Evergrande on its own is unlikely to cause a financial crisis. Last week’s news that the Chinese government has informed banks that the firm would not be making a loan interest payment this week is a sign that the government are utilising tools to stem global economic fallout.
Although many banks have exposure to China, only Minsheng bank has any meaningful exposure, with Evergrande comprising 10.6% of its total loan book. Nevertheless, NPLs are still low for Chinese banks at somewhere between 1-2% depending on the bank and NPL coverage is high. However, if the government opts not to use tools to engineer a soft landing for Evergrande – e.g., the government does not step in to ensure that the estimated 1.6 million homes paid for but not yet delivered are built – then there could be a crisis. These things usually take form in a loss of confidence, which triggers a so-called “run on the bank” – customers go to reclaim their money all at the same time, creating a vicious cycle. But the government will look to avoid mass hysteria and try to calm consumers before this happens.
The most recent cracks started to show over a year ago when the “Three Red Lines” were informally introduced and Evergrande was shown to have failed all three of them – amongst others. That applied pressure on the company to de-leverage. At the same time, China has introduced a series of policies to achieve a theme of “common prosperity”, that is to enlarge the middle class at the expense of the ultra-wealthy by lifting up the lower class. The property sector was ensnared in this, with new policies introduced to curb price inflation, slow building growth, and ensure that builders have strong balance sheets.
This has seen the implementation of a series of broad-based and profound changes that could reshape China’s private sector – starting with tech, and not limited to other sectors such as education, property, healthcare, and now gaming (in Macau). There are execution risks to these changes and there will be casualties along the way. However, China is uniquely positioned to quickly make and correct policy changes, given its top-down decision-making.
These policy changes are strategic and likely to translate to structural impediments to growth; what they are not designed to do is to annihilate the property sector, which is still a large and important part of the economy. It represents nearly 30% of GDP, provides an essential contribution to provincial revenues (in the form of land sales), and employs millions of people. Against this context, we must delineate what is an Evergrande-specific issue versus what is not. There are tens of thousands of property developers in China, and many of them will not survive a deceleration in the property space due to lack of scale, lack of profitability as margins erode, more limited access to capital, etc. Those that do survive will likely see slowing sales, shrinking margins, and consolidation; there may also be enhanced government scrutiny on the sector.
Policy changes that have the intended effect of a slowdown in property sector activity could lead to slower consumer demand, given that property represents 70% of Chinese household wealth. This coupled with rolling COVID-19 lockdowns is likely to put pressure on already sluggish consumer demand. In addition to this, China’s zero tolerance COVID policy will likely result in continued lockdowns moving forward. On a macro level, less consumer demand could translate to slower sales for multi-national companies that had previously enjoyed support from Chinese domestic consumers.
Already we are seeing a slowdown in some commodity prices in response to an expected growth slowdown in China. Iron ore, a key component of steel, which itself is a key raw material in building and infrastructure has seen its prices deflate. It stands to reason that other commodities used in homebuilding would also see a slowdown in the coming year based on less demand.
Prior to the sell-off, Evergrande – like most Chinese property names – were well-held by Asian investors, with some European accounts also involved. Most investors will be institutional, given the complexity of retail investors getting involved. Current market pricing estimates that investors in Evergrande’s USD bonds are likely to recover very little – mid- to high-20’s, with no expectation of a coupon. The likeliest outcome is that the company will engage with creditors to come up with a restructuring agreement.
How China handles Evergrande, and others, could be consequential. If mismanaged, then the loss of confidence could have contagion effects to other financial markets, especially other high yield markets. If it is orderly and well managed, then investors are right to view this as idiosyncratic with limited impact to other financial markets.
By Jennifer James, Lead Emerging Markets Analyst