Evergrande prompts China to put its house in order

Real estate activity and construction accounts officially for 14.5% of China’s gross domestic product. Even that may minimise the economic importance of the property sector. Harvard professor Kenneth Rogoff and co-author Yuanchen Yang last week doubled¹ that estimate by including indirect exposure such as financing, labour inputs and management. By this measure, the sector’s share of GDP has tripled over the past two decades, they reported, adding that China’s economy is more reliant on the property market than Spain and Ireland before the 2008 financial crisis.

China’s property market accounts for a larger share of the economy than in most other countries, and is more expensive. The ratios of median home prices to median incomes in China’s cities are as much as five times higher than European and US cities, according to cost-of-living database numbeo.com (see table). The price-to-income for Beijing and Shenzhen housing stands at 49 and 47 times respectively, more than double the ratio for Paris or London.

Evergrande’s debt

On 22 September, Evergrande said that it had reached an agreement with bondholders for a coupon payment in renminbi due the following day, worth RMB 232 million (USD 36 million). The company missed interest payments on a second ‘offshore’ coupon worth USD 84 million. With little data, the market is trading the company’s debt at a flat 25 cents to the dollar, suggesting that investors expect the company to default. 

In total, Evergrande owes dollar and renminbi-denominated bond payments worth more than USD 1 billion over the next four months, according to Bloomberg data. China’s banking limitations on lending mean that the company’s business model also depended on selling financial products and it has missed payments to retail investors worth around USD 6.2 billion. It also owes USD 1.8 billion, sold through lenders known as trusts, before the end of this year, with another USD 4 billion due in 2022. Some of these trusts either have reimbursed their institutional clients and private investors or are negotiating extensions, Bloomberg reports.

Evergrande’s problems have not surprised those watching its leveraged finance model. Ratings agencies have cut the company’s debt scores this month. Fitch, for example, downgraded the firm three notches in three steps since 22 June. The latest, on 7 September, took Evergrande from B+ a year ago, to CC and the agency wrote that “a default of some kind appears probable.”

‘Red lines’

Despite working to reduce its leverage, Evergrande has failed all three ‘red lines’ that China introduced last year to limit property developers’ risk. Under these tests, developers must maintain a liabilities-to-assets ratio of less than 70%, keep cash to cover short-term debt and have a net debt-to-equity ratio below 100%.

Still, the numbers may overstate the risks of contagion. As long as the default risks remain limited to Evergrande, China has the fiscal and monetary tools to avoid a major impact.

In July the People’s Bank of China cut the amount of cash that banks have to hold in reserve, known as the ‘reserve ratio requirement’ (RRR). If the country’s growth does slow, the central bank can further ease policy through another RRR cut in the last quarter of this year.

Local governments already planned to ramp-up bond issuance in the coming months and last week, the PBoC injected RMB 460 billion of cash into the country’s banking system, ensuring that financial markets continued to function. The Shanghai stock exchange dismissed the week’s earlier contagion fears to close 0.3% higher on 24 September and the Chinese government’s benchmark 10-year bond yielded 2.88%, from a peak of more than 3.3% this year.

China’s political priority will be to make sure that the firm’s customers eventually see their homes built with local authorities managing the contracts through other developers. In the meantime, equity and fixed income investors on the other hand, will have to shoulder their losses.

That would be in line with the government’s ambition to discourage risky behaviour or moral hazard, and its efforts to reform bankruptcy rules, restructure inefficient companies and let them default. It has also engaged in a regulatory crackdown on technology firms and last week the PBoC outlawed cryptocurrencies.

Building on growth

China’s regulatory and credit tightening will translate into some slightly weaker full-year economic growth, led by the property sector. GDP for 2021 should be around 8.5%, although the third quarter will undoubtedly experience low or even zero growth. Next year, we expect China to post growth of 5.6%, in line with its longer-term average. The Chinese economy is adapting as it shifts to domestic-driven demand, slowly peaking urbanisation and an ageing working population.

Our portfolio positioning favours renminbi-denominated government bonds. Given that the Chinese property sector has looked fragile for some time, we have avoided vulnerable, high yield names. We increased our exposure to Chinese equities in August after their underperformance year-to-date, bringing our portfolio position to neutral. The Chinese currency should hold its value as most sovereign debt is financed in renminbi with high reserves of foreign currency. China’s current account balance, along with foreign direct investment and portfolio flows, remain strong, underpinning the renminbi in the medium term. We see the Chinese currency trading around 6.45 against the dollar by the end of this year, and 6.35 per USD by the end of 2022.

We also continue to watch for any signs of onshore, or offshore, contagion. Specifically, we look at the health of the Chinese high yield market, where almost two-thirds of credit is tied to real estate, much of it trading at distressed values. In contrast, dollar-denominated investment grade fixed income continues to trade with no signs of contagion.

In time, China is positioned to stave-off the worst of the Evergrande fallout. Furthermore, by stamping out the worst excesses of leveraging practices, overall, we believe that this is a necessary evolution of the Chinese economic model.

¹ https://voxeu.org/article/can-china-s-outsized-real-estate-sector-amplify-delta-induced-slowdown

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