The potential Impact of Evergrande

Key points:

• Evergrande: widely regarded as ‘not systemic’ by western commentators. (The PBOC had its own view in 2018, as discussed below.)
• Evergrande is a consequence of state-directed deleveraging, most likely to avoid:
  • A bigger crash further down the road as household debt rises
  • Worsening misallocation of capital within the PRC
  • A roadblock on the pivot away from a heavily ‘export orientated’ economy towards a ‘domestic consumption’ based economy
• May not be ‘systemic’ by itself, but easily big enough to re-set the scenery if mis-handled. 
• Primary risk is via a loss of confidence in the real estate sector.

An Introduction to Evergrande

Good afternoon,

China’s property giant, Evergrande, has been in the news owing to a collapse in equity and bond valuations, and an expected default. The following text will try to condense views expressed by major banks, reports, and some media sources.

(1 US$ = 6.67 CNY)

China Evergrande Group (EVERRE / 3333 HK & c.) a huge property company with a pipeline of projects across China and a huge debt load of around CNY2.10 trillion (before ‘minority interest’ obligations are included) and an order book estimated to be around 1.70 million units awaiting completion.

CNY2.10 trillion is about US$314 billion, of which over CNY800 billion or US$124 billion falls due within the next 12 months.

The company has long operated with long periods of negative operating cash flow as projects are started and has become increasingly reliant on shorter term funding just as the Chinese state has made ‘de-leveraging’ a priority. Therefore, the circumstances of the company’s woes are not a total surprise.

Evergrande’s interest payments

A key bond interest payment was due Thursday the 23rd September, on the 8.25% bond due March 2022, the principal being US$2.25 billion. Payment was considered unlikely, and this will trigger cross-defaults on other paper. Heng Da Real Estate did make an assurance that the coupon (about US$84 million) would be paid. As of the following Friday it hasn’t, and pricing suggests that holders of Evergrande’s offshore bonds will get wiped out.

Source: Bloomberg

China’s outlier position in residential property investment relative to (Purchasing Power Parity) GDP. This is the epoch-making wave of urbanisation that Evergrande and its peers have surfed since the turn of the century.

Source: IMF staff estimates

Is this a systemic threat?

Possibly, but most observers doubt that it will be.

There are metrics that suggest that at first take the threat is not systemic if you judge by how much exposure individual Chinese banks have to commercial property developers, and this is certainly the narrative that many major banks are running with as of now.

The limitation of this approach is that ‘you measure what you can measure’, and not always to greatest effect.

The second limitation is the uncertainty as to what degree is EV a ‘shadow bank’ as opposed to a conventional property developer.

There is a wider risk that lenders are unwilling to roll existing credit or extend new credit to peers in the real estate sector, and that that losses from WMPs — Wealth Management Products — which are not well understood but essentially amount to ‘shadow banking’ and could represent a channel via which contagion could spread.

Evergrande’s total liabilities are estimated as:

• 1.80 % Chinese GDP
• 0.60 % of total assets of the Chinese banking system

It is important to note that a lot of EV’s liabilities are to suppliers, rather than directly to the banking system, so there is a second-order risk of suppliers becoming insolvent, rather than a direct hit to bank Tier 1 capital.

Given the increasing maturity of Chinese regulators and experience with other corporate failures, this looks ‘containable’ and unlikely to become a disorderly event.

However…

• 15% of China’s GDP is connected to real estate once construction – clearly a part of the Evergrande jig-saw set – and property services are included.
• 70% of urban China’s wealth resides in housing.
• Unofficially, Evergrande’s land bank collateral value may be overstated.

A restructure would emphasize the preservation of the project pipeline in order to minimize upstream impacts on Evergrande’s suppliers and help preserve their solvency.

Maintaining Confidence

If Evergrande’s financial impact does not leak across the financial system, then ‘it’s not systemic’.

However, it does not have to be financially systemic to have a profound affect across the Chinese economy given the substantial up and down stream effects that link suppliers and homebuyers to Evergrande’s property pipeline.

Additionally, as with banking, there is a confidence issue. If there is a decline in confidence among property buyers, then softening prices may endanger other prominent property developers who are highly leveraged with vulnerable equity. (See the comparison of assets with leverage below.)

By the end of 2017, outstanding debt of China’s household sector stood at RMB40.5 trillion, representing a y-o-y increase of 21.4%, and 7.1 times increase than that of
2008. (sic) (PBOC Financial Stability report.)

• Steadily increased leverage. Prices have risen, but the margin for safety across the sector has declined.
• Total short-term funding (<12 mo) of top 200 Prop Co’s roughly equal to FX reserves

Credit: Rose Technology

What to look for if risk bleeds into the banking sector? Look for distress in spreading sequentially from smaller entities such as the Bank of Jinzhou, ShengJing, to China Minsheng.

Credit: Rose Technology

Impact on the Australian markets

The first impact has been seen via further pressure on the iron ore price, which was already impacted by Chinese decisions to reduce steel consumption. Evergrande was just another layer. Weaker iron ore prices will impact State and Federal finances. So far that impact is estimated at AU$6 billion.

A reduction in demand as wealth effects ripple through the Chinese economy is likely to affect Chinese demand for Australian goods. On balance the impact is AUD negative. In the near term, the 0.676 level is a key area for the AUD.

Some media has painted a dramatically negative picture of the impact on the Australian economy.

A likely decline in the consumption of raw material exports is clearly negative. However, that is more symptomatic of longer-term structural changes in the Chinese economy that will play out regardless of Evergrande. It is not automatically the case that Evergrande’s woes translate into a shock for our economy. It may be the case, that for Australia, we are past ‘Peak China’.

Data shows that mainland China’s stock of foreign investment in Australia is about 2% and in turn Australia’s share of the total stock of investment in China is about the same level, and declining.

Although what happens in China’s financial markets is of key importance to Australia, Australia is far more correlated with the US.

Source: Bloomberg; ICE; RBA

Australian producers

Producers of iron ore and copper have been seeing excellent prices for their products – despite the drop in iron ore prices, the main outcome is a less exciting result for stakeholders, as lower prices are still profitable. The previously mentioned impact on public finances is material, however.

Impact on the gold price

Gold is generally a defensive ‘risk-off’ asset and may be expected to do well out if risk aversion rises.

However, there are some potential headwinds to that outlook.

Firstly, US Treasuries will be in demand as a ‘risk off’ asset and this will drive increased demand for the US dollar.

If there is a wider impact across the Chinese economy, wealth effects may cause a round of ‘dis-saving’ from consumers which could negatively impact domestic demand for gold. This could be amplified if the CNY weakens in response to economic stress, raising the yuan price for gold.

It is reported that there are currently US$6.20 billion (CNY40 billion) of missed payments from Wealth Management Products (WMPs) sold by Evergrande. If Evergrande’s woes propagate to the wider residential property market and peer-group real estate developers, it would be reasonable to expect Chinese households to be impacted via lower house prices, stock values and potential losses on savings vehicles. Reports that Chinese trusts may have absorbed some of the losses on WMPs already may also reduce confidence in investing via those entities.

There is therefore the possibility that Chinese households may respond to this ‘potential’ scenario by mobilizing gold holdings as a valuable asset that is liquid and transparent to help smooth consumption in the face of a shock to household finances.

Investors payouts on Evergrande WMPs pipeline:

• US$1.8billion in Q4 2021
• US$4.0billion in 2022

Trusts reduce their exposure to real estate

• Trusts account for an estimated 41% of Evergrande’s total financing
• Trusts reduced lending to the property sector by US$30 billion (CNY201 billion) in H1 2021

The H1 reduction in debt from trusts implies a growing squeeze on a highly indebted sector and declining liquidity may mean other real estate developers have gone the Evergrande route and sought to shift more financing to suppliers and more opaque channels.

Summary

A hugely complex range of choices face the Chinese government as they try to square multiple circles:

• Avoiding contagion in the property sector without showing preference for Evergrande.
• Demonstrating that domestic capital markets are maturing, and capable of both signaling and coping with (severely) bad outcomes – vital steps along China’s long-term economic pathway.
• Avoiding moral hazard. (China has been trying to reduce this problem for years.)
• Balancing the CCP’s ‘Common Prosperity’ with all of the above.

In the short term, sources close to the Chinese government have said that China Evergrande will be restructured into three units with the emphasis on making property purchasers whole.

(If I had a dime for every time I heard ‘this is not a Lehman moment’ I would be well on the way to meeting some of the upcoming coupon payments for Evergrande…)

Perhaps the final word should go to of the People’s Bank of China, and the PBOC 2018 Financial Stability Report:

“Real estate risks may spread over to the financial system through multiple channels. The direct channels include: first, banks have intensive exposure to the real estate sector. At end-2017, outstanding amount of real estate related loans accounted for 26.8 percent of all banking credit, indicating banks will be directly exposed to credit risks once the real estate market experiences serious disruptions; second, some real estate companies also raised money through trusts, wealth management products and other non-bank financing which feature complex financing structure and multiple reinvestment, and risks may spread over to the financial industry through these non-bank channels.

“Third, as a large share of the credit was collateralized by real estates, shocks can spill over to the financial industry through changes in the valuation of collaterals.”

A world-weary observer might recall that when contagion did occur in the GFC, key elements involved sudden changes in the value of collateral held within the financial system, and that many means of financing were complex, hard to value or understand, and in some cases involved re-hypothecation elsewhere in the system.

Regards,

Nick Frappell
Global General Manager

For ABC Refinery