Evergrande is just a fraction of the financial system, so the bigger implications will depend on the broader real estate sector and policy response.
Concerns are rising as Evergrande, China’s most indebted developer, moves towards insolvency.
As we enter the final stage of its default/restructuring endgame, clients are increasingly concerned about risks – market contagion, systemic financial, and macro – that could result from a messy outcome.
This saga has become a defining theme for the risk off sentiment in markets lately.
How big is the Evergrande issue? On its own, Evergrande’s total loan exposure is a very small fraction, more than 1% of system-wide loans. Its amount of outstanding USD bonds is around 2% of the total offshore USD bond market in Hong Kong.
But the company is amongst the more aggressive developers in China, and has ramped up debt quickly over the last decade. Its margins were thinner than average, and even depressed coming into this year.
As a result of its fast expansion, it is the largest high yield bond issuer, and accounts for around 4% of the Asia high yield index. It also has an extensive network of suppliers, customers, that may be impacted.
The company’s overall liabilities (including pre-sale obligations) are around USD300bn, 75% of which are due in the next 12 months.
While the problem around Evergrande originated from its over-levered business model, it was brought in focus by the tightening of regulations.
So while Evergrande may be unique in one respect – it is more leveraged than most for example – it is not the only company that is coming under regulatory pressure.
When the government rolled out the so called three red line policies last year, Evergrande was amongst the companies that faced the toughest deleveraging tasks ahead.
Subsequently, other backdoor financing options were discovered by regulators and stopped, and the overall land auction system also tightened. Banking sector loan standards were raised as well.
So in a way Evergrande is emblematic of a broader issue. So potentially the size of the market that gets impacted could get larger. This is a potential situation that bears close monitoring, in our view.
From a macro perspective, the Evergrande will put more pressure on the sector to de-leverage and lead to more consolidation. As the property market cycle has already turned, we think both sales growth and investment growth will slow further in the coming months.
And in combination with a slower recovery in domestic demand (due to Delta clusters), overall growth could see more downside in the next few quarters.
The silver lining is that policy easing is now becoming more likely, and we expect both monetary and fiscal policy to ease.
While some banks certainly have a higher exposure to the sector and at-risk developers, the overall banking sector risk should be manageable.
As we have learnt from earlier episodes of how regulators dealt with Baoshang, they will act decisively to support banking sector stability, and may indeed, even pre-emptively inject liquidity.
From an investment perspective, we recommend a cautious stance on the sector given uncertainty is still high. In equities, we prefer sectors with policy tailwinds such as clean energy, electric vehicles, and automation.
We like A shares over H shares. In fixed income, we recommend diversifying away from single company exposure through investment in funds or broad credit indices. We are still constructive on China Government Bonds. Concerns are rising as Evergrande, China’s most indebted developer, moves towards insolvency.
As we enter the final stage of its default/restructuring endgame, clients are increasingly concerned about risks – market contagion, systemic financial, and macro – that could result from a messy outcome.
This saga has become a defining theme for the risk off sentiment in markets lately.
How big is the Evergrande issue? On its own, Evergrande’s total loan exposure is a very small fraction, more than 1% of system-wide loans. Its amount of outstanding USD bonds is around 2% of the total offshore USD bond market in Hong Kong.
But the company is amongst the more aggressive developers in China, and has ramped up debt quickly over the last decade. Its margins were thinner than average, and even depressed coming into this year.
As a result of its fast expansion, it is the largest high yield bond issuer, and accounts for around 4% of the Asia high yield index. It also has an extensive network of suppliers, customers, that may be impacted.
The company’s overall liabilities (including pre-sale obligations) are around USD300bn, 75% of which are due in the next 12 months.
While the problem around Evergrande originated from its over-levered business model, it was brought in focus by the tightening of regulations.
So while Evergrande may be unique in one respect – it is more leveraged than most for example – it is not the only company that is coming under regulatory pressure.
When the government rolled out the so called three red line policies last year, Evergrande was amongst the companies that faced the toughest deleveraging tasks ahead.
Subsequently, other backdoor financing options were discovered by regulators and stopped, and the overall land auction system also tightened. Banking sector loan standards were raised as well.
So in a way Evergrande is emblematic of a broader issue. So potentially the size of the market that gets impacted could get larger. This is a potential situation that bears close monitoring, in our view.
From a macro perspective, the Evergrande will put more pressure on the sector to de-leverage and lead to more consolidation. As the property market cycle has already turned, we think both sales growth and investment growth will slow further in the coming months.
And in combination with a slower recovery in domestic demand (due to Delta clusters), overall growth could see more downside in the next few quarters.
The silver lining is that policy easing is now becoming more likely, and we expect both monetary and fiscal policy to ease.
While some banks certainly have a higher exposure to the sector and at-risk developers, the overall banking sector risk should be manageable.
As we have learnt from earlier episodes of how regulators dealt with Baoshang, they will act decisively to support banking sector stability, and may indeed, even pre-emptively inject liquidity.
From an investment perspective, we recommend a cautious stance on the sector given uncertainty is still high. In equities, we prefer sectors with policy tailwinds such as clean energy, electric vehicles, and automation.
We like A shares over H shares. In fixed income, we recommend diversifying away from single company exposure through investment in funds or broad credit indices. We are still constructive on China Government Bonds.
As we enter the final stage of its default/restructuring endgame, clients are increasingly concerned about risks – market contagion, systemic financial, and macro – that could result from a messy outcome.
This saga has become a defining theme for the risk off sentiment in markets lately.
How big is the Evergrande issue? On its own, Evergrande’s total loan exposure is a very small fraction, more than 1% of system-wide loans. Its amount of outstanding USD bonds is around 2% of the total offshore USD bond market in Hong Kong.
But the company is amongst the more aggressive developers in China, and has ramped up debt quickly over the last decade. Its margins were thinner than average, and even depressed coming into this year.
As a result of its fast expansion, it is the largest high yield bond issuer, and accounts for around 4% of the Asia high yield index. It also has an extensive network of suppliers, customers, that may be impacted.
The company’s overall liabilities (including pre-sale obligations) are around USD300bn, 75% of which are due in the next 12 months.
While the problem around Evergrande originated from its over-levered business model, it was brought in focus by the tightening of regulations.
So while Evergrande may be unique in one respect – it is more leveraged than most for example – it is not the only company that is coming under regulatory pressure.
When the government rolled out the so called three red line policies last year, Evergrande was amongst the companies that faced the toughest deleveraging tasks ahead.
Subsequently, other backdoor financing options were discovered by regulators and stopped, and the overall land auction system also tightened. Banking sector loan standards were raised as well.
So in a way Evergrande is emblematic of a broader issue. So potentially the size of the market that gets impacted could get larger. This is a potential situation that bears close monitoring, in our view.
From a macro perspective, the Evergrande will put more pressure on the sector to de-leverage and lead to more consolidation. As the property market cycle has already turned, we think both sales growth and investment growth will slow further in the coming months.
And in combination with a slower recovery in domestic demand (due to Delta clusters), overall growth could see more downside in the next few quarters.
The silver lining is that policy easing is now becoming more likely, and we expect both monetary and fiscal policy to ease.
While some banks certainly have a higher exposure to the sector and at-risk developers, the overall banking sector risk should be manageable.
As we have learnt from earlier episodes of how regulators dealt with Baoshang, they will act decisively to support banking sector stability, and may indeed, even pre-emptively inject liquidity.
From an investment perspective, we recommend a cautious stance on the sector given uncertainty is still high. In equities, we prefer sectors with policy tailwinds such as clean energy, electric vehicles, and automation.
We like A shares over H shares. In fixed income, we recommend diversifying away from single company exposure through investment in funds or broad credit indices. We are still constructive on China Government Bonds. Concerns are rising as Evergrande, China’s most indebted developer, moves towards insolvency.
As we enter the final stage of its default/restructuring endgame, clients are increasingly concerned about risks – market contagion, systemic financial, and macro – that could result from a messy outcome.
This saga has become a defining theme for the risk off sentiment in markets lately.
How big is the Evergrande issue? On its own, Evergrande’s total loan exposure is a very small fraction, more than 1% of system-wide loans. Its amount of outstanding USD bonds is around 2% of the total offshore USD bond market in Hong Kong.
But the company is amongst the more aggressive developers in China, and has ramped up debt quickly over the last decade. Its margins were thinner than average, and even depressed coming into this year.
As a result of its fast expansion, it is the largest high yield bond issuer, and accounts for around 4% of the Asia high yield index. It also has an extensive network of suppliers, customers, that may be impacted.
The company’s overall liabilities (including pre-sale obligations) are around USD300bn, 75% of which are due in the next 12 months.
While the problem around Evergrande originated from its over-levered business model, it was brought in focus by the tightening of regulations.
So while Evergrande may be unique in one respect – it is more leveraged than most for example – it is not the only company that is coming under regulatory pressure.
When the government rolled out the so called three red line policies last year, Evergrande was amongst the companies that faced the toughest deleveraging tasks ahead.
Subsequently, other backdoor financing options were discovered by regulators and stopped, and the overall land auction system also tightened. Banking sector loan standards were raised as well.
So in a way Evergrande is emblematic of a broader issue. So potentially the size of the market that gets impacted could get larger. This is a potential situation that bears close monitoring, in our view.
From a macro perspective, the Evergrande will put more pressure on the sector to de-leverage and lead to more consolidation. As the property market cycle has already turned, we think both sales growth and investment growth will slow further in the coming months.
And in combination with a slower recovery in domestic demand (due to Delta clusters), overall growth could see more downside in the next few quarters.
The silver lining is that policy easing is now becoming more likely, and we expect both monetary and fiscal policy to ease.
While some banks certainly have a higher exposure to the sector and at-risk developers, the overall banking sector risk should be manageable.
As we have learnt from earlier episodes of how regulators dealt with Baoshang, they will act decisively to support banking sector stability, and may indeed, even pre-emptively inject liquidity.
From an investment perspective, we recommend a cautious stance on the sector given uncertainty is still high. In equities, we prefer sectors with policy tailwinds such as clean energy, electric vehicles, and automation.
We like A shares over H shares. In fixed income, we recommend diversifying away from single company exposure through investment in funds or broad credit indices. We are still constructive on China Government Bonds.
Markets have been laser-focused on Evergrande, China’s most indebted developer, as it moves towards insolvency. As we enter the final stage of its default or restructuring endgame, investors are increasingly concerned about risks - including market contagion, systemic financial, and macro – that could result from a messy outcome. And it’s not just investors; the financial media has been vigorously debating whether this is China’s “Lehman Brothers moment.” In today’s Top Market Takeaways we put Evergrande in context. On its own, Evergrande is only a small fraction of the financial system. Bigger concerns are whether other developers will also end up in a similar predicament. Regulators are closely watching the situation, and we think they will act to backstop the underlying physical housing market and the financial system, and thus forestall an overly sharp growth downturn. Nonetheless, the economy was already facing mounting headwinds, and a further slowdown is likely.
Is Evergrande unique or symptomatic of a broader issue?
Evergrande is unique in terms of its sheer increase in debt relative to its peers, but its problems highlight the risks of continued deleveraging and introduction of moral hazard within the property sector. Evergrande is China’s largest developer, with a US$350 billion balance sheet including US$300 billion in liabilities.1 Its high leverage ratio and tight liquidity meant that it was amongst the first batch of developers to come under pressure from the ‘Three Red Lines’ policy framework, which limited developers’ ability to refinance unless their leverage ratio was reduced.
While US$300 billion sounds like a lot, Chinese real estate firms as a group have US$16 trillion in total assets. That puts Evergrande at barely over 2% of the total (either in terms of assets or liabilities). If we also include the construction sector, we see another US$4 trillion, pushing the size of the broader property sector up to US$20 trillion. Evergrande is down into the ~1% range as a share of the total.
In the bond market, Evergrande has nearly US$20 billion in US dollar debt outstanding, most of which comes due over the next 24 months, and it has more than US$10 billion of local renminbi bond exposure as well. However, the total size of the Hong Kong and China corporate dollar bond market is US$1.4 trillion, which means that Evergrande is barely above 1%. Evergrande is, however, the largest high-yield issuer and accounts for 4% of the JACI non-investment grade index.2
Chinese developers as a group have increased debt faster than the rest of the economy. But Evergrande stands out with its high leverage and low margins. While the problems surrounding Evergrande originated from its over-leveraged business model, these were brought into focus by regulatory tightening. So while Evergrande may be unique – it is more leveraged than most – it is not the only company that is coming under regulatory pressure. There are also other companies that have high enough leverage to make the markets wary. So in a way, Evergrande is emblematic of a broader issue. The potential size of the market that gets impacted could get larger, making this a situation that deserves close monitoring, in our view.
Is there a risk to the banking system?
Assuming banks’ loan exposures to Evergrande are about US$80bn, how big is that in the broader context? Chinese commercial banks have total assets of US$47 trillion, including a loan book of US$30 trillion.3 Evergrande’s loans and trust loans make up less than one percent of that. J.P. Morgan Investment Bank estimates that the non-performing loans impact from Evergrande alone is small. From a broader perspective, if regulations and sector-wide weakness begin to impact a wider set of property-related companies, it becomes a more serious, but still manageable issue. According to Citi, 41% of bank system assets were directly or indirectly associated with the property sector at the end of 2020. J.P. Morgan Investment Bank estimates that bank provision levels can cover defaults on half of the real estate development loans, in a worst-case scenario. While some banks certainly have a higher exposure to the sector and at-risk developers, the overall banking sector risk should be manageable. Shadow bank and wealth management product exposures are also relatively small. Risks to this view are if banks have a higher than initially believed non-loan exposure to at-risk developers, or if broader property sector weakness causes defaults along the supply chain.
Is this China’s “Lehman” or “Minsky” or “LTCM (Long-Term Capital Management)” moment?
Not likely. First, this is not China’s first rodeo dealing with financial system risks. China is already five years past the end of its historic debt boom – and has already faced a large wave of defaults in the banking system, which are collectively far bigger than Evergrande today. China’s overall debt ratio climbed by about 100 percentage points in the decade after the global financial crisis. Much of this increase was loans to risky Local Government Financing Vehicles (LGFVs), which amounted to US$5trn by some estimates.4 This borrowing trend largely stopped in 2017 when policymakers reversed course and began to deleverage the financial system. This shift caused a rise in bad loans, leaving China’s small and medium-sized banks in particular with an overhang of non-performing assets and kicking off a five-year wave of bank workouts, restructurings and recapitalizations.
Indeed, the country is already mid-way through the ensuing bank cleanup, with dozens of restructurings completed to-date and more in the pipeline. Second, during this process, the PBOC and regulators put in place a robust set of policies specifically aimed at reducing banks’ market liability exposures and guaranteeing ample liquidity in response to shocks. Depending on the situation, the regulator tends to devise different solutions. For LGFVs, for example, Chinese banks were allowed to roll over LGFV claims on their balance sheets pending future state-sponsored workout resolutions. The interbank wealth management product boom was also brought to an end by tightened regulations.
Since 2016, the PBOC increased the number of funding channels and windows and used these tools to keep the system flush with liquidity, regardless of market shocks, as a lender of last resort. As a result, over the past five years, short-term interbank rates have been anchored at or near historic lows, and volatility has collapsed. It is likely that Chinese authorities today have no intention to let system-wide funding stresses occur, and are on hand to provide liquidity as needed.
So the overall message is that China has been cleaning up its system over the last few years, and handling several episodes of large defaults that resulted from them. While every episode is different, regulators always closely watched for spillover effects onto the financial system and were timely with liquidity support.
Is China at risk of a property crisis as seen in the US, Spain, etc.?
Many aspects of China’s property sector are different from developed market peers, making the prospect of a housing crisis less likely. While property developers have taken on ever greater amounts of leverage, households are far less leveraged, especially compared to their global peers. While household mortgage leverage ratios have risen steadily as a share of income, they have not risen on a loan-to-value basis relative to the value of housing purchased – in sharp contrast to the experience of other economies that saw housing bubbles. In the US during the period of 2000-07, the ratio of new mortgage debt as a share of housing sales increased sharply, reaching a peak of 85% before subsequently collapsing and turning negative for the next half-decade. By contrast, China’s ratio has hovered around 30% on average over the past 15 years5 – simply put, Chinese buyers have borrowed 30% and paid 70% when buying a home. On the prices and supply front, while prices in some cities have increased substantially relative to income, there does not appear to be a countrywide imbalance on a price-to-income basis. Media reports often tout the substantial excess supply of apartments, but the data does not indicate that. Following the significant increase in excess property supply in the years prior to 2015, the ratio has since normalized to a healthier level.
How will this damage economic activity and what are the risks of an extended property-led slowdown?
China’s property sector is much larger than almost every other major economy, making property one of, if not the key driver of the economic cycle. Recent research puts property’s contribution to China’s GDP at nearly 30%, including upstream and downstream linkages.6 This compares to 15% in the US and even higher than the peak reached by Spain just before the global financial crisis. The post-pandemic recovery has only enhanced such dependency, as real estate has been one of best-performing sectors since the second quarter of 2020. This dependence is one of the reasons why policymakers are aiming to reduce the overall size and influence of the sector.
Evergrande accounts for around 4% of national sales.7 The company’s unwind will likely spur faster consolidation in the entire sector. We expect both housing sales and investment growth to turn negative by the end of the year, which will put downward pressure on growth. To gauge the risk of a sharper and more extended slowdown in the housing sector, we need to watch whether policymakers will provide a backstop to the overall housing market to prevent more widespread liquidity issues, which could in turn impact sales and investment more broadly.
Since property is so central to the economy, collateral damage in terms of the impact on upstream and downstream related sectors (durable goods, materials, equipment) is possible. There are two types of transmission: first, weakness in property developers can flow through to suppliers and contractors, and it also results in lower land sales, which impacts local governments’ fiscal revenues. Second, buyers wary of project delivery, or on expectations of falling prices, could remain on the sidelines. This could further put downward pressure on prices resulting in weaker sales and funding conditions. Whether these risks materialize will depend on the policy response. It also depends on whether Evergrande, or indeed any other company runs into a similar predicament and ends up distributing the losses amongst its various creditors (employees, suppliers, banks, institutional investors, onshore and offshore creditors etc.).
What are the near-term investment implications?
While we are not expecting broad contagion due to policy actions, we expect volatility to persist and the economy to face potentially severe headwinds. We are constructive on A-shares, focusing on policy beneficiaries. We are cautious on H-shares and MSCI China in view of slowing growth and tightened regulatory policies which could put downward pressure on earnings and valuations. We continue to remain constructive on the RMB and Chinese Government Bonds (CGBs) amidst continued interest rate differentials versus developed markets and a stable currency outlook.
1 Federal Reserve as of May 22, 2013. https://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm
2 J.P. Morgan Global Index Research, as of Sept 20, 2021.
3 PBOC, National Bureau of Statistics, as of July 31, 2021.
4 PBOC, National Bureau of Statistics, as of December 31, 2020.
5 Federal Reserve, Office of Federal Housing Oversight, PBOC, National Bureau of Statistics, as of December 31, 2020.
6 https://www.nber.org/papers/w27697
7 CRIC Research, Full Year 2020 number as of January 5, 2021.
The MSCI China Index captures large and mid cap representation across China H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). The index covers about 85% of this China equity universe. Currently, the index also includes Large Cap A shares represented at 10% of their free float adjusted market capitalization
The J.P. Morgan Asia Credit Index (JACI) provides an investable and liquid benchmark by providing exposure to Asia-ex Japan region US-dollar bonds, including sovereigns, quasi-sovereigns and corporate entities. It follows a traditional market capitalization technique.
All market and economic data as of September 24, 2021 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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