Fixed Income Boutique
Panic struck global markets on Monday 20 September as there was speculation that an Evergrande default could be tantamount to the Lehman Brothers’ bankruptcy of 2008. Evergrande announced on Wednesday that it had “resolved” an interest payment due on domestic bonds and there were rumors about plans for three state-owned entities (SOEs) to take over the troubled private developer.
A comprehensive restructuring of the company’s ~300 billion USD total liabilities is almost certain. The government told the company on Thursday that it should avoid a short-term default on its dollar bonds and the company may still pay its coupon within the ongoing 30-day grace period. But the government’s intention is to make sure domestic retail investors who have bought properties from Evergrande or invested through its wealth management products do not incur losses, as well as to avoid a disorderly default. A blanket bailout for bondholders is highly unlikely.
A 300 billion USD default may sound large enough to potentially trigger a systemic banking crisis, but that’s not at all the case
Evergrande has a wide variety of creditors and thus it is not overly dependent on banks. Its outstanding loans and bonds are estimated between RMB571-835 billion (depending on the source and what’s included as debts), which is just 0.35-0.5% of Chinese banks’ total loans or 0.2-0.3% of total assets. Moreover, Evergrande’s outstanding international bonds amount to USD19.2 billion, which represents just 1.9% of China’s real estate benchmark bonds in the broad diversified corporate EM bond index (CEMBI), and just 0.035% of the overall CEMBI.
This is important because collapses in financial asset prices can occur suddenly and can have a negative effect on the balance sheet and creditworthiness of those institutions who hold them. Unlike financial assets, real estate prices tend to move slowly, and much more so in a highly regulated market like China. Real estate bubbles can burst, and real estate collapses have occurred and triggered financial crises. However, China’s real estate sector is a hybrid system driven only partially by market forces. The Chinese government has strict control over real estate prices, and regional governments are in control of land supply – and even demand as they can also repurchase previously sold land. The Chinese government wants to avoid further rapid increases in housing prices as part of its broader aim of increasing “common prosperity” – see our previous insight China’s ongoing volatility: A movement to address ESG challenges . But it doesn’t want property prices to collapse. Real estate and related sectors account for more than a quarter of the Chinese economy. Thus, a fully-fledged real estate crisis would imply major policy mistakes that don’t seem very likely.
Unlike Huarong Asset Management, which the government decided to recapitalize, Evergrande is not too big to fail, and it’s not a financial institution. That’s precisely why the Chinese government is unlikely to bail Evergrande out.
China has been attempting to reduce excessive leverage on the real estate sector for a long while. In August 2020, the Chinese government introduced its “three red lines” for real estate developers. Basically, developers have until 2023 to comply with three conditions:
Those who fail one of the three red lines are classified as yellow and can only increase their debt stock by 10% per year, while those failing to meet two or all three are classified as orange or red and can only increase their debt stock by 5% or 0% percent, respectively. Furthermore, in December 2020, the People’s Bank of China (PBOC) introduced caps to property loans and mortgages by banks as a share of their total outstanding loans to prevent an overheating of the real estate sector.
As shown in the chart below, developers have made quite some progress towards meeting the three red lines by 2023 in just six months. Evergrande was among the three developers in red at the end of 2020, and while it was able to reduce its net gearing below 100% by mid-2021, its unrestricted cash was just enough to cover 40% of its short-term debt in mid-2021. Hence, a liquidity crisis is hardly surprising for the company.
Bond defaults in China have been very rare so far and this has created the expectation that the government will always step in to avoid them. Economists call this moral hazard. A set of incentives that leads investors to take excessive risks because they’re unlikely to incur into losses if risks materialize. Reducing moral hazard may not only result in a more efficient allocation of resources, but perhaps even in an improved financial situation for Chinese banks as they will continue to reduce their exposure to a highly leveraged real estate sector.
The real estate and its related sectors comprise about 29% of the Chinese economy by value added, which is quite large by international standards . There’s no doubt that curbing the excesses of the Chinese real estate sector will result in slower GDP growth in the short term as fewer properties are likely to be built and sold. In fact, some analysts reduced their GDP growth expectations for 2022 by 0.2-0.9 percentage points in the last few days on the back of the ongoing real estate activity slowdown. In short, there’s a risk of a significant China slowdown. However, the authorities are being quite proactive to manage this slowdown, the PBOC has been injecting liquidity via open-market operations to prevent a tightening of financial conditions and we expect further monetary and fiscal easing to take place through the rest of 2021. This policy easing should prevent the slowdown from being long-lasting. Moreover, in the long term, this is likely to result in a re-allocation of resources to more productive sectors in the economy.
Evergrande’s bonds have fallen by more than 66% since end-May, dragging down China’s real estate sector by ~17% and the entire China high-yield bond market by 11% in the same period. It makes sense for the market to price in a higher risk of default given the government’s intention to reduce moral hazard and increase financial discipline among corporate issuers, particularly in the real estate sector. However, too many Chinese high-yield issuers are now trading at stressed and distressed levels including several who are rather unlikely to restructure their debts. Thus, we think there has been an almost indiscriminate sell-off of China’s high-yield segment, which brings about many great opportunities to active investors like ourselves who have the expertise and the sufficient resources to analyze each issuer on a detailed individual basis.
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