Kaisa default points to troubling debt scenario

China's softening property market weighs on economy, local finances

China's first debt default of the year came early. Property developer Kaisa Group Holdings Ltd announced on January 1 their failure to repay some HK$400 million ($52 million) to HSBC. Kaisa disclosed Tuesday that two of its partners were looking to terminate their involvement in two urban redevelopment projects in Shenzhen, Guangdong Province, and demanding a refund of 1.2 billion yuan ($193 million).

Unsurprisingly, yields on Kaisa's bonds have soared on this news. Rates on debt vehicles set to mature in April 2016 and December 2015 reportedly surged to 99.15 percent and 146 percent respectively.

To many, behind-the-scenes political machinations seem the cause behind the default. Holders of this position point out that Kwok Ying Shing, the group's chairman, has reportedly been the subject of judicial investigation. Others have taken a wider view by suggesting that Kaisa's default could be just the beginning of a wider repayment crisis in China's real estate sector.

After years of booming development, the second half of 2014 saw a considerable slowdown in sales and investment growth in China's property market. Looking ahead, many consider the further deterioration of real estate market conditions as a major source of risk for the country's economy.

With sales weakening in all but a handful of top-tier cities, liquidity in the property sector is becoming increasingly strained. Banks are exercising prudence when lending to property companies. This shift has prompted developers and related businesses to tap trust companies and shadow banking channels for financing, resulting in substantially higher borrowing costs. If sales continue to drop, more weak links in the sector's capital chain could rupture in the not-too-distant future.

Chinese property companies have found little relief in the global debt market, where creditors are becoming more selective and demanding higher returns in response to wavering fundamentals. Indeed, the Bank for International Settlements warned last year that Chinese property firms could be opening themselves up to danger through refinancing and repayment pressures in the international market. An impending interest rate hike in the US and continued depreciation of the renminbi are likely to compound these risks.

Of course, with China's real estate market feeding demand for dozens of industries and accounting for a huge share of the country's domestic economic output, additional slackness in housing may lead to serious trouble for banks and local government finances.

Statistics show that loans to property and construction companies amounted to 7 trillion yuan by the end of 2013, accounting for 11.9 percent of total commercial loans at that time. In the event of a housing collapse, scores of small banks could fall into bankruptcy.

A sustained downturn in the property sector will inevitably drag down investment growth. Land sales will also decrease, cutting into local fiscal revenues. As is well known, many local governments across China are heavily reliant on fees from land transfers to balance their budgets and fund development. Inevitably, slower investment growth in the property sector will make it harder for some localities to repay their debts.

Central authorities are accelerating their efforts to sort out China's tangled web of local government debts. Much work remains to be done, and some now believe that 2015 might even see defaults among certain local government financing vehicles. While the future remains unclear, given current financial and economic conditions in China, investors and policymakers should brace for turbulence.