The real estate giant Evergrande, Hong Kong’s Hang Seng index falls by 3.4%, putting the rest of the international stock markets in the spotlight. Evergrande is on the verge of collapse after accumulating a debt of nearly 300,000 million dollars and announcing that it will not be able to meet its obligations in the short term.
Allianz Global Investors
Debt and demographics are two of China’s long-term economic challenges. And the debt issue has been in particular focus recently with the high-profile travails of China Evergrande Group, one of China’s largest property developers.
It’s notable that China’s domestic capital markets – equities, bonds and currency – have been quite stable recently. China A-shares, for example, are close to flat over the last three months, at the same time as Evergrande bonds have clearly been signalling their liquidity challenges.
So there appears to be some disconnect between media headlines on Evergrande around the world, and the perspective of local equity market participants.
There is a well-worn Chinese proverb which loosely translates as “killing a chicken to scare the monkeys”. This refers to making an example out of someone in order to threaten others, in the manner of “pour encourager les autres”. Our view is that Evergrande is the proverbial chicken, and a strong signal is being sent to the rest of the property sector to rein in leverage. Debt and demographics are two of China’s long-term economic challenges. And the debt issue has been in particular focus recently with the high-profile travails of China Evergrande Group, one of China’s largest property developers.
Founded 25 years ago, Evergrande’s strategy had been to buy up huge amounts of land (their reserves are big enough to house around 10 million people), wait for house prices to rise, pre-sell their properties and reinvest back into the land bank. In 2017, their chairman was the richest man in China with an estimated net worth of USD 42.5 billion. Evergrande’s model relied on access to credit. They built up around USD 120 billion in debt which was also used to expand into a range of non-core areas. This included buying a football team in the Chinese Super League, seen as an attempt to curry favour with President Xi Jinping, an avid football fan. Source: Wind, as of June 30, 2021.
Evergrande’s liquidity problems stemmed initially from the introduction of a “three red lines” test last year, a new policy designed to control financial risk in property companies. This test requires highly geared companies like Evergrande to reduce their leverage before they can raise more debt.
The first signs of stress for Evergrande came in Q4 2020, when their bonds and equity took a hit amid concerns that a USD 20 billion bond repayment could not be made. In the event, a deal with creditors was reached and the can was kicked down the road, reinforcing the perception that Evergrande had “too big to fail” status.
What has changed between then and now is the strength of the economic recovery. As we have seen in other areas, such as the crackdown on internet companies, the authorities are using the growth dividend as an opportunity to take action against what are seen to be high-risk areas.
These actions will, of course, have the impact of slowing economic growth. But in hindsight, policymakers gave themselves this headroom with a 6% GDP growth target this year, when the market consensus was over 8%. The property sector has long been viewed as a source of financial risk. Property developers, such as Evergrande, have leveraged up aggressively over the past decade. The prevailing view had been that the government could not tighten policy for long, given its systematic importance to the economy. But in addition to the economic recovery, policy direction has also changed in other areas so that a managed slowdown in the property sector is now seen as helpful in achieving certain targets.
First, “common prosperity” and the aim to reduce wealth inequality. Property accounts for around 40% of assets owned by Chinese households. And with the surging prices over the last two decades, property has become one of the biggest contributors to wealth inequality in China.
Second, a property slowdown helps China achieve its environmental goals – steel accounts for 15% of national carbon emissions. Back to killing the chicken to scare the monkey – what do the Evergrande (and other property company) difficulties mean for markets? In our view, regulators have made a judgement that this does not represent a systematic risk. They have plenty of policy tools to stimulate the property sector.
But it is more likely that they will prolong the tightening period to deter excessive risk-taking in the future. The property sector is a small part of the China equity market – around 2% weight in MSCI China A benchmarks and 3% in MSCI All China.
So, although these developments reaffirm our negative view on the property sector as a whole, we are not expecting a broader-based impact. Indeed, if anything this will bring forward the need for some monetary and fiscal easing, which should be supportive for equity markets as we head into the final months of the year.
Finally, we are entering a holiday season for China markets. First there is the Mid-Autumn Festival on Tuesday 21 September. Then China National Day and the Golden Week holiday from 1 October. As a result, China’s equity markets and the Stock Connect scheme will be closed for several days. We’ve added a calendar below to help with planning investment activity.
Paul Lukaszewski, Head of Corporate Debt – Asia Pacific at Aberdeen Standard Investments
The financial contagion risks of an Evergrande default in global markets are limited. Evergrande’s debt and equity financial exposure is mainly concentrated in China. Even the Chinese offshore bond market is unique, with domestic investors accounting for 80% or more of the holdings of dollar-denominated bonds issued by Chinese companies.
For contagion to reach global financial markets would require the second- and third-order effects of the Evergrande situation to trigger a much larger domestic crisis in China, which we consider unlikely.
Edmond de Rothschild AM Investment Team
Chinese stock markets plunged after Evergrande said it could not meet interest payments on its debt in September. The MSCI Emerging Market Index was down 1.83% at Thursday’s close. China led the decline, down 4.70%, due to weak macroeconomic data in August and concerns about Evergrande contagion. China applied to join the CPTPP (Comprehensive and Progressive Agreement for Trans-Pacific Partnership) trade pact to boost its regional economic clout. In August, industrial production rose by 5.3% y-o-y, down from 6.4% in July, i.e. below the expected 5.8%. Retail sales growth slowed sharply to 2.5% y-o-y, compared to the 7.4% expected by the consensus, dragged down by a further contraction in automobile sales and a decline in restaurant sales amid the recent Covid-19 outbreak. Fixed asset investment was more or less in line with expectations, rising 8.9% y-o-y from January to August. The Macao government launched a public consultation to revise the Gaming Law to strengthen oversight in areas such as licensing, profit sharing, day-to-day supervision and local holdings. This follows earlier efforts to regulate illegal lending and gambling-related cash transfers. A rapidly expanding outbreak of the Delta strain in the southeastern province of Fujian is posing a new threat to the recovery of the local tourism industry. The Ministry of Industry and Information Technology (MIIT) is encouraging mergers and reorganisations of new energy vehicle (NEV) manufacturers to boost industrial concentration.
Paul Gurzal, Head of Credit, and Akram GHARBI, Head of High Yield Credit, La Française AM
The risk premium between the Chinese high yield market (ICE BOA ML ticker, “ACYC”) and the global high yield debt market (ICE BOA ML Index, “HW00” ticker) is at its highest point since 2011, at 720 basis points, i.e. 3 standard deviations from the historical average (250 basis points). At current levels, 1080 bp spreads for the Chinese HY index and 812 bp for the Asian HY (ICE BOA ML index, ticker “ACHY”), the markets are forecasting a default rate of 15.5% and 12% respectively over the next 12 months for these two zones (assuming a recovery rate of 30%). This level now largely incorporates the specific cases of companies currently in difficulty, such as Evergrande, and which, in our view, is incompatible with the situation of the economies in this region.
This differential is not justified by the different economic growth potential between China and the rest of the world. China’s growth forecasts for 2021 are still higher than the average for developed countries (+8% for China compared to 6% for developed countries). It also reflects a resurgence of specific risks following a deliberately restrictive policy by the Chinese government to limit the risk of a bubble in the real estate market and to control the level of corporate indebtedness (the “3 red lines” policy is part of this framework). The Chinese government’s intention is not to provoke a wave of uncontrolled bankruptcies, but to eliminate defaulting companies in order to better allocate resources over time. In China, defaults are “supervised” by the central government according to political, economic and social prerogatives. The recent recapitalisation of Huarong is a perfect example of this.