Welcome back everyone, so a quick update on Evergrande, the heavily indebted Chinese property
developer.
As I’m sure you know Evergrande missed a coupon payment on September 23rd, but as we
mentioned at the time, missing that payment was not counted as a default – the terms
of the bond gave Evergrande a 30-day grace period to make the payment – and it probably
made sense for them to make the most of that grace period which would have run out this
weekend.
Last night it was announced that the company had wired the funds on Thursday to Citibank,
the bond trustee and so investors should receive their money before the grace period expires
on Saturday.
Evergrande’s shares are up almost 8% right now and the Hang Seng mainland properties
index is up 3.4%.
The grace period would have expired at midnight New York time this Saturday, and missing it
would have resulted in a default - setting the stage for the bond investors to take legal
action.
This payment will buy time for Evergrande and avoid lawsuits for now.
It also sends a good signal to international investors many of whom are concerned that
the company will prioritize local creditors at the expense of foreign bond investors.
Evergrande are by no means out of the woods though.
The payment buys them one more week of time.
Evergrande had cash and cash equivalents of $13.6bn as of the end of June and total liabilities
of over $300bn.
They have $36bn of borrowings and $91bn of trade payables due in the next year, so they
are quite short on cash, and they can only meet those payments by quickly selling assets.
Evergrande scrapped their talks earlier this week to sell a stake in their property-management
arm and additionally announced that real estate sales have fallen by 97% during the peak home-buying
season in China, this only worsens their liquidity crisis.
Evergrande suspended their shares for over two weeks, the trading suspension was lifted
on Thursday after they disclosed that they had terminated a potential sale of their property
services unit a week earlier.
Evergrande has been trying to sell a majority stake in their property management division
for 2.6 billion dollars.
This sale fell through as government officials who were brokering the deal were reported
to be unable to calm the buyer’s nerves.
Evergrande also failed to sell their Hong Kong headquarters, for similar reasons.
As a bit of a side note, Evergrande announced this week that it would “fully co-operate”
with an inquiry into its accounts from Hong Kong’s accountancy watchdog, which is also
investigating PwC’s audit of the company.
So, for now, this coupon payment buys the time that Evergrande desperately needs for
asset sales and it increases the likelihood of an orderly restructuring, rather than a
disorderly collapse.
The property leverage problem in China is of course more widespread than Evergrande
Group.
Other Chinese property developers including Fantasia Group and Sinic Holdings, have defaulted
on smaller bonds, and you can see that yields on riskier Chinese borrowers have reached
their highest levels since 2009.
Kaisa, another large developer, has a bond interest payment due today that is expected
to be paid and that is being closely watched.
That bond is trading at 35 cents on the dollar right now.
The Chinese government has so far given no indication that it will offer any financial
support to the Chinese property sector.
Senior officials weighed in on the issue for the first-time last Friday when a PBOC official
blamed Evergrande for its issues and said they were being resolved through “market
and rule of law principles”.
He added that any spillover to the financial system was “controllable”.
What is happening right now with Evergrande and the broader Chinese property sector is
of great interest globally as it could signal a huge change in the way that the Chinese
Economy works going forward.
This matters both for China and for the rest of the world, as China has been the major
engine of global growth in recent years.
Between 2013 and 2018 China made up one third of global economic growth.
The problem is that the Chinese economy has been more reliant on real estate as a driver
of economic growth than any other economy in the world has been, and a lot of this growth
has been driven by malinvestment in both property and infrastructure.
Now, this is not a new issue and it has been widely discussed for quite some time, so why
has it suddenly become a problem now?
There are a few answers to that question, one of which is that the Chinese economy which
is fueled by excess leverage and malinvestment is simply running out of steam.
Another reason is that President Xi does not believe in real estate speculation and wants
to calm the property market, this was not the case with prior leaders.
While China is home to the largest number of unoccupied apartments in the world, housing
affordability is amongst the worst in the world.
Apartments in Shenzhen cost around 25 years of average household income to buy.
In London, a city not famed for its affordability an apartment costs 13 years of average household
income, in New York the multiple is 8 years.
Another reason that this might be happening right now is that China is showing relatively
strong growth this year mostly due to a bounceback from the terrible prior year.
China can allow the property sector to contract this year while still coming close to their
growth and job creation targets.
China’s ruling party convenes for the first time in more than a year this November, laying
the ground for a twice-a-decade party congress in 2022 which is expected to extend President
Xi’s term as leader.
From a political point of view it might be hard for Xi not to support the property market
before this important political event, but from an economic point of view it might be
high risk to do that as eventually the chickens come home to roost.
As I covered in my prior videos, Chinese regulators who have been trying over the last few years
to reduce the economy’s overreliance on debt implemented the “three red lines”
for property developers in August 2020.
The three red lines were hard limits on a property development company’s debt-to-asset
ratio, its debt-to-equity ratio, and its cash-to-short-term-debt ratio.
This new policy had an instant effect on property developers.
Not only could they no longer borrow, but they were forced to deleverage.
This meant selling assets, laying off staff and taking losses on the chin – and all
of the property developers were doing this at once.
This caused a spiral, as the losses only made their debt ratios look worse, putting further
pressure on developers to deleverage further.
Right now, Evergrande is the firm struggling the most, but the pain being inflicted by
the three red lines on Chinese property developers is as you can see, much more widespread.
As the pain intensifies, you have to ask if the government will reduce their pressure
on these huge property developers.
The government specifically want to reduce leverage and speculation and increase housing
affordability and there is no way of doing this without inflicting pain.
The question is, will the government ease up if the problem of defaults starts to get
out of control.
Xi has not gone easy on the tech and education sectors in China and seems to regard all Chinese
companies as instruments of a one-party state.
There are a few choices that can be made: Beijing can decide to accept a much lower
growth rate going forward; they can go easier on the property developers by easing off on
the three red lines; or they can increase local government infrastructure spending to
make up for the shrinking property sector.
I think they are unlikely to decide to accept a lower growth rate – this wouldn’t be
politically acceptable in the short term.
Increasing local government spending might also be tough, especially because a lot of
local government revenues come from leasing land to property developers.
Thus the most likely outcome is that Beijing relaxes the three red lines a bit so that
they can better manage the decline of the property sector.
It would appear that China has a goal to switch from property development as a source of economic
growth to green energy.
Between now and 2060 46.6 trillion dollars will need to be spent to meet Chinas carbon
neutrality goals.
That comes to 1.2 trillion dollars per year being invested for the next 38 years.
That leads to the question of whether this new industry can step in and be big enough
to make up for the shrinking real estate sector?
If you enjoyed this video you’ll probably enjoy my other video on the five biggest fat
finger mistakes in markets – available at this link.
Talk to you soon.