The Not-So-Thin 'Red Lines' of Chinese Real Estate

A 'possible storm' in China... The not-so-thin 'red lines' of Chinese real estate... Evergrande is flapping in the wind... An example for everyone else... The Federal Reserve stays the course... Our 'Bull vs. Bear Summit' is coming...

Prepare for the worst, hope for the best...

That's what it sounds like the Chinese government is doing today... at least when it comes to the impending, orchestrated blowup of the country's largest real estate developer, China Evergrande.

We first wrote about this story in Monday's Digest, and it's far from over...

The resolution of the short-term crisis – the company figuring out a way to pay off its debts or go bankrupt – and the fallout from either outcome hasn't even begun yet.

At this point, a huge spillover of consequences to U.S. investors who aren't directly involved doesn't seem likely. But the same can't be said for the people of China...

As the Wall Street Journal reported today, Chinese authorities have been telling local government officials to prepare for the "possible storm" that is the end of the road for the debt-saddled property owner. Citing anonymous officials, the Journal said...

Local governments have been ordered to assemble groups of accountants and legal experts to examine the finances around Evergrande's operations in their respective regions, talk to local state-owned and private property developers to prepare to take over local real-estate projects and set up law-enforcement teams to monitor public anger and so-called "mass incidents," a euphemism for protests...

It might be hard to imagine the scope of what we're talking about here.

So, allow us to paint a picture to reiterate what all this could (or could not) mean for the global economy and stock markets today...

Just think if a company owned more than 1,300 real estate developments worth $350 billion. Beyond that, this company also had business lines in electric vehicles, bottled water, and insurance...

And this company, founded by a man who is literally a high-stakes gambler, took out mounds of debt – it reportedly has $300 billion in liabilities and owes $75 billion in net interest-bearing debt today – to fund what many times were speculative real estate deals... and often resulted in giant, empty apartment towers.

Some critics called them "ghost cities" and said the whole thing is a "pyramid scheme."

Then, imagine this giant, debt-saddled real estate developer – the biggest in the country – went broke, essentially at the urging of the government.

That's what is happening in China with Evergrande right now.

This all has to do with China's three 'red lines' of real estate...

Earlier this year, the Chinese communist government announced a new policy. As Stansberry NewsWire editor C. Scott Garliss explained on Monday, its aim was "trying to wring excessive debt out of its financial system" – and specifically, real estate.

If the government's new criteria weren't met, regulators would then place limits on how much money a real estate developer could borrow, if any at all.

It was a response to growing debt levels in general in the country – which now exceed 300% of its gross domestic product ("GDP") – rising land prices, oversupply... and the basic acknowledgement that housing has become unaffordable over the past 15 to 20 years for millions of everyday people for a variety of reasons.

As global asset-management firm UBS wrote in a January report, the three "red lines" are...

1. Liability-to-asset (excluding advance receipts) ratio of less than 70%
2. Net gearing ratio (total debt divided by total shareholders' equity) of less than 100%
3. Cash-to-short-term-debt ratio of more than one time

From the UBS report...

If the developers fail to meet one, two, or all of the "three red lines," regulators would then place limits on the extent to which they can grow debt.

To simplify the implications of the policies, China's authorities created a color code scheme, which breaks down as follows:

As you can see, at most, the largest allowable annual growth in debt is 15% for a company to be considered in the "green" zone... At the start of this year, nearly half of the country's 66 major developers were in that group.

Evergrande was one of four that was "red"... It breached all three criteria, so regulators said the company couldn't borrow any money anymore. That made business darn near impossible for Evergrande, especially when property sales slowed just last month.

As Scott wrote on Monday...

Last year, Chinese regulators introduced caps on debt ratios. Evergrande is working to meet those requirements by the end of 2022. It's trying to sell assets and spin off business units in order to pay down its debt.

Meanwhile, the Chinese government seems perfectly content with using the business as an example that it's serious about limiting the amount of debt in the system. Via state-run media, government officials said that Evergrande is "not too big to fail."

That statement, in itself, is interesting given the history of the real estate market in China...

Back in the 1980s and 1990s, the government started to sell real estate to raise revenue to fund growth across the country... And the buyers were developers like Evergrande.

Today, real estate makes up 29% of China's GDP.

Former hedge-fund manager Marc Rubinstein, who visited and did business in China starting in the mid-2000s, wrote a great piece on this topic recently in his free newsletter...

China is a country full of paradoxes and one of them sits at the heart of the residential real estate market where Evergrande operates. Lest you forget, China is a communist state, and all land is owned by the state. In order to solve a funding problem, early reformers came up with a fudge. Zhao Ziyang, a former premier, describes in his memoir how he was introduced to the idea of selling land to raise funds:

It was perhaps 1985 or 1986 when I talked to Huo Yingdong [a Hong Kong tycoon better known as Henry Fok] and mentioned that we didn't have funds for urban development. He asked me, "If you have land, how can you not have money?"

I thought this was a strange comment. Having land was one issue; a lack of funds was another. What did the two have to do with one another? He said, "If municipalities have land, they should get permission to lease some of it, bring in some income, and let other people develop the land."

Indeed, I had noticed how in Hong Kong buildings and streets were constructed quickly. A place could be quickly transformed. But for us it was very difficult.

In 1988, the government changed the constitution to allow rights to use land – not to own, to use – to be bought and sold under long term leases. Residential use typically comes with a seventy year lease; commercial use with fifty years. No one really expects land to revert to the government after that time, but the fudge serves a purpose.

In the seven years between 2009 and 2015, the Chinese government collected 22 trillion yuan from selling land. By privatizing this state asset, the government has been able to fund massive infrastructure investment on a scale that the taxpayer wouldn't have been able to bear.

Evergrande, founded in 1996, became an even bigger buyer during this stretch.

It also became a publicly traded company in 2009 and cleaned up its balance sheet in advance of that listing... However, that didn't last very long. According to Rubinstein...

The company immediately geared up and started to expand in a literal land grab. The year after IPO, it grew its land bank by 75%, investing in a pipeline of developments across 62 cities, up from 25 the previous year. It took scale to a new level, building mini-cities rather than just apartment blocks that could accommodate as many as 65,000 people on a single site. The company raised cash from pre-sales, signing up prospective buyers years before completion. And it also raised debt: net gearing (net debt as a percentage of shareholders' equity) rose to 52% in the year after IPO.

Connecting the dots to China's not-so-thin "red lines" policy... that last number now exceeds 100%.

Today, Evergrande owed its bondholders a total of $83.5 million in a scheduled interest payment...

It couldn't afford to make the payments as required, though... So it negotiated a "resolution" with bondholders. As Scott reported yesterday...

Whether the entire sum will be paid is unclear. But creditors are getting something.

Of course, this outcome might just be delaying the inevitable... And it comes after the company reportedly already missed another interest payment to investors on Tuesday. However, it has 30 days to make good on that one.

Looking broader, the "not too big to fail" approach could also simply show those folks paying attention that China is very serious about President Xi Jinping's publicly stated goal of "common prosperity"... and any further whiffs of rumors about more crackdowns are likely to bear real action.

All in all, we're not going to necessarily argue with the hardline stance from the Chinese government (though there's room for disagreement). In the end, it sounds like its economy is better without a company like Evergrande operating as it has.

We recently watched a video of 15 empty apartment towers in one China city – sitting unfinished for seven years – being demolished after the builders ran out of money to do the work. Just like that, one "ghost" complex went up in smoke.

Yet, for now, Wall Street investors still have questions...

Mainly, will this turn into a systemic crisis and what are the implications for China's growth outlook?

As we wrote on Monday, an Evergrande bankruptcy could possibly turn into a systemic crisis in China... But at least in the short term, even if that were to happen, it appears unlikely that it would spill directly into the U.S. or the rest of the world.

Investment giant BlackRock (BLK) maintains some holdings in Evergrande, and investment banks Goldman Sachs (GS) and JPMorgan Chase (JPM) own small positions, too... But that's limited exposure, relatively speaking.

Plus, even in China, the $75 billion in outstanding Evergrande loans might sound like a lot... But it's less than 0.5% of China's total banking assets. As Scott wrote yesterday...

Currently, the systemic questions don't look widespread. But those answers are also never clear up front. It could take some time for the dust to settle. Yet, this is a step in the right direction for the company to avoid default. The next round of payments is due on September 29.

From a growth perspective, Beijing said just last week it's on track to meet its 6% target for the year. This statement was made knowing what was transpiring with Evergrande. In addition, state-sponsored media were calling overnight for a firewall to be set up between real estate and the financial system.

Going forward, we still must pay attention to how this situation plays out... given that it could sway investors' sentiment. If sentiment turns negative on this issue – and enough investors fear a stock market "contagion" event – they could decide to "sell first and ask questions later."

At the same time, this could turn into a buying opportunity for anyone who can navigate things properly...

As True Wealth Opportunities: China analyst Brian Tycangco shared on Twitter earlier this week, he agrees with the opinion that there will be "plenty of pain" for Evergrande as the Chinese government looks to make an example of the well-known firm.

But Brian also says opportunities to buy well-managed and fundamentally sound property developers in the world's second-largest economy – like one firm that's sitting on 60% open gains in the True Wealth Opportunities: China model portfolio – could also present themselves. As Brian wrote on September 3...

There will be more of these [examples] as Beijing keeps its foot on the neck of real estate market. But it will create opportunities for stronger firms to consolidate their market shares.

Stay tuned... Be sure to follow Brian on Twitter if you don't already... And of course, check out our True Wealth Opportunities: China newsletter for more insights.

Subscribers received their latest issue earlier today...

Our colleague Steve Sjuggerud, the editor of True Wealth Opportunities: China, and Brian shared more on this story in the issue... And they updated folks on their hand-picked portfolio of well-run companies from countries they regard as the "Next Chinas."

Subscribers who've followed their advice are already up an astonishing 466% on one position in less than two years... Three others are up double-digit percentages... And Steve and Brian just added another today. Click here for more information on a subscription.

Back here in the U.S., the Federal Reserve says it will start to end pandemic stimulus – eventually...

Remarks yesterday from Fed Chair Jerome Powell after the much-anticipated meeting of the central bank suggest that monetary policy will remain supportive... while the guardrails that have kept the American government on track are slowly removed.

The markets expected this type of message. And with investors wary of the Fed's timing on the withdrawal of economic stimulus measures, predictability is at a premium. As Scott explained this morning in his daily commentary...

The Federal Reserve will soon begin to wind down its asset purchase program...

The central bank said it will taper the program in its latest policy announcement. Currently, it's buying $120 billion worth of Treasurys and mortgage-backed securities every month.

The Fed said it will reduce purchases as the economic recovery continued to progress...

The worst-case scenario would have been the commencement of a tapering program today, signaling the withdrawal of stimulus. But since it made no such commitment, investors can feel confident the central bank will keep policy accommodative for now.

One of the ways that the Fed has supported the U.S. economy over the past year and a half has been through buying bonds. Those efforts have helped keep yields – and interest rates – low... And in turn, they've made it cheaper for companies and people to borrow, which allows for stronger economic growth.

A more concrete decision about 'tapering' could come in November or December...

The Fed's bond-buying efforts, along with other stimulus measures, have worked... and the U.S. economy has roared back from the depths of the COVID-19 panic in March 2020.

Yesterday, the Fed also projected full-year GDP growth at 5.9%... That's a drop from its earlier estimate of 7%, but it's still on target to be the highest rate since 1984.

Also as anticipated, the Fed left interest rates unchanged.

The so-called "dot plot" – in which the 18 Fed board members anonymously forecast when interest rates will begin to rise – shows that half of the members expect rates to begin to rise toward the end of 2022... The others think rates will go up only in 2023.

Meanwhile, interest rates will remain at their current level of 0% to 0.25% – at least until the Fed reaches its two long-term goals...

First, the Fed wants to see average inflation closer to 2%. After years of the economy undershooting that target, the central bank updated its policy last year to say that it would be fine if inflation overshot 2% for an extended period of time.

Today, "official" inflation readings are running at 5.3%... And Powell indicated yesterday that the inflation goal has already been achieved.

The second goal of the Fed is that it wants to see the U.S. economy nearing maximum employment. The unemployment rate is around 5.2%, according to the Bureau of Labor Statistics, compared to below 4% before the pandemic began. In other words, there's still room for improvement.

Also of note, Powell said the Fed continues to think that the current higher inflation won't be permanent. However, he also acknowledged that supply-chain bottlenecks that have contributed to higher prices might last another few months.

(As we've explained before, that's what we've been saying all along... There's reason to believe elevated inflation may hang around longer than the Fed has been telling us.)

Overall, while it's hardly an 'all clear' signal, the Fed's message is positive in the near term for the markets...

The Fed is telling us it has increased confidence in the economic recovery... That should underpin a steady rally in the major U.S. stock indexes.

When emergency measures to support the economy are withdrawn, though, expectations of market returns – without the Fed pouring fuel on the market fire – should come down. According to Scott...

Investors should expect returns for indexes like the S&P 500 and Nasdaq Composite to return toward normalized levels of 9.7% and 10.9%, respectively, on a total return (dividends invested) basis.

Before we wrap up today, we're excited to tell you about a new upcoming event...

It's a "Bulls vs. Bears" showdown, featuring some of our most familiar colleagues...

Next Tuesday, September 28, Steve will join Retirement Millionaire editor Dr. David "Doc" Eifrig and Extreme Value editor Dan Ferris to debate where the markets are going next.

With inflation on the rise, stocks still hitting all-time highs, and the pandemic still going... these three experts will meet under one roof to discuss why they believe the markets will go higher from here... or why you should protect your portfolio more than ever today.

Steve, Doc, and Dan will share what you should be doing with your money right now in this "no holds barred" event. There are sure to be differences of opinion... But they do agree on one thing – how best to navigate the markets' twists and turns today.

The event is absolutely free to attend. And just for tuning in, you'll get the name of the No. 1 most dangerous stock in the world, as well as why you should avoid it at all costs right now. Sign up for our "Bull vs. Bear Summit" right now.

Why the Fed Has Lost Control

The Federal Reserve is always behind the curve, and it cannot afford to tighten in this environment... That's according to Egon von Greyerz, the founder and managing partner of Matterhorn Asset Management. Be sure to watch his full interview with our editor-at-large Daniela Cambone today...

Click here to watch this video right now. For more free video content, subscribe to our Stansberry Research YouTube channel... and don't forget to follow us on Facebook, Instagram, LinkedIn, and Twitter.

New 52-week highs (as of 9/22/21): Asana (ASAN), AutoZone (AZO), Black Stone Minerals (BSM), Cloudflare (NET), OptimizeRx (OPRX), PLDT (PHI), and Thermo Fisher Scientific (TMO).

In today's mailbag, feedback on yesterday's Digest about supply chains and shipping containers. Do you have a comment or question? E-mail us at feedback@stansberryresearch.com.

"Many thanks for such a fact-filled piece on the container problem. It certainly shows that everything is interconnected." – Paid-up subscriber B. B.

"Hi Kim, I feel for you and your wait for your household goods. When I moved from New Zealand (Palmerston North) to Texas, my things first were trucked to Wellington, then to Auckland and then on a ship. From there it went to Sydney, Australia and then across the Pacific to Los Angeles. And finally, trucked to my residency in Texas. Took 3 months. But everything survived the trip. Hope you get your things soon!" – Paid-up subscriber Gary A.

"Kim, I always enjoy your well thought out and well put together Digests.

"A belated thought on your house buying. I think you were a bit hard on yourself for circumstances that were beyond your control.

"Regarding equipment (stuff) shortages: I run a small A/V integrator company. We sold a job the first of July this year. I checked on all equipment availability and told the customer we will install in September. We will finally start the installation next week...

"We sold another nice job toward the end of July this year, and ordered everything that I knew was going to have a long lead time. The availability of about half of the important, needed equipment was originally to be available in October has been pushed to January 2022! At least the customer has something that we can set up to use in the meantime." – Paid-up subscriber Bert P.

All the best,

Corey McLaughlin and Kim Iskyan
Baltimore and Ashton, Maryland
September 23, 2021