China’s Evergrande Collapse Is Spreading

China real estate developer Evergrande, facing default, is now expected to restructure its debt. Evergrande has hired debt restructuring advisers, its offshore bonds trade around 30 cents, and market convention (as of this week) is to trade the bonds “flat” (i.e., without accrued interest, meaning the market no longer thinks that staying current is a safe assumption). The situation appears likely to get worse, moreover, as the true scope of the company’s liabilities are discovered (cash or liabilities passed through wealth-management products organized by Evergrande is the latest one), in what has become a standard phase of Chinese (and to be fair, many other nations’) workouts. However, as we’ve been noting, Evergrande is no longer the only issue at this stage. The issue now is the Chinese property sector.

China Property Sector Bonds Showing the First Cracks

Our immediate concern remains contagion to other property sector bonds. As we argued in our latest monthly commentary, Setup for a Setback, the proximate problem was all the other Chinese property bonds that were not reflecting Evergrande risks. Almost all other offshore property bonds were trading at par/100 cents at the end of August. Our concern was very narrow and game-theoretic – why own a bond at par when Evergrande is telling you 70 cent losses, or more, are possible? We highlighted low-rated Kaisa bonds and high-rated Country Garden bonds as ones to watch (and we’d add that low-rated Fantasia will be another bellwether).

Those other bonds have finally begun to get hit in the past few days, but we think this is just starting. The chart below shows Evergrande bonds against those of some key issuers in the property sector as of September 16. (The chart looks a lot worse now than it did in our commentary, but there’s more to go, in our view.)

Evergrande Leading China’s Property Bonds Down

Evergrande vs Peers - Bond Price Chart

Source: Bloomberg, VanEck. Data as of 9/16/2021.

Contagion to China’s Property Sector via Prices

Prior to its default, Evergrande was quite serious in trying to adhere to government policy, in particular the “three red lines” limiting leverage. In fact, Evergrande just recently crossed one of those lines into positive territory. Evergrande was also very focused on raising liquidity to avoid default. In particular, Evergrande lowered property prices (perhaps by around 15%) in order to generate sales.¹ It also tried to sell a large commercial property in Hong Kong. But it was eventually prevented from doing so by, it appears, the Chinese government.² In any case, we are only making another simple game-theoretic point almost identical to the point we made about bond prices earlier in the crisis. Property companies are likely to respond to these lower real estate prices by lowering prices. The same logic would seem to apply to homeowners. Additionally, anyone who was thinking of selling a large commercial property is now aware that there may come a point when they’re prevented from doing so, obviously pressuring current pricing.

China’s Economy Was Already Tilting Down

China led global growth out of the pandemic, and was already sending weaker signals before Evergrande hit. The below chart shows that China’s PMIs were weak and risked leading the world to a slowdown. (In our commentary, we also noted that a lot of the data internal to the PMIs pointed to sustained weakness.) Anyway, risks from the property sector are adverse for Chinese growth and, given China’s growth-leadership, will have implications for global growth. This is happening at a time when markets are closely scrutinizing Chinese and global growth data for any signs of a turn.

China’s Economy Sent Weaker Signals Prior to Evergrande

Composite PMIs in China, US, and Eurozone

Source: Bloomberg

China Isn’t Optimizing for Markets or Growth

From the new change in policy tone, a safe conclusion is that China isn’t optimizing for markets or growth. We don’t need to inform you that the thrust of China’s economic policy seems to have changed, perhaps dramatically. From tutoring to gambling rules, Chinese policy is asserting itself as the key driver of market outcomes—and the thrust of the policy message is that market outcomes are not what are being optimized. Among China’s goals are greater sharing of prosperity and…more affordable housing. We’re not sure that the developments market participants care about, such as asset prices, figure significantly in this worldview.

Government to the Rescue?

We see no evidence that the local government, which is essentially representing central government policy, is focused on any “rescue”. In fact, the government appears to have prevented the sale of a key asset contemplated by Evergrande, when the company was focused on raising liquidity and avoiding default. As noted above, when Evergrande was busy consolidating businesses, trying to sell assets, avoiding default, and making progress on regulators’ “three red lines”, it tried to sell a major commercial building in Hong Kong.³ The government, however, ended up preventing the sale. In other words, the government’s priority is something else. What might that be? We’d suggest the fact that Evergrande needs to complete around 800,000 to 1,000,000 housing units, and their construction and payables are the government’s priority. Put simply, offshore and other bondholders are not the key focus right now, and given the newness of major Chinese bankruptcies, where bondholders stand in the queue is completely unclear, in our view.

China Strengths Don’t All Map Positively

China’s corporates have a lot of debt. China’s government does not. As a result, figuring out which corporate entities will be backed by the government (and when) has always been a question looming in the background. With Evergrande, it is now in the foreground. And what we hear a lot is that the government will eventually step in to “save” Evergrande and/or prevent further contagion.

We disagree, as argued above. In fact, Chinese policy has already involved government taking over key decisions and allowing the restructuring to proceed. And, because government backing is now in the foreground of bond pricing, we think all bonds in the property sector need to reflect a risk that government doesn’t step in. Our only game-theoretic point is that 100 cents (or even 90 cents) pricing for Chinese corporate bonds does not reflect the coin flip that many of them are becoming.

Contagion to Finance Not the Obvious Channel

Now, the Chinese government also basically owns its banks. As a result, a typical contagion event into the financial system can be mitigated. It is likely that the authorities will ensure that whatever combination of bank forbearance is used (from write-downs to term-outs), bank financing will not be an obvious weak spot. Especially because the Chinese authorities seem to have been able to protect the banking system’s massive deposits from escaping, and certainly from escaping into dollars. At least so far. As a result, we would not at all be surprised by support for the banking system. But don’t confuse such support with support for the property sector, which is still in play.

External Contagion – i.e., a Currency Adjustment – Is a Real Scenario

Chinese currency weakness is a bigger risk than realized, though it will materialize over months and quarters, in our view. Here’s the case: Isn’t it reasonable to assume that China’s capital account is not going to be conducting the normal amount of USD into China’s financial assets? Further, isn’t it reasonable to see a global economic slowdown limiting the normal amount of USD into the Chinese economy for its exported goods? The only real solution to this setup is a weaker currency. The great thing about this scenario is that nobody seems to expect it. And CNY is up 10% in the past two years.

Chinese Currency Weakness on the Way?

CNY and China's Balance of Payments

Source: HSBC; Bloomberg LP. As of Sept 2021.