Neverpaide: An Update on Evergrande’s Apparent Offshore Debt Default

For all intents and purposes, it appears the world’s most widely expected slow-motion corporate bond default finally happened Monday. Yet global stock markets basically shrugged and went up both Monday and Tuesday, in our view illustrating that developed-world markets have long since priced this and moved on.^[i]

That default belonged to Chinese property developer Evergrande, which failed to make an $82.5 million (£62.3 million) overdue bond interest payment by the time a 30-day grace period expired Monday, according to several reports.^[ii] It won’t officially be a default until the bonds’ trustees or investors send Evergrande a formal letter, but paperwork aside, the d-word appears a foregone conclusion. A second developer, Kaisa, appears to have followed suit after it couldn’t get creditors to agree to restructure its debt and reportedly failed to repay a maturing $400 million (£302.2 million) bond on Tuesday.^[iii] Financial commentators we follow continue warning of contagion (a scenario where investors flee from all similar companies indiscriminately after one or two encounter trouble, leaving the entire industry in a cash crunch) and a property market collapse sparking China’s long-feared economic hard landing, but we still see precious little evidence of this. More likely, in our view: Evergrande’s collapse remains orderly and officials continue propping up property markets as needed to promote social and economic stability ahead of the Communist Party’s 20^th National Congress next year, where Xi Jinping is maneuvering for an unprecedented third term as party leader and Chinese President.

In our view, there is an ocean of difference between a sudden, shocking default that happens when no backstops are in place—and an orderly, widely expected default that happens after officials prepared for it. To see this, let us revisit the eurozone’s debt crisis a decade ago. A chaotic default is what commentators we follow warned of throughout 2010 and 2011, as Greece sought multiple bailouts and kept the world on a knife’s edge every time a bond payment came due. Yet an orderly default is what the world received in early 2012, as Greece compromised with creditors after the eurozone’s stability mechanisms were in place (and after investors had dealt with the likelihood of default for two years). Now, our research at the time led us to think Greece’s issues were unlikely to cause major global ripples regardless. But it is worth remembering there was no contagion, no bank panic and no global bear market (typically a deep, long decline of -20% or worse with a fundamental cause).^[iv] Instead, Greece’s default arrived toward the end of the eurozone’s regional bear market.^[v] A strong recovery took hold weeks later, and the nascent bull market continued through two additional Greek defaults.^[vi] (A bull market is a long period of generally rising stock prices.) In short, markets worked as our research finds they always do, pre-pricing the widely expected credit event and moving on long before the dust settled.

Evergrande, from our vantage point, is shaping up as an orderly default. It is widely expected and well-telegraphed, considering the company disclosed its difficulty servicing debt well over a year ago.^[vii] It has been missing bond payments since September and just barely making them before the grace periods expired.^[viii] It has been selling assets for months. Last Friday, it announced plans to restructure offshore debt.^[ix] Meanwhile, regulators have put backstops in place. The People’s Bank of China (PBOC) cut banks’ reserve requirements again on Monday, freeing up more capital for lending.^[x] Regulators have also directed banks to extend funding to solvent property developers, and a statement from the central Politburo’s latest meeting set economic stability as its top priority—specifically noting support for the property sector.^[xi] We think this support should keep credit flowing whilst Evergrande slowly unwinds, a process officials have signalled is now underway. The state-run People’s Daily reports that a team from the provincial government of Guangdong is now helping “Evergrande resolve its risks, enhance its internal risk management and maintain normal business operation.” We wouldn’t read that as a bailout, considering the same article blasted Evergrande for its “mismanagement and break-neck expansion,” but it does indicate that construction on Evergrande’s reported 1.4 million sold-but-unfinished apartments will continue.^[xii] Making homebuyers whole whilst selling Evergrande’s business units to more stable companies seems consistent with maintaining economic and social stability, in our view.

Don’t underestimate that as a goal. Our analysis of economic data and policy finds that Chinese officials have long been willing to tolerate weaker economic growth in the year before the National Party Congress (NPC), where party members select the next Politburo Standing Committee—which then elects a president. In some years, like 2011, we have seen evidence that they deliberately guided growth slower through tighter loan quotas.^[xiii] So late-2021’s weakening economic growth seems right on schedule, in our view. But, normally, we have observed that this weakening is a prelude to stimulus in the year of the NPC, with the apparent aim of juicing growth to make the populace happy during the election. We aren’t clairvoyant and haven’t bugged anyone’s office in Beijing, but it wouldn’t shock us if officials are especially keen to deliver solid growth in 2022, as this is when Xi will be trying to lock down his unusual third term—paving the way to be president for life. Doing whatever it takes to prevent contagion and keep property markets humming seems like sound political strategy, in our view. Technocrats aren’t perfect, but China’s leaders have practice at containing property market troubles—like in 2015, when Kaisa defaulted for the first time, and our research shows they have plenty of firepower to do so again.

As for stocks, we think the gap between mainland Chinese and global developed markets is instructive. Chinese stocks remain in a bear market, which we think stems mostly from a sentiment overreaction toward large Internet firms with offshore stock listings tied to regulatory shifts.^[xiv] Perhaps real estate jitters have contributed to investors’ darkening mood, but we don’t view them as the proximate cause. But in the developed world, we think it is overwhelmingly clear that investors have sized up the Evergrande situation and moved on. It triggered some very short-term volatility in late September, but that was it.^[xv] Tuesday, as the world realised Evergrande was in de-facto default, the MSCI World Index jumped more than 2% and closed a whisker below all-time highs—not what we would expect if Evergrande’s collapse were some global systemic risk or a big negative for the world’s second-largest economy.^[xvi]

So whilst headlines may dwell on Evergrande’s latest pronouncements, we think investors can tune them down. Despite the developer’s woes, China’s economy continues growing and adding to global GDP, which we think is more than enough to satisfy global stocks.^[xvii]