Investment Strategy Insights: Gauging Evergrande’s Spillover Effects

While the risk is palpable, we do not view China Evergrande’s debt-repayment problems as a threat to the global financial system. Comparisons to a “Lehman moment” overlook that then-Treasury Secretary Paulson decided to let Lehman Brothers go. China, on the other hand, has decided to actively steer Evergrande’s resolution, and the company’s $300 billion of unpaid debt must also be put in perspective: It amounts to only about 1% of all bank assets in China, and its holders outside China are relatively few.

Still, as a major residential developer in a nation where real estate and construction account for about 25% of GDP, Evergrande and its debt resolution will be watched closely – and will likely proceed along distinctly non-Western lines. Retail investors in Evergrande’s development projects are likely to take first priority, with construction workers employed by these projects coming in second, domestic debt holders third, and overseas investors in offshore debt last.

Only since 2014 has China gradually introduced the concept of default to its corporate debt system. The rules are still opaque, with the government trying to teach the markets to study the nature of the business behind the debt, and not to look for a government entity to back it – essentially, ‘Never letting a good crisis go to waste.’ While the visible hand of the government directs this orderly winddown, the People’s Bank of China (PBOC) will likely foam the runway by adding extensive liquidity into the system to ensure a margin of safety.

On the ground, where hundreds of Evergrande residential projects are stalled, state-owned enterprises with access to capital will be nudged to take over the remaining work, pay contractors, and sell the properties – at or above the government-declared minimums put in place to mitigate threats to the 40% of bank assets backed by real estate in some form. The solution will involve directing sufficient patience and liquidity to finish Evergrande’s projects, gradually selling its real estate (and most of Evergrande), while using the proceeds to make small investors and workers whole and only then retiring debt at a haircut.

The government, which is effectively subcontracting the winding down of Evergrande to provincial officials, is guided by several objectives: first, to contain the economic fallout; second, to punish Evergrande for failing to heed earlier warnings to deleverage; and third, to teach debt holders to evaluate the credit itself, instead of looking for backers. The government also wants to ensure that wealthy speculators who drove demand for Evergrande apartments bear their share of the pain while sparing those who made down payments on apartments they intended to live in. They would also like to slowly shrink the role of real estate in the economy and redirect China’s large savings into more productive investments; these include technology, clean energy, education, and other areas that will enhance China’s international competitiveness and further President’s Xi’s goal of “common prosperity.”

So far, outside the property sector, which investors are avoiding, we’ve observed minimal negative spillover effects on Chinese credit, which has seen only mild spread widening. Positive flows continue into China’s government debt, non-property credit, and equity markets. If Evergrande’s unwinding hastens government efforts to shrink the real estate sector, a decline in construction would slow China’s economy during the period while a transition is attempted elsewhere, while spilling over to the metals and materials sectors globally.

Critically, the extent of spillover from China’s slowing on regulatory sentiment is still not knowable. Before the Evergrande crisis, the government had been tightening regulations on industries it believed had demonstrated capitalistic excesses. That process has been on hold as Evergrande moves through dangerous territory. Whether heightened regulation resumes once Evergrande’s problems are resolved remains the biggest question mark.