China Investment Focus: Evergrande and its implications

Evergrande is the second-largest property developer in China by sales. The company was founded in 1996 in Guangzhou, southern China.

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Commentaire Mensuel
1 Oct 2021

Evergrande is the second-largest property developer in China by sales. The company was founded in 1996 in Guangzhou, southern China.

Evergrande: facts and figures

In 2020, the company had CNY 507bln in revenues, 200,000 employees and indirectly up to 3.8mln construction workers. The company is active in close to 280 cities, mostly tier 2 and tier 3 and owns a substantial land position (CNY 550bln).

The Evergrande Galaxy

Source: Evergrande company filing.

Over the years, the company expanded its activities far beyond real estate development with investments and activities in property management, electrical vehicles, internet and media, mineral water, tourism and even a football club.

The company’s difficulties arose from its excessive reliance on leverage, as well as the tougher stance adopted by the Chinese regulator (3 red lines imposed on property developers). Being so “overextended” also did not really help.

At the end of June 2021, Evergrande had CNY 782bln / $188.5bln of debt outstanding and CNY 87bln / $13.7bln in cash and equivalents, 75bln / $11.6bln of which are restricted. Altogether, total liabilities were close to $300bln. If it has no debt maturing before March 2022, Evergrande has to repay $669mln through to the end of the year, mostly on dollar bonds.

 

Evergrande’s summer timeline

China Evergrande Group Timeline 2021

Source: Banque Eric Sturdza, Bloomberg.

 

Major threats arising from a non-organised default

The potential collapse of Evergrande is seen as posing a major risk to China’s stability and financial markets from various perspectives:

Social risk: Probably the one that the Chinese Communist Party (CCP) fears the most, and the one that is least likely to materialise. Some local governments are already reported to be stepping up to complete unfinished Evergrande’s projects in order to make homebuyers (1.4mln) whole, as well as fulfil Evergrande’s obligations to its contractors.

Financial contagion risk: Banks have outstanding loans to Evergrande of at least RMB 230bln, equivalent to 0.5% of China’s total banking system loans. This amount appears largely manageable especially for large banks that are well-capitalized and backed by the Chinese authorities. Loan losses would be more problematic for smaller banks, more directly tied to Evergrande, such as China Minsheng Bank, China Zheshang Bank or Shenjing Bank, but those banks are far from being deemed “too big to fail” and could be consolidated into stronger hands. Proactive action from the PBOC to ringfence the problem and add liquidity to the system should prevent a nasty contagion. The Evergrande’s liabilities held by non-bank financial institutions and through wealth management products (WMP) could be more problematic. This funding channel has been a growing one for Evergrande and “weaker” property developers and is more difficult to track. If based on previous experiences, the Chinese investors owning those WMP could face significant haircuts, Chinese authorities could push for a more favourable settlement to avoid social unrest. Making funding more difficult to access for property developers should ultimately benefit the sector, fostering good practices and consolidation in the strongest players, but the short term could prove challenging for some of them.

International contagion risk: International commentators were prompt to speak of a systemic risk similar to Lehman Brothers for Evergrande. At this stage, those concerns seem exaggerated, as non-Chinese banks have very limited exposure to Evergrande’s debt. One point to consider is however the different treatment of domestic creditors vs. international ones: Coupons were paid on CNY bonds, but not on USD bonds. If international investors were to be treated less favourably in the restructuration process, it could have generated a ripple effect:
1. Confirm investor views that domestic investments have to be favoured over offshore ones when investing in China and widen the gap between the two.
2. Increase resentment amongst international investors, which could translate into outflows from the Chinese markets (domestic and offshore).

 

Stock market implications

Even if Evergrande is not yet officially in default, equity holders have already been wiped out as its share price, and those from its main listed subsidiaries have collapsed.

Chinese Stock Markets

Source: Banque Eric Sturdza, Bloomberg.

Despite the negative press surrounding Evergrande, property stocks represented in the major indices have been so far pretty resilient, only starting to underperform materially in September.

Interestingly enough, tech stocks and ADRs (Chinese stocks listed in the US) have still been the worst performers this year.

Another interesting reading is the continued outperformance of the Chinese onshore stock market (A shares), compared to offshore listed ones (HK, US, etc.). More surprising, the CSI300 index – the 300 biggest companies listed in Shenzen and Shanghai – delivered a positive performance in September (+1.2%)

 

Fixed income implications

Evergrande’s debt is already trading at 25-30cts on the dollar, implying some form of default and restructuration, and significant haircuts expected by bondholders.

Chinese credit markets were prompt to react to Evergrande’s crisis. China’s high yield credit spread widened by a significant margin. They are now wider than at the peak of the COVID crisis.

Onshore IG China Debt vs. Offshore HY - Yield to Worst

Source: Banque Eric Sturdza, Bloomberg.

Even if Evergrande’s weight in the index is pretty limited (less than 3%), the real estate sector accounts for more than a third of the Bloomberg USD credit China High Yield index (offshore HY dollar bonds) and is widely populated with 2nd and 3rd tier players.

In the meantime, Investment Grade bonds issued in RMB generated positive returns as investors gravitated towards longer-dated bonds and government bonds in a typical flight to quality. As such, yields on investment-grade rated bonds issued in RMB have been marginally down, quite a sharp contrast with the high yield debt issued in USD.

 

What to watch and expect?

The restructuring process is going to be a lengthy one with potentially numerous ups and downs.

Key elements to watch to assess a potential deterioration or improvement of the situation.

  • Government interventions either through local governments or indirectly by pushing state-owned property developers to take over Evergrande’s projects and assets.
  • Asset disposals. Pretty limited so far preventing a negative feedback loop on asset prices. Evergrande has significant assets (land bank and non-core subsidiaries) and selling them would raise cash.
  • Potential contagion to other property developers, financial and non-financial institutions. By adding liquidity into the system ($17bln last week and $15bln this week) the PBoC is addressing this issue and still has additional levers to pull if needed. Any spillover to other actors would add to systemic risk fears and would be negative.
  • Any willingness not to treat international creditors on an equal footing with domestic ones could translate into a severe loss of confidence and outflows from China and EM assets.

 

Main read-throughs

  • Expect additional fiscal and monetary measures to stimulate the economy and to counter the negative impacts of Evergrande. Contrary to other countries, China did very little in 2020 and can do a lot more. The PBoC already lowered its reserve requirement rate once in 2021.
  • Short term, a possible relief rally assuming the authorities are seen as successful at containing and addressing the Evergrande situation.
  • With more fiscal support and an improving Evergrande’s situation, it could turn out to be an attractive entry point for medium to long term investors, given the underperformance of Chinese equities, their valuation discount vs. the rest of the world and robust growth prospects.
  • Long term, the real estate sector and notably the better and more disciplined players should emerge stronger from this situation. Notwithstanding a potential relief rally, the sector should continue to be under pressure over the medium term as the tougher stance of the authorities won’t disappear overnight and as financing conditions for the sector should remain strict.
  • Once again, this crisis stressed the increasing relevance of onshore markets and their strategic positioning vs. offshore ones.

 

As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolio.

Adam TurbervilleAdam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

The views and statements contained herein are those of Banque Eric Sturdza SA as of 28/09/2021 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.