China's property market has long been the symbol of its rise but the trend has inverted. The market is in a crunch with housing left unfinished, and developers struggling to manage costs. What does this mean for law firms and their clients? Meanwhile, Kirkland and White & Case advise on a deal and Clyde & Co acts on a lost painting case.

I'm Ludo Lugnani and this is ZipLaw: an independent newsletter covering the best commercial and legal news from the day. We explain how each story impacts law firms and their clients so that you can stand out in interviews and applications.

Today's read (8 minutes):

• 🔍 Why is China's Property market Crashing?
• 🙋 Q&A: Is there data pointing to a slow down in inflation?
• ⚖️ Case: Clyde & Co act on lost painting case
• 🤝 Deal: Kirkland and White & Case advise on SPAC deal

Why is China's Property market Crashing?

For decades the property industry has been symbolic of China’s rise. Private entrepreneurs have made fortunes, cities have sold out lands, and people have witnessed their net worth soar as home values rose.

An astonishing 70% of Chinese household wealth is now tied up in real estate.

But now the trend has inverted. New project starts fell by 45% in July compared with a year ago, the value of new home sales by 29% and property investment by 12%. The effects are rippling through the economy, hitting furniture-makers and steelworkers alike.

This housing crisis has two key root causes.

Firstly, since mid-2020, the government has restricted developers’ ratios of liabilities to assets, net debt to equity and cash to short-term debt, in a policy known as the three red lines. This has forced many to stop unsustainable borrowing and sell down assets, severely limiting their ability to continue building.

Secondly, China’s zero-covid policy has forced dozens of cities to lock residents in their homes for days, and sometimes weeks, on end when covid cases are discovered. The shutdowns have stopped people from viewing homes. They have also had an impact on the consumer psyche. Entrepreneurs fear the sudden closure of their businesses. Employees worry about being laid off. This sort of uncertainty does not encourage homebuying.

To regain faith in the housing market, the public needs to see stalled projects finished. Meanwhile, construction firms and workers need to be reimbursed, and investors paid back on their fixed-income products. All this must be done without propping up the unsustainable debt bubble that the property market has become.

How does this impact law firms' clients?

• Corporate clients are facing rising costs, and the prospect of insolvencies. Individuals are exiting the buyers’ market, and waiting for un-finished properties they pre-paid for.

The result of this situation is a huge struggle. China’s developers need to sell homes long before they are built to generate liquidity. Last year they pre-sold 90% of homes. These types of clients are struggling to contain their fixed costs, and managing completion of their properties. In the longer term, this can lead many of these developers to end up out of business.

A notable example is Evergrande, the world’s most indebted developer, who defaulted in December. An effort to restructure its offshore debts, intended as a model to follow, missed an end-of-July deadline. Evergrande is not the only one. At least 28 other property firms have missed payments to investors or gone into restructuring. Trading in the shares of 30 Hong Kong-listed developers, constituting 10% of the market by sales, has been frozen. In early August half of China’s listed developers traded at a price-to-earnings ratio of less than 0.5, the level that Evergrande traded at four months before it defaulted.

Large developers are not immune to these issues. Country Garden, China’s biggest developer by sales, also came under pressure. Analysts dismissed the notion that Country Gardenut on August 30th the firm revealed that profits for the first half of the year had fallen by almost 100%

Then there are of course individuals who are either home owners or buyers. They are also heavily affected by this situation. Most buyers have dropped out of the market creating a lower demand for an endless supply of unfinished housing. Meanwhile, many others continue to wait for years for homes they have pre-paid. Just 60% of homes that were pre-sold between 2013 and 2020 have been delivered.

How does this impact law firms?

• Law firms can expect an increase in instructions for their litigation departments from individuals and suppliers, corporate and banking to secure loans from the government. Construction and employment lawyers will be asked to advise on stalled projects, and managing redundancies of employees tied to the construction.
• Top Departments: Litigation, Banking, Corporate, Construction and Employment.

Law firms’ litigation departments can expect to be busy as individuals bring claims against developers that fail to follow through with construction promises. In the past, this seemed to be a slim possibility as it was thought that authorities would not allow protests. A report by PwC noted that when building stalls, the “unco-ordinated households normally have little ability to influence things”. However this has all changed. In July, volunteers began sharing data on social media. So far about 350 boycotts have been identified; analysts believe this is a fraction of the true number. State censors try to remove references to the information, but knowledge appears to spread. This wave of litigation is further enhanced by claims brought by suppliers who are unable to take payments from developers due to stalled construction, and a lack of liquidity.

Banking and corporate lawyers can expect to receive instructions from developers on securing state support. For their part, policymakers have repeatedly cut mortgage rates since mid-May. To guarantee the supply of homes, the central government is fully guaranteeing bond issuance by private developers, shifting the risk to the state. Longfor, a struggling firm, priced a 1.5bn-yuan bond at a 3.3% coupon rate on August 26th, far below the market rate. The government is also providing support in the form of direct liquidity. On August 22nd the central bank and finance ministry said that they would back special loans from state-directed policy banks to finish pre-sold homes. It is expected that 200bn yuan would be made available. However, this programme may account for just 10% of what is needed to complete all unfinished homes. About $5trn-worth of residential property has been pre-sold since 2020.

Developers’ financial struggles will continue the boom in work for restructuring and insolvency lawyers. This theory could be further supported by new aggressive measures taken by major cities. Zhengzhou city officials have issued a directive to developers that says all stalled construction must restart by October 6th. Insolvent companies that cannot do so must file for restructuring to bring in new investment, and repay down-payments made by homebuyers. Failure to do so could result in developers being investigated for embezzlement and other serious crimes.

Lastly, we can expect construction and employment lawyers to continue to be on call as developers manage stalled construction projects, and try to revamp others where possible. Problems could arise around stalled projects, which lead to lay-offs of construction employees which could easily open up developers to employment related claims over their dismissals. However, even if some projects can be terminated, developers will be aware that demand is likely to fall as China’s population growth slows. Home sales reached 1.57bn square metres in 2021, more than twice as high as in 2007. But Chen Long of Plenum, another research firm, projects that real annual demand will fall to 0.88bn-1.36bn square metres over the next decade, as the demographic shift takes hold and urbanisation slows. They will then have to deal with a property bubble and a snowball effect crash.

Top Court Case:

A group of Lloyd's underwriting syndicates is suing an international art dealer over a 19th-century Russian painting lost in Moscow while the dealer tried to find a buyer. The underwriters are suing art dealer Andre Ruzhnikov for the estimated £150,000 value of Frantz Alexeevich Roubaud's 1889 painting "Turk Game," which is also known as "The Sheep Stealer," saying he breached his contract to find a buyer or return the painting to them.

According to the claim, Ruzhnikov owned the painting from November 2013 to November 2014. The painting was damaged after being displayed at a Monaco art fair, and the syndicates compensated Ruzhnikov for repairs and the loss of the work of art's value.The syndicates took ownership of the painting in November 2014 in return for paying Ruzhnikov €475,000, a total loss of the painting's value. Ruzhnikov was obligated to find a buyer for the painting under the agreement, as he had more expertise of the market for Russian fine art.Ruzhnikov had to return the painting to the syndicates if he could not find a buyer. Without their approval, Ruzhnikov passed the painting to a Moscow-based art dealer to sell. Ruzhnikov informed the claimants in July that the Moscow-based art dealer had not found a buyer and had died from COVID-19 in January.

The Lloyd's underwriting syndicates are represented by Rebecca Jacobs of 7KBW, instructed by Clyde & Co.

Top Deal:

Mobile app company Asia Innovations Group announced it has entered into a merger agreement with special purpose acquisition company, Magnum Opus Acquisition. The new company being valued at $2.5 billion. Asia Innovations said the company's existing shareholders will own approximately 84% of the resulting equity interest in the combined company

Asia Innovations said it operates an "integrated platform of products designed for mobile devices across social, mobile gaming, e-commerce, and payments." It says it has more than 400 million registered users in 150 countries, and operates products such as Uplive, a live video platform, social dating apps Lamour and CuteU, and ecommerce platform Hekka. Magnum Opus is a SPAC managed by L2 Capital, a private investment firm that aimed to partner "at the forefront of convergence of consumption and technology."

The announcement comes amid a big week for Asia-based SPAC mergers. On Thursday, Beijing-based biopharmaceutical company Yisheng Biopharma Co. Ltd., announced it will merge with Hong Kong-based blank-check company Summit Healthcare Acquisition Corp. in a transaction that values the new company at $834 million.

Kirkland & Ellis is advising Asia Innovations. White & Case is advising Magnum Opus.

Answering your questions!

Q: Thank you for the newsletters Ludo - always very insightful. I was just wondering if there was anything you could mention to balance out the argument that inflation is constantly rising? I know all evidence points to that but is there anything in your view that we could use to balance this out when discussing this topic in an interview? Thank you! - Alison (Coventry, UK)

Ludo: Great question! You are right that all of the indicators are pointing towards a constant rise in inflation, and the co-ordinated rise in interest rates round the world is an additional point to support this theory.

However, you are equally right in looking for factors to balance this out. It is easy to fall in the trap of taking everything for granted, but there is always some data that can support counter arguments.

For instance, the Drewry World Container Index, which measures the price of a range of 40-foot containers across major shipping routes, has declined by 61% year on year. In September last year the index was logging all-time highs at over $10,000; on September 29th, it dropped to $4,014. Costs have declined consistently each week since February, but the recent fall has been notably sharper. Average costs are down by almost $2,000 in the past five weeks.

Shipping costs between Shanghai and America’s west coast have dropped most sharply. Prices of containers between Shanghai and Los Angeles are down 73% year-on-year, as congestion and blockages of China’s ports have eased.

The key reason behind this is a slowing global economy. In August the J.P. Morgan Global Manufacturing purchasing manager’s index, a survey of businesses around the world, fell to a 26-month low of 50.3, barely above the 50 that indicates a sector is growing. This could be a sign that the growth of inflation could slow down. Research by the Bank for International Settlements, a club of central banks, suggests that a speedy resolution of supply-chain snarl-ups would be the difference between American inflation falling to around 2% in 2024 or remaining above 3%.