Pre-Three Red Lines banks sought to limit lending to developers

Trying to make sense of things

Here’s an epic quote before we get to the post.

The era is over, economic transformation must happen. People’s Bank of China Governor Pan Gongsheng:

“The traditional model of relying heavily on infrastructure and real estate might generate higher growth, but it would also delay structural adjustment and undermine growth sustainability,” Pan said at the conference, organized by the Hong Kong Monetary Authority and the Bank for International Settlements.

“The ongoing economic transformation will be a long and difficult journey. But it’s a journey we must take.”¹

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Back in 2011/2012, this author was working in a company with a number or long-term assets, good assets, assets that Chinese banks really like. But that didn't mean it was easy to get bank loans.

Bankers in China are always worrying. To be fair, they have difficult jobs. Their operating environment is challenging. There were no credit scores. To make matters worse, occasionally borrowers ran away with the money.

To combat these risks, banks needed good collateral (guarantee 担保 danbao) to get through their risk departments. Unless you were an SOE, which implies state backing, you had to offer up something. For many business owners, the best collateral was property.

Property prices were on a tear. Investors in property were making so much money, it was almost impossible to lose. Of course, there were cycles, but the lesson everyone learned was buy-buy-buy. Property prices might be down a little, but it'll work out eventually.

It's worth taking a moment to consider why property was such a good investment for so long. The history of China's property market is one key, the changes from government supplied (ahem, low quality) to allowing "commercial" residential property. Another is household demand to upgrade to newer, better, more spacious living conditions. Yet another key is the perverse incentives created by the 1994 tax reform, we wrote about in The End of a Chapter.

Looking forward, we think the high inventory absorption rates indicate property is very unlikely (<10%) to generate favorable returns in the future (near/mid term). With declining demographics and when a former official acknowledges²³ the housing over-supply problem—we find it hard to be anything but pessimistic about the direction of property prices.

Back to banks. It's well known bank loans were usually the cheapest source of funding in China—if you could get them. Interest rates on bank debt ranged from *below* the benchmark rate to 200-300 bps above. Other sources of credit funding were above 10%, sometimes as high as 20-30% annualized 高利贷.

Below is a chart of China's policy rates, compiled by the Bank of International Settlements. Borrowing near these rates compared to double digit rates from other channels would be a huge advantage to levered buyers (of any asset).