Evergrande’s fall from grace has been spectacular. A year or two ago, the idea of such a large China real estate developer defaulting, with a debt pile of more than $300bn, would have seemed, if not impossible, pretty unlikely. So how do we see this playing out, and what does it mean for the rest of China, Asia, and the rest of emerging market debt?
Resisting meaningful action
We believe the problems in the Chinese real estate sector are largely self-inflicted by the authorities, who have allowed financial conditions to tighten to the point that the country ran a balanced budget in the first half of the year. This has caused several defaults in the sector, and there may be more to come. These defaults could easily have been prevented, as the government has ample means to shore up these companies and reassure investors.
We think the Chinese government will continue to resist taking the kind of meaningful action that will end the rumours, and we could see more defaults. So far, we’ve seen some small measures intended to increase liquidity at the margin, such as speeding up mortgage referrals, and a loosening of restrictions on use of coal. We haven’t yet seen the kind of major intervention that could stop the rot, such as a cut in bank reserve requirements or an increase in total social financing, China’s key broad measure of credit and liquidity.
Why won’t the government step in? We think President Xi is serious about economic reform. China has long been too reliant on unproductive infrastructure spending, particularly in real estate, which has resulted in unprofitable developers racking up huge amounts of debt. The government’s “three red lines”, its financial ratio tests unveiled in 2020 to constrain property developers, are to be taken seriously. Xi wants to make real economic progress before he is granted a third term at the 20th party congress in the second half of next year. This means not allowing the real estate sector to resolve this problem by taking on even more debt, and if that means defaults and lower growth, so be it.
Walking a tightrope
Whether this hard-line policy can work in the long term is another question. Real estate accounts for 80% of Chinese household wealth. Losses will cause consumption to be diverted into building savings back up, dragging on economic growth and slowing down the pivot towards a consumption-based economy that Xi is aiming for. The government is walking a tightrope between necessary reform and the communist party’s much vaunted “common prosperity” policy.
Our base case is that this tightrope walk will continue, and we will see further volatility and further defaults in the Chinese real estate sector. Material deterioration in economic data or some kind of shock will probably be needed before we see resolution in the form of state intervention.
This means that we are underweight the real estate sector in our strategies, and where we do have exposure, it’s to higher quality issuers in bonds that will be redeemed soon, where our analysis shows there’s enough cash to meet payments. We are also underweight China – where we prefer companies outside the real estate sector – and Asia more broadly, where we see lower growth in China affecting the whole region. Our only overweight country in Asia is India, where we hold carefully selected utilities and telecoms.
Diversification is key
The benefit of investing across broad emerging markets is that we can diversify away from a country or a region where conditions are more challenging. It’s not just Asia that is exposed to Chinese real estate – it’s a $60 trillion asset class that has seen decades of growth with global implications. As such, we’ve reviewed our whole portfolio to ensure we believe our China exposure is at the right level.
Overall, we remain broadly positive on risk across our emerging market debt strategies, despite our underweight to China. When adjusted for ratings and duration, spreads in emerging market credit relative to developed market credit are as cheap as they’ve been for the last five years. Emerging market credit has also been a good place to be in a year where interest rates have risen: the corporate index is up 90bps at the time of writing, and high yield EM credit is up over 2.5%.1
Seeking out the best opportunities
We are still able to find plenty of great companies we want to invest in across EM. The US economy remains in a very strong place, which benefits exporters in places like Mexico and Brazil. Even as China slows, global demand for protein benefits meat producers in Latin America. Another big market story in 2021 has been energy – oil is up over 75% this year2 – and that has been good for our exposures in eastern Europe and the Middle East.
As our strategies are engaged in promoting the transition to net zero carbon emissions by 2050, names in the energy space are very carefully selected, with a focus on ESG considerations. Certain countries are moving in a positive direction, such as Saudi Arabia, which announced its intention to reach net zero by 2060. We are engaging with our holdings across all of EM to encourage them to publish and commit to carbon targets. While we completely understand the challenges some energy companies particularly in EM might face, we think the lower cost of funding associated with sustainability outweighs the challenges.
Away from China, we see inflation as the key risk, so we are focusing on companies that we believe can pass on price pressure, and we’ve become slightly more cautious on sovereign exposure in Africa. Even so, the breadth of our market continues to give us plenty of opportunity to create broad portfolios of bonds we like, offering a significant yield premium to the broad fixed income markets.