The fallout of China Evergrande’s imminent credit event will be felt far and wide across the global financial markets for months to come and is likely to raise questions about investing in China’s fixed income market.
Before Evergrande, there was the debt debacle earlier this year of China Huarong, a state-owned enterprise. The difference today is that Evergrande is more entrenched in the Chinese economy and is less likely to get direct government support for its debt troubles. Despite its seemingly “too big to fail” scale, we expect the government to focus on coordinating an orderly restructuring resolution of the company, instead of offering direct support.
However, until more concrete government action plans are seen by the broader market, we expect financial markets to continue to be under pressure as a higher systemic risk premium is built-in in the short term given the unprecedented scale and complexity.
Will there be systemic risk?
With Evergrande’s size and broad linkages in the Chinese economy, the question of how much systemic risk the company poses has been top of mind for investors. However, we believe authorities can and will intervene to prevent spillovers to the broader property market and financial system to avoid systemic risk. We also believe the government has sufficient policy tools to minimize the impact.
Evergrande’s total interest-bearing debts amounted to approximately 0.36% of total banking system loans. And even if trade payables are included as debts, they account for less than 1% of the banking system’s loans. Hence, the direct impact to the banking system is very limited, although some banks, such as smaller regional banks, may have relatively larger exposures to the company. Evergrande’s US dollar-denominated bonds amount to approximately US$19 billion or 5.5% of the JACI High Yield Index, which has dragged performance of the asset class and will move up the default rate statistics. However, current credit spreads in Asia high yield bonds, even if we exclude Evergrande, are pricing in close to 10% implied default probability. As we do not think Evergrande will result in a systemic situation, we think the market is way too bearish.
Whither China’s property sector?
Domestically, a credit event would put pressure on the entire property sector, particularly the highly leveraged players and the banks that lent to them. In the worst-case scenario, the property market can be negatively impacted in two ways. One, it could trigger a fire sale of Evergrande’s property inventories, leading to significant downward pressure on housing prices. This, in turn, puts pressure on profitability of peers and has a negative wealth impact on homeowners. Two, the failure of the company to deliver pre-sold housing units could lead to significant loss for homebuyers and a confidence crisis in other developers. Volume and prices in the physical property market will see significant declines.
As China’s largest property developer, the scenario of Evergrande’s collapse threatens to impact numerous suppliers, individual home buyers, and employees, making for a complicated resolution process with potential for unintended social issues and contagion risks. We believe the worst-case scenario is unlikely to happen given the resulting social and economic disruption. We believe a restructuring scenario wherein homebuyer and supplier protection are the top priority is the most likely outcome. In a number of cities, Evergrande has been prohibited from selling property at prices deemed too low, citing unfair market competition. This reflects the authorities’ priority of maintaining market stability amid the policy tightening cycle. The market can also reference recent financial distress incidents involving large Chinese companies wherein government involvement in their resolutions has avoided contagion impacts.
Evergrande’s crisis should not have come as a surprise. The credit tightening bias towards the Chinese property sector has been in place for some time. For instance, since 2018, property developers could only issue offshore bonds for refinancing outstanding offshore debts. Recently, a policy called “three red lines” was introduced, which also aimed to reduce overall leverage in the sector and at the company level. The policies led to a fundamental divergence in the sector with the stronger names starting a deleveraging cycle while the weaker names faced liquidity pressure. While many property developers have sped up asset disposal, property sales, and other measures to increase cash flow or pay down debts, the market situation has deteriorated more sharply than expected for the weakest names as the property market in China continues to cool off. Besides Evergrande, a few property developers defaulted since the beginning of the year.
What happens to China’s tightening policy?
We believe policy relaxation is unlikely in the near term. It is still too early to call for the reversal of sector policy direction, given that this is just the beginning of the deceleration and property sales activity in the past year was still elevated. We also believe today’s policy makers are more determined in cooling down the sector than those in the previous cycles, as controlling the housing market is viewed to be of long term national strategic importance in terms of addressing issues such as low birth rate, systemic risk, credit allocation, and wealth inequality. That being said, if the deceleration is faster than targeted and leads to significant drag on the economy (given property’s contribution to GDP), we think at the margin policies will be fine-tuned to contain the tail risks.
Implications for investing in China’s fixed income market
In our view, the recent cases of high-profile defaults underscore our long-held belief in the need for thorough, independent credit research in fixed income investing regardless of the market involved. We continue to see opportunities in the Chinese bond market, both onshore and offshore. However, with the potential for more defaults, we cannot overemphasize the need for getting the credit analysis right, instead of relying on external credit ratings or hard-to-quantify implicit government support as the basis for an investment. In our view, the current rating methodologies by international and onshore credit rating agencies need to be revised to better reflect the intrinsic credit risk. For instance, recent central government initiatives to develop credit approaches in the onshore credit rating process should help improve the quality of credit ratings.
In short, as China continues to undergo policy and market reforms and push forward market liberalization, including foreign access to onshore capital markets, international investors should consider partnering with asset managers that have strong on-the-ground capability to help navigate this huge, complex, but potentially alpha-rich market.