In the west, investors worry about black swans.
These are hard-to-predict, and rare events that are beyond the realm of normal expectations.
In China they are more concerned with what they call “gray rhinos” — large and
visible problems that are ignored until they start moving fast.
A good example of a grey rhino is China Evergrande Group which finally missed making a bond coupon
payment on Monday, when its thirty-day grace period ended.
While ratings agencies have not officially declared a default (as of the time of this
recording), S&P Global Ratings did say yesterday that a default is “inevitable.”
To give you an idea of how tight things are for Evergrande, they missed a coupon payment
of $82.5 million dollars when their total liabilities exceed 300 billion dollars.
To convert those into more understandable numbers, the average American is about $53k
dollars in debt, and the coupon that Evergrande missed after scraping around for thirty days
and selling anything they could, is equivalent to around $14.57 cents to that average American
as a percentage of overall debt.
So things are pretty tight.
So what has been going on lately?
Well, after the market closed last Friday, Evergrande revealed that it would struggle
to repay a previously undisclosed guarantee obligation of $260m.
They announced that “there is no guarantee that the group will have sufficient funds
to continue to perform its financial obligations” and that it “plans to actively engage with
offshore creditors to formulate a viable restructuring plan”.
Hours later, Evergrandes chairman was summoned to a meeting with Chinese government officials.
Around the same time, the Chinese Central Bank, The National Securities Regulator and
the Chinese Banks Regulator all issued what look like coordinated statements that Evergrande’s
woes stemmed from management errors and that its crisis would not destabilize China’s
financial system.
On Monday, shares in Evergrande fell to a record low in Hong Kong trading, and after
the close it was announced that a new risk management committee had been established
by the company.
Hui Ka Yan, the founder and chairman of Evergrande is officially the chairman of this seven-seat
committee, but four slots are held by representatives of state-owned enterprises controlled by either
the central government or regional governments in southern Guangdong province.
So, with state representatives holding the majority of the seats, it would appear that
Hui is no longer in control of Evergrande.
According to the FT, the Guangdong government has assumed responsibility for Evergrande
as the officials in Shenzhen are already busy dealing with with similar problems at Baoneng,
another large property and financial services group.
There are some precedents for what is going on in this situation.
The Chinese government has taken control of other heavily indebted companies through similar
mechanisms in recent years, the best example being HNA Group, which was effectively taken
over by local government officials early last year.
HNA’s insolvency is the biggest bankruptcy that China has seen since introducing its
first bankruptcy law in 2007.
A bankruptcy of this size is to a certain extent uncharted territory as less than 100
listed companies have ever gone through bankruptcy proceedings in China.
None of the prior examples were as big, or as interconnected with the Chinese economy
as Evergrande is, so unwinding a company like this without doing too much harm to the property
sector will be quite a challenge.
HNA was one of the four “grey rhinos” along with Anbang Insurance Group, Fosun International
and Dalian Wanda that were brought to heel by the Chinese government back in 2017 after
regulators grew concerned about the scale of their borrowing and international investments.
None of those companies had as high a profile or as central a role in the Chinese economy
as Evergrande does, but HNA is the closest example.
They were in a similar situation to Evergrande where they didn’t generate enough profit
to cover their interest payments back in 2017.
Between 2018 and 2020 they were divested assets deciding to focus on their core aviation business.
This proved to be ill-timed with the Covid-19 pandemic which brought about the group’s
collapse.
The government of China’s southern province of Hainan, effectively took control of the
group in February 2020.
HNA was around 1/5 the size of Evergrande with around $60 billion in creditor claims.
In September of this year, HNA said it would be reorganized into four independently operated
sections, including ones for aviation and financial, and that all equity held by its
old shareholders would be wiped out after the reorganization.
So based on how Beijing has managed highly indebted companies over the past three to
four years, the working group is likely to take over Evergrande and find state-owned
developers to complete the existing development projects.
After that, original shareholders including Hui Ka Yan will most likely be wiped out.
It would appear right now that there is no political motivation to save Evergrande.
While it may be a bit late, Beijing wants to send a clear signal that the Communist
Party won’t tolerate massive debt accumulation that threatens financial stability.
Of course, they have said this sort of thing before.
But every time the going got tough, the government backed down and the leverage fueled party
continued.
In this case, it does look like they are more serious.
The thing is that the cost of letting things collapse is quite high, but the cost of not
letting things collapse is just as high, but typically these costs only occur in the future,
while the former occur today.
So, for the Chinese Government, it’s a question of when you are willing to take the pain.
The Chinese authorities are hoping to break-up and liquidate Evergrande in a way that does
not require a general bailout of the sector, or much fiscal and monetary juicing of the
economy, this will be a challenge.
The first clue that official discipline might not be ironclad is that the People’s Bank
of China cut the required reserves ratio by 50 basis points on Monday, the second cut
this year in a move widely seen as designed to reassure investors bracing for Evergrande’s
possible default.
After the cut was announced, the Hang Seng Mainland Properties index rose by around 4%
on Tuesday.
It is worth noting that in economic situations where businesses are trying to expand their
business operations, but are constrained by the inability to raise funds, easing credit
can lead to more productive investment.
But in situations where they already have adequate access to credit, easing will only
lead to more speculative investment.
The question now is whether the government can limit the fallout from this collapse.
Already we have seen real estate sales in China freeze up and the stocks and bonds of
smaller, lower-rated real estate developers fall.
At least 10 developers have defaulted on bonds since June.
Kaisa, a major issuer of dollar bonds, has been pushed to the brink of collapse too.
Junk dollar bond yields have soared above 20%, making it prohibitively expensive for
cash-strapped Chinese firms to borrow offshore.
China is trying to limit the fallout on the broader housing market, and this is a particularly
sensitive issue in a country where real estate makes up around thirty percent of economic
output and as much as 75% of household wealth.
With all of the developers dumping property, stabilizing house prices will be a challenge.
Last week, Kaisa priced a Hong Kong harbor-front plot of land at a 20 per cent discount to
its audited value of $1.2bn.
This kind of discount is unheard of in Hong Kong.
For global bondholders, an Evergrande default is likely to start a prolonged battle for
repayment.
Chinese authorities have been very clear that social stability is of the greatest importance,
indicating that they may prioritize home buyers, suppliers and contractors who are still awaiting
payment from Evergrande.
The company is on the hook for around 1.6 million uncompleted apartments that buyers
have already paid for.
Evergrande’s offshore bondholders include Ashmore Group, BlackRock, UBS and HSBC.
As Evergrande’s stock and bond prices have fallen, Ashmore bought another $100 million
of bonds in the third quarter.
Bringing their holdings to more than $500 million at the end of September.
“No matter what the outcome, offshore bondholders are last in line for payment and are certainly
going to have to accept haircuts, possibly significant ones.
As I mentioned in an earlier piece, these Chinese property companies have two sets of
bond obligations which are very different from each other.
The onshore bonds are local currency denominated and the offshore bonds are dollar denominated.
The offshore bonds have no legal claim on onshore assets – and investors knew that
when they bought them.
They call them bonds, but any serious investor will tell you that they are more like senior
equity.
The real question here is to what extent China cares about burning offshore investors.
Evergrande’s dollar notes are trading at around 20 cents on the dollar right now meaning
that the market is pricing in a haircut of around 80%.
Officials may be somewhat concerned with how foreign investors are treated in the restructuring
process, as Chinese developers have become quite dependent on access to international
markets for funding.
These offshore bonds are a small percentage of the overall debt, but as I’m sure you
can imagine, the main concern in this unwind will be stability within China.
While addressing social downside is a priority, how the offshore U.S. dollar debt investors
are treated will be an important signal of future China risk pricing.
The problems at Evergrande are of course being echoed by Kaisa, the second-biggest borrower
on international markets in China’s real estate sector.
This morning Kaisa suspended trading in its shares “pending an announcement” after
a $400m bond matured without any sign of payment to investors.
Kaisa has close to $3bn due in the next year.
They made an offer to their investors last week to extend the maturity of its debt and
avoid default, which the bondholders rejected.
They have been trying to sell real estate at fire sale prices with little success.
Kaisa has already missed payments on wealth management products in mainland China last
month and they were the first Chinese developers to default on international debt back in 2015.
If you missed my prior piece on how Chinese State owned enterprises are stepping in to
bail out local governments due to the collapse of property auctions in China, here is a link.
It will give you an idea of how complex this whole situation is.
Have a great day, and talk to you soon, bye.