Is China Evergrande a Contagion Event?

Many of the longstanding issues surrounding China Evergrande group , the property focus conglomerate , have been coming to a head over the last week. These issues have accelerated a selloff within the Hong Kong property sector and are starting to impact the wider global market. Evergrande is the biggest offshore dollar bond holder in the market. The stock peaked in 2017 and the share price has been in a steady decline since then the recent selloff has taken the share price to 10 year low.

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Evergrande is the biggest offshore dollar bond holder in the market.

Many of the longstanding issues surrounding China Evergrande Group, the property focus conglomerate, have been coming to a head over the last week, these issues have accelerated a selloff within the Hong Kong property sector and are starting to impact the wider global market. Many analysts have suggested this could be another Lehman moment. In this week’s big conversation, we look at the potential fallout from Evergrande and the policy response.

The problems that China on the ground are facing aren’t particularly new. The stock peaked in 2017 and the share price has been in a steady decline since then. The recent selloff has taken the share price to 10 year low.

It’s issues have accelerated because of a missed interest payments on Monday, whilst on Thursday September 23rd, it’s due to pay $83 million interest on its March 2022 bond and then another 47 million in interest during the 29th of September against its March 2024 bond.

As of Wednesday 22 September, they are going to pay interest, but only on their onshore bonds and not their offshore dollar debt. So this remains a very, very fluid situation choosing to pay onshore but not offshore bondholders and also suppliers doesn’t suggest a plan for longevity. Evergrande is the biggest offshore dollar bond holder in the market.

Contagion risk has already been priced into dollar bonds

The current issues center around the wealth management products of its banking arm, but these have been built up against its property portfolio. Contagion risk has already been priced into dollar bonds and payables. Yields on dollar bonds have been rising sharply since mid July, but this time the reverberations have spread much further, investors are starting to price for a prolonged slowdown across China’s key real estate sector, which is wider implications and the possibility that authorities will add assets of overleveraged private companies reflect their actual risks.

Amongst the casualties in Monday’s Hong Kong market when mainland China was closed for a holiday were SINIC Holdings Group, which collapsed 87% before being suspended.

It’s a relatively small cap company. But anything with leverage has come into the crosshairs whilst price moves can be exacerbated by the vagaries of the algos. Some of the bigger property companies such as Henderson Land Development fell by 15% in a few days and the losses weren’t confined to just the property sector. Insurance giant Ping An group fell over 10% over only a few sessions.

Why is this happening now?

So apart from the immediacy of Evergreen’s interest payments, why is this happening now? Well, in many ways, this has been part of an ongoing process. The big conversation outlined China’s economic transition a couple of times over the summer and many times before that. Ugly China shifted stance at least three years ago and started raining in the worst excesses of its private sector. In order to address the leverage in the economy, Fixed asset investment peaked around 2018 and this was at the same time that growth in private sector credit, which is the shadow banking system, went into negative territory. Chinese authorities have been trying to avoid an outcome that could be similar to Japan’s so called lost decade in the aftermath of its own property and stock-market bubble, which peaked in 1989 and then collapsed. Although China’s response to the 2020 pandemic was like every other government yet more credit. This was quickly dialed back.

The three red lines that China imposed last year

The monetary and fiscal response has been relatively reserved when compared to the US, Europe and Japan over the same period.

Credit spreads had previously been too tight and this has encouraged undue risk storing up issues for the future. Now as part of the process of rebalancing and redistributing that has also seen Chinese authorities take a shot at the large tech companies, policy makers have allowed credit spreads to widen out and reflect some of the true underlying fundamentals, particularly in the high yield sector.

This compares to Europe and the U. S. where policymakers have continued to suppress credit spreads and ultimately the real risks. Tight spreads are either a sign of a healthy economy or of market distortions and it’s likely that excess leverage employed by Evergrande has been repeated by companies in other geographies as well, but they are currently disguised by monetary policy.

China had been pressing for improved balance sheets last year. In August 2020. The outline for the corporate sector three red lines, and these were:

• a ceiling on the debt to asset ratio,
• a cap on the net debt ratio
• and a cap on short term debt cash ratios

At that time last year, Evergrande was already in breach of all three of these red lines according to Stephen Legion of your eyes and S. L. J. Research.

By summer 2021 the short term debt to cash ratio had been resolved, but the other two remained outstanding and starved.

Evergrande has been unable to roll over its liabilities. Today. Evergrande is solvent, but it’s facing acute liquidity issues now. So far, property prices have remained relatively steady, but if they begin to drop, especially in tier four and tier five cities, then the liquidity issues could transition into one of solvency. And there’s also a lingering belief that many mark to market levels on existing portfolios have been inflated before insolvency becomes an issue, it’s likely that specific parts of the capital structure will be allowed to fail while other areas will be shored up or protected. Stephen legion suggests that the seniority of evergreens assets will be firstly citizens with down payments at the top of the structure followed by vendors or suppliers, then holders of onshore bonds, then holders of offshore or dollar denominated bonds and then it will be the equity holders right at the bottom of the pile and it’s the holders of offshore bonds and equity that are likely to lose out. Onshore bonds have been trading with far less volatility than offshore dollar denominated debt and as of today, those onshore bonds do appear to have been protected. The authorities are testing the water to see what level of financial re pricing they can achieve without infecting the rest of the market or the economy.

And it’s a bit like a controlled explosion.

They’ll not want to cause an event to impact good companies or state owned enterprises. They will let the excesses of the private sector come under pressure and they’ll be happy to see the affordability of housing improve. There was always this policy tightrope but we’ve been here before. In fact, every time China’s credit growth has been reined in, there’s always been an impact on both the domestic and the global economy. So far, the down swings have always been rescued by more credit. Recently, credit has been targeted towards the domestic economy to help short banks and those state owned enterprises. But clearly policymakers won’t want to lose control and when China is testing the water, there’s usually collateral damage across the rest of the global economy. The pullback in the outlook for China’s real estate sector will require a re-evaluation of demand for many global commodities China’s iron ore futures have halved since their peak.

In April 2021, the outlook for commodity demand is catching up with the European basic resources sector, which is a large global mining component.

On Monday the index fell over 5% intraday for a three day loss of 10% breaking through support of a topping formation. Commodity prices may remain elevated due to bottlenecks but demand will fall. The S&P itself has also extended the recent losses. So far. The U. S. Market is sold off into each of the last five options expires and then bounced Monday was the first time since May that losses extended beyond the expiry and the U. S. Market is stretched on many metrics. A China and do slowdown however, would help cat bond yields and that would be favorable again for us tech names. And we would also expect emerging market equities to continue their underperformance versus the U. S. But China has already been negatively impacting the performance of emerging-market stocks throughout much of 2021. If the Chinese currency weakens, then that would help the dollar make gains against most other currencies. And since last year most of the dollar weakness has been actually against the euro and the Renminbi. It’s been strengthening those two currencies. If the Chinese currency just down and now the dollar adjusts up because domestic companies in China is scrambling to offset some of their dollar denominated debts, then this will again increase the likelihood that emerging markets will continue to underperform but should we fear a wider contagion beyond demand for commodities and performance of emerging markets versus the U. S. China

Evergrande is a behemoth of a company and the authorities will be very wary of letting things get out of hand. Liabilities alone are staggering $300 billion.

Most of this is domestic and not dollar denominated debt.

It’s equivalent to around 2% of China’s $14 trillion 200,000 employees, many of whom have invested their earnings into those problematic wealth management products, many of which are based on the performance of Evergrande asset prices. Now that’s more in common with Enron rather than Lehman. Many employees had their pensions tied up in the energy company stock when it went into liquidation in the early 2000s And in addition to the couple 100,000 direct employees, there are also hundreds of thousands more employed in both upstream and downstream jobs. The current cash crunch has put 800 of its building projects on hold, increasing the risk to those jobs. But will this be an event on the scale of Lehman in 2008 or even the eurozone crisis in 2011 and 12. It doesn’t look like it yet. If we look at the currency, we can see that the volatility has picked up a little bit but it’s still well short of the levels that were achieved back in 2015 when we had a couple of mini devaluations of the renminbi and then a global industrial profits recession. We would normally expect currency volatility to reflect contagion risks but so far there’s been very little.

The Australian dollar has pulled back slightly, but it hardly reflects a significant surge in risk.

This currency has already under performed many of the underlying commodities over the last year. So it’s no surprise that metals such as copper have been dropping towards the levels of the OSI, the Aussie has not had a significant leg lower yet, but we must watch how this topping formation progresses. Credit default swaps would also be a good place to look for signs that risks the building of the five year cD S for some of the overseas banks with exposure to mainland China, such a standard chartered bank have hardly moved, reflecting little sign of actual contagion risk. Goldman Sachs has significant exposure to China, their five year credit default swap moved higher well before the Lehman event of 2008 starting off from a far higher base than today, where now they are currently low and stable and there are far more other banks out there with exposure which is showing very little activity as well. So therefore it looks like the risks around Evergrande worst accelerating are still considered to be domestic issues.

There is clearly a risk that policymakers lose control and a slowing Chinese property sector will have implications for other global assets.

We should watch the CDSs of these international banks, we should watch the volatility of domestic currencies and the performance of international risk on risk off bellwethers such as the Aussie dollar or the korean one for signs that the risks are actually spreading Us. Secretary markets are stretched as we discussed last week. They’re vulnerable to a five or 10% decline, which is already the major consensus before today. But levels of skew in the options market are high, suggesting that the deep downside is a major contagion event. Well that’s already hedged. The key risk is therefore a disorderly surge in the U. S. Dollar and a tightening of financial conditions which then triggers a whole series of knock on effects across commodities and other emerging markets. Or so far, the U. S. Dollar has been grinding higher but not surging. The Fed has been primed by last year’s events to cap fX volatility with swap lines and reassurances if necessary. Even if the Fed is getting an itchy taper finger, they will caveat all future policy proclamations by being flexible enough to dial back on any tightening promises they make. So Evergrande is a problem. It’s been brewing for a while and the authorities are probably happy to let the company go.

A slowdown in the property sector will have serious implications for the global reflation and long term inflation stories.

But domestically within China, it may help redirect capital over the long term to other more productive areas today’s price action. Therefore looks like a pause for breath, which may indeed lead to our shock because of elevated levels of volatility. But that doesn’t mean that markets are pricing for contagion events. And obviously, if you’ve got any questions about this episode or anything else to do with financial markets or the economy, please put your questions in the comments section or send them to TBC at refinitiv.com.