In the past couple of weeks, the travails of China Evergrande, China’s and the World’s third largest property developper shook the financial markets, raising a number of questions about the Chinese property sector and the Chinese bond market as a whole.
Evergrande is one of the largest developers in China and is listed in the world Fortune 500 List.
The firm has completed nearly 900 commercial, residential, and infrastructure projects throughout the country since 1997. The company is best known for its involvement in building the Flower City Stadium in Guangzhou. The stadium broke ground in 2020, and it is set to be the largest football arena in the world.Evergrande is also behind Ocean Flower Island, a man-made archipelago with theme parks, malls, and museums.
Along with these large-scale projects, Evergrande has also developed numerous residences and townships in China. Potential buyers can tour its properties through online listings, video calls, and even VR. The company’s housing developments primarily consist of luxury condos and villas, but it also offers mid-range and affordable options.
In the past few days, the police had to intervene to calm investors gathering in front of Evergrande’s headquarters, demanding the repayment of their favorite Wealth Management products.
Trouble accelerated when the company delayed a redemption payment on US$ of bonds in June, and defaulted last week. The company’s shares fell 12% in Hong Kong, extending this year’s drop to 80% and closing at the lowest level since November 2014. Evergrande’s 12 % dollar bond due 2024 dropped about 5.5 cents to 25 cents, pricing in a high likelihood of default
With close to CNY 2 trillion of outstanding debt, ( US$ 312 Billion ), China Evergrande is one of the world’s most indebted company, ranking third behind Volkswagen and ATT and closely followed by Apple Inc’s 258 Billion outstanding debt.
Once China’s top-selling property developer, China Evergrande is now teetering between a messy meltdown with far-reaching impacts, a managed collapse or the less likely prospect of a bailout by the Chinese Government.
Founded in Guangzhou in 1996, Evergrande has epitomised China’s freewheeling era of borrowing and building, but with two trillion yuan its collapse looms as one of China’s largest ever.
It is the first real test of China’s financial market ability to withstand a big corporate default and Chinese equities sold off yesterday as investors worried about the contagion effect.
There were a number of warning signs last year and we have been completely out of the Chinese real estate sector for more than 18 months now.
China’s Real Estate phenomenal rise
For years and even decades, China’s real estate development was an uninterrupted and baffling success story, fulled by the appetite of a rising affluent Chinese middle class for real estate. Developers would create entire cities from scratch, having them idle for years before finally tenants and owners moved in to make them alive.
The story of China’s real estate development is not only the story of China’s spectacular rise in GDP and income per capita, but also the story of a massive urbanisation that has moved hundreds of millions of Chinese form the country side to urban centres.
In the past 20 years alone, The Chinese GDP per capita quintupled from US$ 3’000 to US$ 16’000 equivalents, an extraordinary feat by any historical standards.
Over the same period, Disposable income was multiplied by an even more astounding 7.2 times.
With savings ratios in the high 30 %, and a population of 1.4 billion people, that represents in excess of US$ 7.2 trillion equivalent of savings flowing every year in savings products and, the first of all of them Real estate.
In 1980, 20 % only of the Chinese population lived in urban Centers. In 2020, that ratio reached 60.6 % of the 1.44 billion population, meaning that. ore that 600 Million people had to find a home in cities over the past 40 years…
No wonder if the real estate and property development sector experienced massive growth over the years, with housing the investment of choice for generations of Chinese not yet covered by State pension plans and plagued with job insecurity.
But by the same token, the outsized development of the real estate market and the growing infatuation of Chinese savers not only for real estate but for the wealth management products that were issued by the country’s majors to finance their future developments also became a concern for the Government on a constant basis.
We highlighted in one of our recent posts that we would not be surprised if the Chinese Government took measures to re-direct savings from the over-inflated real estate market towards the undervalued stock market.
Chine Evergrande’s collapse may be the trigger that was needed to accelerate the shift
Evergrande re-structuring is a certainty
In the last couple of years, debt and land-buying curbs and hundreds of new rules have been imposed on Chinese developers as part of a push to cut financial risks and promote affordable housing.
On the buy side, more restrictions were put in buyers in terms of number of property they could own, amount and percentage of downpayment they had to make and total indebtedness accumulated per household.
The supply side curbs had a significant impact on the profitability of the developers and the 2020 Covid-related confinement dealt a significant blow to their liquidity positions.
The last batch of Government Debt and land-buying curbs and hundreds of new rules have been hitting developers far harder than they had expected, setting off a scramble to sell assets . The most leveraged ones, such as Evergrande, went through an acute cash drain.
Evergrande which accelerated efforts to cut its debts in 2020 after regulators introduced caps, does not have any major offshore bond maturities until early next year but tardy payment of suppliers and interest on loans have brought to a head concerns that have long nagged at investors.
The spiral of cash-strapped companies has started and without access to fresh funding, Evergrande will not be able to pay suppliers, finish projects or repay its debt, prompting it to propose delays in repayments of its debt and the wealth management products it had issued for short term financing.
China’s government is assembling a group of accounting and legal experts to examine the finances of China Evergrande Group, a potential precursor to a restructuring of the world’s most indebted developer.
Regulators in Evergrande’s home province of Guangdong dispatched a team last month from King & Wood Mallesons, a law firm whose specialties include restructuring.
The move adds to signs that Chinese authorities are laying the groundwork for what could be one of the country’s biggest debt restructurings.
The company has been trying to sell assets since June to de-leverage its balance sheet and raise cash but to no avail. Evergrande said it hasn’t made material progress on plans to sell stakes in its electric-car and property services units, adding that the planned disposal of its Hong Kong headquarters building hasn’t been completed as expected. Asset sales had been one of the most important pillars of Evergrande’s plan to escape its cash crunch.
While the developer doesn’t have any bonds maturing until 2022, it faces $669 million in coupon payments this year, including $83.5 million due Sept. 23 for a dollar note. Fitch Ratings highlighted an increased chance of default on these interest payments when it slashed Evergrande’s ratings deeper into junk territory last week.
Without state intervention, the risk is that Evergrande enters a downward spiral. The developer said in its statement on Tuesday that property sales will drop in the normally buoyant month of September because of waning confidence among homebuyers, who often need to give the company large down payments for properties that may take years to complete.
Considering the potential of social unrest due to the size of its debt and its wide holding amongst the population, the issue a politically sensitive one Protesters gathered at the company’s Shenzhen headquarters for at least the third straight day on Tuesday, braving the rain to demand repayment on overdue wealth-management products.
The extent of the losses facing investors will depend in part on whether Chinese authorities and state-run banks take steps to limit the fallout.
Evergrande is now the biggest test yet of President Xi Jinping’s willingness to let over-indebted companies fail as he tries to wring the excesses out of China’s $54 trillion financial system.
The risks of contagion are not negligible. If, as expected Evergrande is defaulting on its debt and goes through a restructuring, the liquidity crunch must also be felt at other large developers that have extended themselves too much and have lesser access to liquidity.
Investors in Wealth Management products are now worried about the fate of their investments globally, some real estate buyers will probably postpone their acquisitions, local lenders and banks will tighten the lending conditions to the sector all at once, creating a dire dynamic of liquidity collapse for the developers.
Reactions have so far concentrated in the bond market and on Evergrande’s stock, as well as the stocks and bonds of the weaker developers such as Guangzhou R&F Properties and Xinyuan Real Estate Co.
Evergrande shares are down about 90% in 14 months, while its dollar bonds are trading at 25 %. The following chart shows that the four largest developers shares have only fallen 20 % in the past few months and that the contagion effect seems to be limited. Interestingly enough, the shares of POLY Developments, which are listed in Shanghai, have actually risen in the past few weeks as the situation of Evergrande worsened, indicating that the domestic perception of the risk of default may not be the same.
Another concern is the contagion risk for the banking system, considering the large size of the debt of the property developers.
There again, the market does not seem to be pricing any contagion effects since July. Chinese Bank stocks were up through August and the beginning of September and we are actually bullish banks in China.
The latest regulatory push that triggered the crisis is the latest in years of efforts to reduce risks in the real estate sector. Yet, unlike previous iterations, it is driving a heightened level of discomfort in markets as investors grapple with authorities’ persistence and with what is at stake for a sector that currently comprises about a quarter of the Chinese economy.
China has been pushing to wean property developers from excessive borrowing for years, putting more and more stringent conditions on banks to finance developers and buyers and pushing the real estate developers to resort more to the bond markets and Wealth Management Products than regular bank credit lines.
Nevertheless, the risk that the current cash crunch spills over into loan losses at banks and pain in credit markets as cash-strapped builders fall into distress, is not negligible, aising the risk of fallout rippling across the economy.
Bank exposure to the sector and to Evergrande is wide and a leaked 2020 document, written off as a fabrication by Evergrande but taken seriously by analysts, showed liabilities extending to more than 128 banks and over 121 non-banking institutions.
But data suggests non-performing loans at commercial banks were a manageable 1.76% last quarter, and compared to the United States, China has far greater control over its financial system and much greater provisioning requirements. Evergrande’s problems have started already several quarters ago and banks have certainly provisioned our re-qualified its debt into non-performing loans.
Real estate crash ?
For now, analysts have played down comparisons to the 2008 collapse of U.S. investment bank Lehman Brothers, which caused crises at counterparties and ultimately seized up global markets, but the real risks lie in a sharp fall in real-estate prices.
An Evergrande fire sale could crush prices, causing leveraged developers to blow up and crippling a sector comprising a quarter of China’s economy.
A drive by authorities to cut developers’ debts is also seen as increasing the likelihood of a property liquidation. So it is likely that real estate prices will go down in the coming future but the stents of the fall still remains to be seen.
One thing is certain is for sure and that is that Evergrande’s collapse will damp Chinese investors appetite for real Estate investments and may even trigger a wave of selling, pushing prices lower.
It will not be the first time real estate prices fall for a period of time. But as the chart below shows, Home prices have been rising constantly since 2016, leading the government to curb demand and price rises.
Average new home prices in China’s 70 major cities rose by 4.2 percent year-on-year in August 2021, after a 4.6 percent gain a month earlier. This was the weakest rise in new home prices since January, as government cooling measures were enough to offset strong property demand.
The government has worked tirelessly to drive de-leveraging in the bloated real estate sector, so throwing a lifeline to Evergrande now is unlikely, according to most analysts.
Evergrande is a private company and the Government’s only concern is to avoid the ripple effects of its collapse on the financial system.
Analysts are increasingly expecting a managed collapse that seeks to protect smaller investors, while bondholders will take a large haircut.
Defaults and bankruptcies are nothing new in the USA where the rate of default of High Yield usually averages 8 % according to Fitch ratings and where highly visible companies such as Legman, Washington Mutual Orr General Motors went bust in the past few years., but they are far less familiar to Chinese investors.
As such Evergrande will probably be the largest company to fail in China since the 1990s, but we do not expect a systemic crisis or a banking crisis to stem out of it.
If anything, its collapse will help the Chinese Government contain the Infatuation of Chinese investors with Real Estate and direct a higher proportion of saving into the stock market.
We remain very positive on Chinese equities for the remaining of the year and accumulate banking stocks.
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