The Big Conversation
Episode 92: Is China evergrande a contagion event?
This week we look at issues surrounding China Evergrande, a leveraged conglomerate that includes property development and banking amongst its operations. Expectations of a default have been running high, but its issues……… and the policy response…… go deep into the transition that China is undertaking. This looks more like a controlled explosion, rather than a contagion event, but the repercussions for global investors will be widespread.
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Roger [00:00:00] Many of the long-standing issues surrounding China Evergrande given group, the property focused conglomerate, have been coming to a head. Over the last week, these issues have accelerated a sell-off 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 Evergrande 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 sell-off has taken the share price to a 10-year low. Its issues have accelerated because of a missed interest payment on Monday, whilst on Thursday September 23rd it's due to pay 83 million dollars interest on its March 2022 bond and then another 47 million in interest due on the 29th September against its March 2024 bond. As of Wednesday 22nd of 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 bondholder in the market. The current issues centre around the wealth management products it's 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 has wider implications and the possibility that authorities will let assets at over-leveraged 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 percent before being suspended. Now 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 percent in a few days, and the losses weren't confined to just the property sector. Insurance giant Ping An Group fell over 10 percent over only a few sessions. So apart from the immediacy of Evergrande'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. Arguably China shifted its stance at least three years ago, and started reining 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 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, policymakers have allowed credit spreads to widen out and reflect some of the true underlying fundamentals, particularly in the high-yield sector. Now this compares to Europe and the US, where policymakers have continued to suppress credit spreads and ultimately the real risks. Now, 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, they outlined 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 Li Jen of Eurizon SLJ Research. By summer 2021, the short-term debt to cash ratio had been resolved, but the other two remained outstanding. And starved of bank credit, 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 whilst other areas will be shored up or protected. Stephen Li Jen suggests that the seniority of Evergrande's 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 waters to see what level of financial repricing 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 a contagion 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. Though as always, this is a 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 downswings have always been rescued by more credit. Recently, that credit has been targeted towards the domestic economy to help shore up 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 has a large global mining component. On Monday, the index fell over five percent intraday for a three-day loss of 10 percent, 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 US market has sold off into each of the last five options expiries and then bounced. Monday was the first time since May that losses extended beyond the expiry. And the US market is stretched on many metrics. A China-induced slowdown, however, would help cap bond yields, and that would be favourable again for US tech names. And we would also expect emerging market equities to continue their underperformance versus the US. 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 adjusts down and now the dollar adjusts up, because domestic companies in China are 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 the performance of emerging markets versus the U.S.? Well 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 a staggering 300 billion dollars. But most of this is domestic and not dollar-denominated debt. It's the equivalent to around two percent of China's 14 trillion-dollar economy. The company has around 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's asset prices. Now, that's more in common with Enron rather than Lehman. At Enron, 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 of hundred thousand 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 underperformed 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 Aussie. The Aussie has not had a significant leg lower yet, but we must watch how this topping information progresses. Credit default swaps would also be a good place to look for signs that risks are building. The five-year CDS for some of the overseas banks with exposure to mainland China, such as 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, whilst accelerating, are still considered to be domestic issues. There's clearly a risk that policymakers lose control, and a slowing Chinese property sector will have implications for other global assets. We should watch the CDS's 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 Won for signs that the risks are actually spreading. U.S. equity markets are stretched, as we discussed last week, they are vulnerable to a five or ten percent decline, which is already the major consensus before today. But levels of skew in the options market are high, suggesting that the deep downside, i.e. a major contagion event, well, that's already hedged. The key risk is therefore a disorderly surge in the US dollar and a tightening of financial conditions, which then triggers a whole series of knock-on effects across commodities and other emerging markets. Well, so far, the US 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 a VAR shock because of elevated levels of volatility. But that doesn't mean that markets are pricing for a contagion event. 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@Refinitiv.com.
Episode 91: Is the bearish stock market consensus wrong?