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Evergrande for Foreign Investors
Evergrande for Foreign Investors: Limiting Contagion Worries
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Strauss Cooperstein Evergrande and other indebted Chinese property giants are on the verge of collapse, proving to be one of the biggest tests to China’s financial system. Evergrande owns more than 1,300 real estate projects across 280 Chinese cities in addition to its other consumer businesses and theme park holdings. For context, Evergrande’s total liabilities collectively amount to roughly 3% of China’s annual GDP. Domestic home buyers and investors have protested at Evergrande’s headquarters demanding repayment of overdue loans, and implications for foreign investors remain unclear. Given that Evergrande’s shares and bonds can be found in many Asian funds and indices, foreign and local investors alike fear “cross default.” In fact, a potential credit default swap would protect the interests of onshore suppliers and creditors (banks and households) at the expense of offshore equity and bond holders. In order to reduce global contagion worries and reassure foreign investors, Chinese authorities, regulators, and the People’s Bank of China (PBoC) must consider implementing gradual monetary policy to begin slight easing and sharing a government plan before any credit event occurs. Waiting to observe a continued decline in property sales and weaker domestic consumption will only increase negative sentiment regarding contagion. On the flip side, bailing out Evergrande too soon will only perpetuate moral hazard in China’s property sector. When considering any spillover into the global economy, investors should recognize that Evergrande is not a “Lehman Moment” given several qualitative and quantitative differences, and instead is a controlled implosion as a result of President Xi’s deleveraging and de-risk initiatives. In fact, the Evergrande crackdown was caused by Chinese regulators concerned with real estate speculation and who plan to test the company’s ability to make interest payments. By initiating property lending restrictions, the “three red lines” policy, and centralized land auctions, Chinese state intervention in its financial and mortgage markets is unlike that of the US’ financial system. This demonstrates Beijing’s commitment to making an example of Evergrande and then resolving the liquidity situation internally, without causing any intended global spillover. Quantitatively, Evergrande’s current liabilities of approximately $300 billion USD (2% of China’s GDP) is still less than Lehman’s $613 billion USD (4% of US GDP in 08’). In addition, the Lehman liabilities were far more entangled in the less regulated and transparent subprime MBS and derivatives markets at the time. The current Chinese property development sector is healthy and almost 30% of national GDP yet only represents 8% of total
Chinese authorities, regulators, and the Peo ple’s Bank of China (PBoC) “ -
Aerial view of Evergrande multifamily properties in Kunming, China Chinese financial sector assets. This distribution suggests that contagion will be less systemic than Lehman, only moderately connected to the financial sector, and at worst limited to within China. in turn restructure China’s credit market system. The situation is currently monitored by watching Evergrande make coupon payments, scramble to sell off its assets including executive aircrafts, and observing any changes in property sector slowdowns that may influence headline economic growth. While resolving credit market contagion may be financially disruptive in the short term, Chinese regulators are also deciding how to best eliminate moral hazard. To do so, it would require a major repricing of credit and corresponding reallocations of credit risk portfolios, since historical loan and bond portfolios have been built off political perceptions. Another possible reason for the delay is the divide between Xi Jinping’s agenda and internal party elites who have different ideas about how to best manage highly indebted property developers. For example, the party elite blockage of Xi’s proposed national real estate property tax represents a divide in CCP intervention strategies. In order to establish a more egalitarian China, Xi’s “common prosperity” drive has pushed for reducing housing prices and increasing the costs of real estate speculation to help middle-class families. Meanwhile, party elites are concerned that they themselves cannot afford additional taxes and that an overconcentration of household wealth in real estate may make homeowners feel their wealth has declined, reducing their willingness to consume goods. These concerns are exacerbated by Covid restrictions and related supply chain disruptions, which are leading to downward pressure on
China.
The delay in bailing out Evergrande primarily stems from the CCP trying to teach overleveraged real estate companies a lesson and
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China Residential Prices, Index 2010=100 (FRED) household consumption and China’s import market. Nevertheless, approaching a potential 3rd term of office, President Xi has called Evergrande a major “challenge” that would impact his reputation if not managed. Some economists have argued that real estate defines modern China more than any other market. This is especially true given that the property sector contributes just under a third of Chinese economic output and GDP growth is a major metric for continued political legitimacy of Xi’s party state. Further, China’s official debt to GDP ratio has soared by nearly 45 percent in the last five years, which proves that achieving politically determined GDP growth requires some continuation of moral hazard. Whenever its high-quality growth slows down, Beijing uses its “residual” GDP growth targets or its lower quality activities like property based malinvestment to boost its numbers. It doesn’t seem that China is ready to fully accept lower and healthier GDP growth rates or is fully committed to stabilizing its debt growth in the short term. Therefore, Xi’s focus on “common prosperity” initiatives in the property sector may eventually have to take the back seat to make way for flexible, pro-growth monetary tools that align with China’s eventual easing strategies. Alternatively, a “dual track system” of affordable
housing provided by state owned enterprises is another less controversial approach. Improving the macro conditions of China’s real estate sector and improving broader financial stability will require an entire party effort and cannot fully be accomplished in advance of the next party election. Thus, President Xi may need to relax his cult of personality that criticizes “excessive capitalist behavior” and instead focus on muting potential domestic and international contagion channels. Expected next steps for regulators and Chinese authorities to reduce any contagion in economic, credit, or market channels may include slight policy tweaks rather than full easing. Firstly, one strategy is to grant a longer transition period for developers to meet the “three red lines” of debt reduction, which include more flexible limits on its debt to asset, debt to equity, and cash to short term debt ratios. Secondly, authorities that control the closed Chinese financial system can pressure banks and other institutional
creditors to extend loan repayments. Thirdly, local governments can invest in rental properties and government backed housing while relaxing policies related to price controls or land supply. As a complicated last resort, some Evergrande executives have expressed open-mindedness in allowing local governments and state-owned developers to overtake the group’s operations on a “region by region” basis. In a similar vein, sharing a government plan before any Evergrande credit event would help mitigate contagion worries for foreign investors. The government has remained silent since it anticipates a largely muted spillover effect in non-property sectors of the Chinese economy and a tactical preference to act rather than release statements. One example of this is using broader PBoC monetary policy tools like a cut in the required reserve ratio or adding short term cash, but these should not be as frequent given Beijing’s higher recent tolerance for economic slowdowns. Another example is forcing Evergrande to sell its stake in Shengjing Bank, a state-owned asset management company. While these actions are productive in reducing short term domestic contagion worries, they are not as effective in reassuring investor confidence in offshore markets that liquidity is returning to normal levels. Instead, a government plan can help communicate to foreign investors that consumer confidence and home buying intentions are stabilizing despite the continued pressure on weak developers. In parallel, a well-constructed plan can reassure that the structural underpinnings of the real estate market are in place and slowing Chinese growth is more related to Covid outbreaks, the ongoing energy crisis, and other supply bottlenecks. While global investors continue to offload high yield-bonds issued by these cashstrapped developers, it is important to remember that while property policy easing may take time, further tightening is unlikely now. The liquidity position of current developers including Evergrande will be the best determinant of how bonds price and trade, especially considering the minimal policy adjustments to be made through the end of this year. Fortunately, domestic spillover has also been relatively contained as PBoC liquidity tools continue to reassure Asian investors that a sound debt restructuring can occur. However, local banks will be first in line for repayment as they continue to fund real estate growth, along with other Chinese creditors before addressing foreign creditors’ needs and concerns. Paying attention to any lawsuits from these foreign creditors or equity and bondholders suffering immense financial losses will be another sign of measured risk when investing in China.
