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A holiday kept China’s markets closed on Monday, but that didn’t stop fears of a Chinese real estate developer potentially defaulting on its debt from roiling sentiment globally, driving US stocks to drop -1.7% on the day.[i] Headlines shrieked that China Evergrande Group, with its roughly $300 billion in debt, faces default. Some argue this could be China’s “Lehman Moment,” triggering a financial crisis that would be a most unwelcome Chinese export. While a default is looking likely, in our view, there are many reasons to question the theory the outcome would be so bad: China has the means, motive and opportunity to prevent big fallout; markets are well aware of the situation; and we doubt it presents a material global risk.
Evergrande, China’s largest property developer, began life in 1996 as the Hengda Group, headquartered in Guangzhou. The company’s chief business is residential real estate development—it claims to have nearly 2,800 projects in 310 Chinese cities (chiefly, apartments).[ii] But it isn’t limited to this. The company also has businesses engaged in electric vehicle (EV) production, healthcare and a theme park, among others. All in all, Evergrande has roughly 200,000 employees, and many more Chinese investors are likely exposed to Evergrande through bonds and other debt investments called wealth management products (WMPs).
Over the past two decades, Evergrande has used its ample access to credit via WMPs, onshore and offshore bonds to finance a rapid expansion. It would pre-sell apartments to Chinese citizens, using the revenue to stay current on debt. One research outfit quoted by The Wall Street Journal estimated it currently has 1.4 million unfinished apartments presold, valued at roughly $200 billion.[iii] But in the last few years, China has been tightening regulation and credit for the property market, an effort to cool fast-rising prices. Officials have capped banks’ real estate lending—to both developers and mortgage borrowers—overhauled property auctions and even implemented price controls on home sales in select cities. Furthermore, last year Chinese regulators drew up a policy dubbed “three red lines” that restricted real estate developers’ leverage. No shock, then, that real estate investment has cooled dramatically after an early-year spike.
Last September, Evergrande started encountering issues servicing its debt, warning Chinese officials in a letter that it may miss interest payments due to investors in January 2021. However, before defaulting, the company reached an agreement with investors holding some $13 billion in debt to convert their holdings into equity. Since then, Evergrande has been trying to sell some of its stakes in underlying businesses like EV production to investors. It is also attempting to liquidate property rather swiftly. Yet debt service troubles remain. At this point, Evergrande is paying some suppliers and WMP holders in kind—with unfinished apartments.[iv] Construction has largely halted. It faces $84 million in interest payments this week and another $48 million on September 29, and default is looking increasingly likely.[v]
Still, there are many reasons to think a financial crisis won’t follow. For one, China could easily step in. The government, which has increasingly allowed corporate bond defaults (a long-term positive), doesn’t seem likely to actually bail out Evergrande, considering it is a highly leveraged company in an industry the government is attempting to rein in. But that doesn’t mean it couldn’t let the company fail and then make onshore investors, suppliers and workers whole (or somewhere near whole) thereafter. They have done it before, and we think they have many reasons to do it again. China’s single-party government places a high value on social stability to ensure it retains power. That is likely doubly true now, given the celebration of the country’s founding—China’s Golden Week—starts October 1. Allowing retail investors to take big losses on Evergrande securities—or property they pre-purchased—could foment instability. In some ways, it already has: People exposed to Evergrande are protesting nationwide. Some are workers, whom management “asked” to invest in the company (or lose their bonus).[vi] Others are would-be apartment owners.
Regardless of how that plays out, we think it is critical to note: None of this is sneaking up on markets. Issues involving Evergrande have made headlines for months now. Its bonds presently trade at 70% – 80% under par value—a level suggesting markets know default looks imminent.[vii] The stock? Hong Kong-listed shares of China Evergrande Group entered this week down -83% in 2021.[viii] With declines of that magnitude, it is difficult to argue the current scenario isn’t pre-priced into efficient markets, in our view. Absent surprise power, it is a bit hard to see how this would trigger a financial crisis.[ix]
Even if China’s government takes no action at all, we doubt the impact outside the country would be very big. Despite incremental reforms over the years, China’s markets are still walled off from the world to a very large extent. US and global banks don’t have material exposure to Evergrande. According to research from UBS, even Chinese banks have limited exposure. Higher-risk property developers account for 4.5% of large banks’ outstanding loans and 6.3% of regional banks’. WMP exposure is unclear, as the market is opaque. But those broadly aren’t owned outside the country, restricting the global reach. The chief aspect of potential international exposure is roughly $20 billion in offshore bonds, but again, those are already trading as if the company defaulted (a default doesn’t mean a bond has zero value), and that scope is too small to create big ripples globally.
The chief way a Chinese financial crisis could impact the world economy is if the country entered a recession and sapped demand. But a property market downturn doesn’t look sizable enough to us to generate that. Could it slow growth? Sure. Construction, real estate, renting and leasing activities accounted for more than 17% of Chinese GDP in 2019 (used to avoid lockdown skew, although this may overstate the impact, considering construction includes many projects unrelated to residential real estate).[x] But a recession? Less likely. When China’s property market hit the skids in 2015, China still grew nicely and generated a chunk of global demand.
Evergrande isn’t the first example of a troubled Chinese company stirring “too big to fail” fears. In 2017, it was HNA Group. In 2019, Baoshang Bank. Just a couple of months ago everyone was convinced bad-debt-investing group Huarong was set to send China reeling. These repeat issues are examples of the fact China still has a long way to go in its financial reforms and liberalizations. They could present headwinds to aspects of the Chinese economy. They could even roil sentiment globally long enough for stocks to reach correction territory (a correction is a short, sharp, sentiment-driven move of -10% to -20%). But they likely lack the power and reach to trigger a global bear market.
Hat Tip: Fisher Investments Research Analyst Charles Dornbush
[i] Source: FactSet, as of 9/20/2021. S&P 500 price return on 9/20/2021.
[ii] Source: Evergrande Group company website, as of 9/20/2021.
[iii] “How Beijing’s Debt Clampdown Shook the Foundation of a Real-Estate Colossus,” Xie Yu and Elaine Yu, The Wall Street Journal, 9/18/2021.
[iv] “China’s Property Curbs Send Economic Tremors,” Xie Yu, The Wall Street Journal, 9/15/2021.
[v] “China Tells Banks Evergrande Won’t Pay Interest Next Week,” Staff, Bloomberg, 9/15/2021.
[vi] “Evergrande Gave Workers a Choice: Lend Us Cash or Lose Your Bonus,” Alexandra Stevenson and Cao Li, The New York Times, 9/19/2021.
[vii] “Evergrande Moment of Truth Arrives With Bond Payment Deadlines,” Rebecca Choong Wilkins, Bloomberg, 9/18/2021.
[viii] Source: FactSet, as of 9/20/2021.
[ix] Note: The whole concept of a Lehman Moment is a little dodgy itself. In our view, the US financial crisis was much more about the unintended consequences of FAS 157—the mark-to-market accounting rule—and the government’s incomprehensible response in letting some firms fail while bailing others out. Obviously, Lehman was part of that incomprehensible response, but it wasn’t alone—and its bankruptcy wasn’t the fundamental trigger for the recession.
[x] Source: National Bureau of Statistics of China, as of 9/20/2021.
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