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Hong Kong banks generally performed well in 2022, with growth in total assets, net interest income and net profit after tax, compared to 2021. However, banks also saw a rise in expected credit losses (ECL) during the same period.

This uptick in ECL is primarily driven by the additional provisions against exposures to real estate developers in the Chinese Mainland. Many Chinese property developers have faced well-publicised financial struggles in the past few years, and more than 70 – mostly privately owned enterprises (POEs) – have defaulted. These developers are now engaged in various degrees of debt restructuring discussions with their creditors, which will take time to be worked out. 


China’s real estate activities have grown rapidly since the late 1990s, and for the past ten years has made up approaching 30% of the nation’s GDP. This is due to the confluence of several aspects, including the government’s aim to provide housing and employment for its increasingly urbanised citizens, local governments’ active sale of land as a primary source of income, developers’ easy access to credit funding, and high investor demand to own Mainland property, all of which encouraged a very active real estate market. 

Debt, including borrowing from banks, was used to fund much of this growth. Debt was directly borrowed by the developers onshore and off, but also end-buyers paid sizeable purchase deposits, also funded with mortgage loans from banks. 

What went wrong was that the developers grew very big, very quickly and started to lose control of the finances. Money borrowed or received through purchase deposits for a particular project became fungible with other projects. The problems were further fuelled as a) people bought additional properties often as speculative investments, also funded by debt, and b) developers increasingly undertook higher risk projects in second and third tier cities where fundamental end-use demand did not exist.

So, what had been a sensible way to support economic growth got derailed – as has happened in so many other countries – because of bad management, speculation and excessive debt leverage.

Remedial action

The government recognised this problem around three years ago and introduced its “three red lines” – restrictions on leverage ratio, gearing ratio and cash ratio – to try to constrain the amount of debt that POEs were able to access. As a result, many POEs were unable to borrow more, and those that didn’t have the cash to complete properties started to default. 

Over the past year or so, defaulting developers have been engaging with their creditors, and in the last few months we’ve started to see restructuring terms being agreed. In theory, the offshore creditors should be included in the restructuring plans. However, the complexity of the groups, the structure of offshore borrowings, and the way the restructurings are being organised means that it is unlikely that offshore creditors will be repaid in full.

Hong Kong banks got into this situation by lending to the offshore holding companies (holdcos) of the real estate developers, which were based in Hong Kong, but often incorporated in offshore centres like Cayman, Bermuda, etc.  However, the vast majority of operating businesses and development projects – sometimes hundreds of them – sat in the Chinese Mainland. Many developer groups are large and complex, with projects held by numerous individual subsidiaries, joint ventures or associates. The offshore holdcos are far distant from the cash-generating assets, with substantial debt owed by the individual project entities and by multiple priority debt hurdles owed by intermediate holding companies.   

The Central Government’s priority is understandably to complete the projects and deliver the property units to the end-buyers (mortgagors), and will help facilitate suitable additional finance to enable this to happen. Any surplus cash from each completed project will be first used to meet new and then existing debt obligations at the project level, and then will flow upstream to meet claims at each intermediate level and only then, if there are surplus funds available after addressing all the onshore stakeholders, will cash reach the offshore holdcos’ creditors.

Although there is a strong drive from national and local government to get these projects completed, the authorities are not going to bailout the developers, nor the creditors. They will allow the process to be worked through, and it will take several years for these projects to be completed.

A few restructuring plans have been announced recently, including for the largest, Evergrande. Some industry analysts have commented that the plans are not really restructurings, they are more long-term deferments of the debt. In the case of Evergrande, creditors are offered one alternative of bullet payments out 10 to 12 years, with interest only capitalised. 

The reality is that these long-term “rescheduling” plans will provide breathing space to enable projects to be finished, but are unlikely to be enough to create value and sufficient cash necessary to repay all the associated debt. 

Complex loans and lessons learned

Banks in Hong Kong have exposure to real estate developers with the debts owed by their offshore holdcos. Often this unsecured debt has no direct claim on Mainland property projects.  Material levels ECL has been taken by banks, but the eventual outcome of “restructurings” and ultimate extent of debt repayment remains uncertain.  

The key lesson for banks from China’s real estate crisis is a reminder of the basic rules of lending: lend (have direct legal recourse) to the entity that legally owns the asset, where the cash will be generated to repay the loan. Over the past few years creditors have let this principle slip, and have accepted the “structural subordination” that goes with these offshore-onshore loans, putting themselves in a very difficult position once a company defaults.   A decade and half of ultra-low interest rates, and an insatiable demand by clients to borrow explains this lapse.  Weaknesses of structural subordination were exacerbated by creditors relying on “refinancing” as their primary source of repayment, a speculative assumption and one that should rarely be the basis of a credit approval.  

The banking sector has seen similar issues before, such as the Mainland government “window companies” in Hong Kong in the late 1990s and Asian commodity companies in more recent years.   The failure to avoid the same mistake this time, and more importantly the need to avoid it in the future, is something bank governance committees should reflect on.   

Despite the material sums involved, and the long wait expected before certainty of loan recoveries will be clear, the China real estate crisis has not been hugely detrimental the Hong Kong banks involved. Hong Kong banks’ profits may be dampened by any further need to raise ECL, but banks in Hong Kong are well capitalized so should comfortably absorb any residual negative impacts.

While the overall impact on Hong Kong banks may not be severe, the China real estate challenge provides useful reminders to risk governance committees that can be distilled into three areas:

  • Constantly ask, where is the next bubble? Actively identify material exposures to potential asset/market bubbles with high concentration and correlation risks and ensure the related risk appetite is reviewed, approved and effectively monitored.   
  • Where an asset bubble is identified, ensure that counterparty underwriting standards and facility structuring requirements reflect the higher risk and keep the portfolio within risk appetite. In this connection, ensure:
    - any cross-border exchange controls are complied with, and
    - repayment does not solely rely on refinancing. 
  • Confirm credit policies restrict any structural subordination of the bank’s facility claims, with any exceptions requiring elevated risk governance approval