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Evergrande: the canary in the coal mine
Evergrande is emblematic of the breakneck pace of China’s urbanisation and GDP growth, fuelled by excessive leverage. But the property developer’s possible default will not be China’s Lehman Brothers’ moment and it will not present a systemic financial risk to global markets. It is more appropriate to consider Evergrande as an early symptom, rather than the cause, of a much deeper problem in China’s housing market; as the canary in the coal mine for a possible Chinese housing recession.
The Evergrande crisis can be ring-fenced because the Chinese government has control over all principal actors and can intervene to manage the restructuring of the assets and liabilities directly.
But it will be a headache for the Chinese government for years to come. China’s property sector represents approximately 29% of national GDP and has been an engine of China’s meteoric economic growth and employment over the last two decades. In 2020, the property sector was valued at $52 trillion, according to a 2019 estimate by Goldman Sachs, which represents approximately four times its national GDP and is twice as large as the US real estate market.
A decline in China’s property sales and prices will significantly impact future housing demand and China’s growth, accelerating a slowdown in national GDP, employment, Chinese middle-class wealth, and, from an international perspective, China’s cross-border capital flows.
Evergrande is China’s second-largest property developer by sales and the world’s most indebted company with has amassed $355 billion of assets across 1,300 developments in 280 cities. The company’s sprawling empire has interests in electric vehicles, theme parks, insurance, bottled water, and even a football team and stadium, all financed by more than $300 billion in debt, with as much as $26.6 billion due over the four years to the end of 2025.
Evergrande has been on the People’s Bank of China’s (PBOC) watchlist since 2018 after failing the central bank’s “three red lines” requirements for real estate companies, designed to curb borrowing and improve financial health in its property sector. These are:
- 70% limit on ratio of liabilities to assets.
- Maintain a net gearing (net debt to equity) cap of less than 100%.
- Cash to short-term debt ratio of at least 1.
Consequently, Evergrande has been restricted from further borrowing, which has exacerbated its liquidity crisis. In recent weeks, Evergrande stopped paying employees and suppliers, which prompted protests, sparking social unrest.
In the last week, Evergrande made coupon payments of $19m due on an onshore bond, but offshore bond payments have been missed, while the property developer’s efforts to raise cash appear to be stalling. The latest roadblock is the breakdown in negotiations with Hopson Development for the sale a 51% controlling stake sale of Evergrande Property Services Group, , worth $5.1 billion, reportedly due to failure to win sufficient shareholder approval. Evergrande’s first 30-days’ grace period to avoid a default on certain of its US dollar-denominated bonds (due to a missed coupon payment) is Saturday (23 October), although not being a business day, the payment of $83.5m is due to be paid on 25 October.
It has been reported by Chinese state media today that the payment will be made to avoid a default. This is likely to have been motivated by a desire to avoid cross-defaults and further legal action that might hinder the basis for a restructuring proposal later in 2021.
Yi Gang, the PBOC Governor, insisted last week that the central bank “can contain the Evergrande risk”. The strategy was first to contain spread within the property sector; and secondly within the financial sector. But the reality is China’s housing market is strewn with over-leveraged property players. Evidence is starting to mount.
Fantasia Holdings, a small Chinese developer, chose to default on a $205.7 million US dollar-denominated bond payment earlier this month. But unlike Evergrande, Fantasia had enough liquidity to make bond payments, but chose not to. It is speculated this optional default was to comply with China’s “three red lines” requirements. Put another way, China’s regulations and the current spotlight on the sector left Fantasia without motivation to meet its offshore bond payments. The markets response was a savage sell-off in dollar-denominated high-yield bonds, as investors speculated that Fantasia’s peer group may follow suit and default. These developments increase the possibility of an accelerated Evergrande restructuring.
What will an Evergrande restructuring look like?
The priority will be to carve out the assets of crucial importance to the stability of the housing sector and the wealth of the Chinese middle class; specifically, the undelivered residential development schemes.
The Chinese government will insist on a strict liability priority is followed for Evergrande stakeholders. First in line to be made whole will be homebuyers who bought undelivered homes. Evergrande sold approximately 1.6m million flats to Chinese homebuyers, which have yet to be delivered, financed by mortgages likely extended by the same domestic banks that also finance Evergrande. The Chinese middle class has a high proportion of their wealth in the housing market (some estimates suggest as much as 70%).
Second, domestic developers (i.e., a large proportion of small developers’ revenues is reliant on Evergrande and are at risk of failure if Evergrande defaults on payments) and appliance manufacturers (e.g., suppliers of kitchens, air conditioning units and bathrooms). Many of these suppliers are small and count Evergrande as its most important client; therefore, failure to make payments could pose a systemic risk to their ongoing viability.
The third-tier of Evergrande stakeholders are China’s onshore bank and bond investors. Last week, Evergrande confirmed the sale of a stake in Shengjing Bank, one of the developer’s principal lenders, for $1.5 billion to the Shengjing local government to repay debts to the bank. International US dollar-denominated bond investors are probably a distant fourth in the creditor repayment priority. There are no derivatives based on Evergrande debt, which removes one additional complication. Still, China’s housing market, the Evergrande supply chain, banks, bondholders and stockholders will all suffer to varying extents, which will weigh on employment and national GDP.
In the secondary debt markets, Evergrande’s US-denominated debt has sold to many well-known distressed/opportunistic debt investors in recent weeks. They are betting that, while they are likely towards the back of the creditor line, eventual recoveries will be higher than their discounted firesale purchase price. Offshore bondholders are waiting for restructuring proposals, while they are unmistakably structurally subordinated, China may have an incentive to accelerate negotiations.
Offshore bondholders: last in line but liquidity needed
Evergrande’s missed bond payments, and now Fantasia’s voluntary default, has pushed up yields and spiked implied borrowing costs across the Chinese property sector. It risks creating a self-fulfilling prophecy in which Chinese property firms struggle to refinance because they are no longer able to tap the offshore bond market and rollover existing bond maturities.
Until a recovery in housing pre-sales emerges, offshore bond markets will be unwilling to underwrite new bond issuances, paving the way for a wave of defaults at maturity to come. China’s banks and domestic bond market will unlikely be able to plug the liquidity gap, as the domestic financing market is trying to deleverage from an overextended housing sector. The sector’s refinancing wall is the clock the Chinese government must race to beat. Thus, while offshore bondholders are last in line, they are also needed but will only be likely to risk further investment in the sector if the yields offered appreciably increase to reflect the now greatly increased credit risk.