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Evergrande Heads for Default
Rob Drijkoningen, Co-Head of Emerging Markets Debt
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We believe systematic risk beyond the Chinese property market remains limited.
After the initial post-pandemic spike in growth, China has witnessed slowing sequential growth in the last two quarters. This is visible in the credit slowdown, which has been compounded by the ongoing clampdown on shadow credit and the policies captured in the "three red lines," created to reduce systemic risk over time for the real estate sector. This has forced the sector to cut leverage in the near term.
While Evergrande was making progress along these lines, the need to dispose of assets, the challenge of rolling over existing loan and debt maturities, and the need to generate sales in a market where consumers became more reluctant given their financial circumstances, the combined stress became too much and there is little doubt now that Evergrande will default on its debt this year. The company is unlikely to pay onshore bank interest payments due September 20 and an offshore dollar bond coupon due September 23, in our view.
Since July, bonds have already been pricing in near-certain default and Chinese banks have been reducing exposure to Evergrande (now just about 20 bps of system loans). Bondholders and bank creditors will face a long restructuring process with uncertain recovery prospects due to the sheer size of Evergrande and complexities of its capital structure, including hidden liabilities. We would also note that, while small banks might have disproportionate exposure to the real estate sector, the banking system at large is well capitalized to absorb related losses.
Conceptually, it's important to understand the liability structure of the real estate sector and Evergrande in particular. The largest percentage of liabilities (providing funding for activities) comes from homebuyers, close to 50%; these buyers in turn are funded by mortgages and/or their own savings. The next funding leg comes from bank loans and bonds (over 25%); the last main category is the equity holders, even though in the case of Evergrande a relatively large percentage of funding was effectively also provided by suppliers. While it's basically a given that the banks and bondholders will face a significant haircut (in light of the government's typical tolerance for losses to well-off investors and business owners), we think authorities will be quicker to act to protect homebuyers, SME suppliers and employment so as to ensure social stability. Tail risks of major disruptions to Evergrande operations are increasing with news of construction halts and protests at Evergrande worksites and offices.
Even without any resolution on Evergrande debt, we expect the government to intervene so the company can continue its operations and complete its properties under development. This is a unique characteristic of China that has been seen in many recent default cases. We don't expect a reversal of policy that will allow developers to re-lever, but we expect measures to stabilize property sales and to ease working capital funding so that properties under construction can be delivered to homebuyers. Some actions the government could take include easing mortgage disbursements, easing working capital credit to developers and getting SOE developers to take over Evergrande projects.
Regarding spillover to financial markets, risks of a Lehman-type of financial contagion are limited even if all Evergrande debt gets written down to zero, because Chinese banks have limited exposure to Evergrande and have reduced property developer loan exposure to 7%. However, the outlook for national property sales is also bleak in what is supposed to be a seasonally strong September and October. This could lead to sector-wide working capital squeeze as a result of a drop in property sales and a cutback in payables, which in turn could lead to widespread construction halts and the inability of developers to deliver on homes that have been pre-paid. Broader construction halts and failure of developers to deliver to homebuyers who represent about 67% of property developer liabilities would have far-reaching implications for social and economic stability.
In the last few days, the situation has deteriorated, pressuring the government to step in quickly to avoid more widespread construction halts and uncontrollable outcomes.
Obviously, the property sector remains fragile as the Evergrande situation continues to weigh on the market, irrespective of quality. Volatility is expected to remain until there is some clarity on how the situation will be dealt with. The concern here is that cash collection could fall significantly, putting further pressure on the liquidity of companies. Weak property demand could also spill over into the commodity sector, as the property segment typically accounts for about 40% (including residential and non-residential) of steel demand and about 8% of copper demand (not including white goods demand). As a result, construction halts will result in weaker commodity prices. While some commodities such as iron ore could be more adversely affected in this cycle, we think risks of a 2008- or 2015-style crash in commodities are small. Two important factors that will offset the weaker demand in 2H21 are lower inventory and production cuts in China, which have already been enacted due to strict environmental controls. These factors have kept most commodity prices buoyant even as Chinese demand has weakened. Higher infrastructure spending, if it materializes over the next few months, may also offset weakness in property.
To put the moves in context for the wider market, see the table below:
Index (Fri to Fri)
Current level (bps)
WoW spread change (bps)
YTD spread change (bps)
JACI Composite 288 +6.4 -8
JACI IG Corp 197 -1.1 -38
JACI BBB 223 +1.1 -30
JACI HY Corp 735 +55 +156
JACI BB 499 +24 +12
JACI B 1038 +152 +267
Source: Bloomberg. The JACI is the JP Morgan Asian Credit Index. Data as of September 17, 2021.
So, while a lot of negative news has been priced in, the handling of the situation will be key prior to investors returning to the market. Across our Emerging Markets Debt and multi-sector strategies we don't have any Evergrande exposure and remain defensive in the Chinese high yield property names we own, avoiding riskier segments. We are confident that, in due time, opportunities will arise in property from this situation—but not yet; given the slowdown, which might well be compounded given the importance of the property sector to the economy (about 14% directly and 25% indirectly contributing to GDP), we continue to like being long government bonds or related exposure. Before adding risk, we'd need to see substantive evidence of support from the government to turn things around.
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