Tom Claridge, Portfolio Manager
The doom-mongers were out in force on Monday – concerns over the solvency and liquidity of Chinese property developer, Evergrande, led some to describe it as ‘China’s Lehman moment’. An interest payment by the company on Wednesday, and the highest daily injection of liquidity by China’s Central Bank in eight months, have calmed the nerves somewhat. That said, credit fears at one of the country’s largest borrowers in a sector that represents a quarter of Chinese output, are worthy of attention. The reality is that policy choices put China in this position, and policy choices will get them out of it.
The three red lines
The Chinese authorities, in line with the new ‘common prosperity’ agenda and clampdowns in other parts of the economy, have been trying to address imbalances in the property sector. The Chinese economic policy agenda is targeting a transition away from unproductive investment and debt. Instead, it is focusing on productive investment and consumption, with reform of the property sector at the forefront. This led in to the imposition of the ‘three red lines’ for property developers: debt levels can be no more than 1) 70% of asset levels, 2) 100% of equity levels, and 3) the ratio of cash to short term debt must be greater than one.
Despite policy intentions to make the property sector more robust in the long term, it has caused something of a fire sale of assets in the short term. Property developers rush to comply with these restrictions, which has particularly impacted Evergrande.
Have the risks changed?
Property prices have long been considered a one way bet in China. Lending money to a company as large as Evergrande, with an assumed government back stop, has been seen as ‘risk free’ by domestic lenders and retail investors. The implied message from the Chinese Communist Party is that these days are over. Evergrande’s banks are refusing to lend to it, its share price has fallen by over 80% year to date and its US dollar denominated debt maturing in 2024, is priced at 28 cents in the dollar.
This has certainly caused ripples in financial markets over recent weeks. The yield of Chinese non-investment grade bonds has sky-rocketed since the start of the year, from less than 8% to over 16% currently, and an index of Chinese real estate companies has lost close to a third of its value year to date. Globally, the strain can be seen in iron ore prices which has, in turn, impacted mining companies and commodity sensitive currencies such as the Australian dollar. At a headline level, at its lows on Monday, the S&P 500 was down over 5% from its recent all-time highs. [i]
There are two important mitigating factors for global investors. Firstly, the crisis is policy driven and self-inflicted, thus the Chinese Communist Party is in control of how far they want to go. The plan seems to be to inflict a bloody nose on the property sector and alert investors that the age of moral hazard is over. The days of inflating Chinese growth with endless property development are potentially coming to an end. And do not expect equity holders or foreign investors to be bailed out. Ultimately though, primacy will be given to financial stability and social cohesion. Anything that threatens domestic retail investors, threatens to create a systemic issue, or threatens to substantially impact property prices is unlikely to be sanctioned, reducing the level of risk to global investors.
Secondly, unlike Lehman, Chinese property is unlikely to be a systemic issue for global investors. We are seeing spill-overs in certain exposed sectors, but unlike the US mortgage crisis, these are not systemically important. Further, clearly risk is most dangerous when it is not correctly quantified. As is well documented, many US mortgage products in 2007 were thought to be as good as risk free, causing the wrong type of investors (banks, globally) to invest with the wrong level of exposure (a lot). Whilst domestically the impact will be more acute, global investors in Chinese high yield bonds and stocks widely understand these asset classes are high risk and therefore are, for the most part, owned by investors that can tolerate the risk and at appropriate levels of exposure.
Evergrande may well prove to be a significant moment for the Chinese economy as it redefines risk parameters and moves the country away from debt financed excessive property investment. It may also lead to continued volatility in directly impacted asset classes. It is, however, unlikely to result in anything systemically significant for global investors.
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