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China Evergrande, What’s the Story? 

Luke Sheather
Luke Sheather
Posted 23.09.2021 in Industry Updates
The developing story around China Evergrande has been topical within the news landscape, and we take this opportunity to share the background and our insights into how this will impact investments.

China Evergrande Group is the second-largest property developer in the world and the most indebted. They have over $US 300 billion of debt owing to more than 70,000 investors worldwide. They also have 778 projects spanning 223 cities, 160,000 employees and an estimated 3.8 million jobs tied to its activities. They are in every aspect, a ‘whale’ in the property world.

What’s the issue and how did this occur?

Throughout the course of the year, China’s President, Xi Jinping, has led a regulatory crackdown across several local sectors including property, technology, and education. Xi’s vision for China is “Common Prosperity” and as it relates to the property sector, the objective is to make housing and land more affordable for its lower middle class. Additionally, China’s chief banking regulator last year identified the banks’ excessive exposure to the property market as the biggest risk facing the financial system.

To both cool the market and curtail risk, China has recently tightened mortgage approvals, raised rates for first-time buyers, introduced rental controls, suspended centralised land sales and is reconsidering a national property tax.

The government also recently drafted what is known as the “three red lines”; three financial debt metrics that property developers must adhere to if they want to borrow more or refinance. Unfortunately, in Evergrande’s case, it is in breach of all three red lines.

As a result of the measures taken, China’s property market has been in decline. Data last week showed home sales by value slumped 20% in August from a year earlier. Given Evergrande’s significant balance sheet exposure to the property market and its inability to refinance its loans to terms it was once accustomed to, the property developer now faces the very real prospect of defaulting on its borrowings. This week it is due to pay roughly $US 120 million in interest payments with only a fraction of that amount available in cash holdings.

What are the implications on markets?

An Evergrande collapse would likely have repercussions across the whole Chinese economy but particularly its property and credit markets. Debt recovery efforts by creditors (those that are owed by Evergrande) would lead to a fire sale of assets and properties, which would collapse prices further and all businesses across the property supply chain (including Australia’s iron ore producers) would be adversely impacted. Perceived credit risk would also heighten, which would see credit spreads widen and the value of corporate bond investments reduced.

The risk of a worst-case scenario where Evergrande-related stress spreads across the world’s financial system has also triggered some panic selling across capital markets globally this week.

How might this play out?

There are two alternatives for Evergrande – bankruptcy or a government-directed restructuring, with the latter being the most probable.

China’s banking sector is almost entirely state-owned and therefore they can swiftly intervene and issue an order to bail Evergrande out at any time. In this instance, China’s ability to turn on a dime is a big positive and should hopefully limit the systemic impact of Evergrande’s failure.

However, no public assurances of such a plan have been made just yet, as China might be looking to make an example of Evergrande to reduce debt levels in the sector going forward.

Given the property sector contributes 29% of its GDP, China will be striving to find a happy medium between pursuing its regulatory crackdown whilst maintaining its economic growth trajectory.

A final word

The low-interest rate era still has a while to run yet, and this is unlikely to be the last major insolvency we see over the next few years.  As other countries around the world look to alleviate risk and tighten lending standards, companies that have been taking advantage of cheap debt and leveraging up to the brink will be most at risk.

For investors, a diversified investment strategy across all regions, sectors and asset classes is ever-important in mitigating the risk of these isolated company failures.

 

Enjoy this article? Read Luke’s August Market Update here

Luke Sheather
Luke Sheather
Luke Sheather
As Capital Partners Investment Specialist, Luke does far more than simply identifying and recommending investments, Luke sees it as his role to help clients contemplate and answer life’s big questions.

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