China's property sector suffered an additional beating this week as Kaisa Group made a desperate
plea for help, other Chinese property developers began to shake, and the U.S. Federal Reserve
sent its first direct warning about potential global contagion.
So first up, the Federal reserve released their semiannual report on financial stability
this Monday, and in it the Fed pointed specifically to the crisis at Evergrande, (China's most
indebted developer) warning that China's ongoing property woes could elevate "financial stresses
in China, which could further strain global financial markets and negatively affect the
United States."
Evergrande as we know, sparked fears of contagion back in September, when they warned that they
might default on debts of more than $300 billion.
Since then, we’ve seen that several other large Chinese property developers are also
in trouble.
And as we will discuss in a moment the panic seems to be spreading to the less leveraged
developers too.
The Federal Reserve warned that given the size of China's economy and financial system,
and its global ties, "financial stresses in China could strain global financial markets
through a deterioration of risk sentiment, pose risks to global economic growth, and
affect the United States."
Now this is quite a change for the Fed as Jerome Powell said back in September that
the debt problems of Evergrande seem particular to China and that there's not a lot of direct
United States exposure.
A big deadline for Evergrande occurs today, when the grace period ends for three dollar
bond coupons that sum up to $148 million dollars.
Evergrande missed the initial interest deadlines last month and the 30-day grace periods runs
out today.
There’s been no indication that Evergrande will miss this payment and missing it could
trigger cross-default clauses among their $19.2 billion of outstanding dollar notes
and give creditors more room to negotiate.
It is a little bit surprising at the time of this recording that there has been no news
of a wire transfer, but that could still happen today.
Evergrande and Beijing seem to be managing the company’s struggles under a veil of
secrecy, allowing Evergrande to meet some payment deadlines without explaining exactly
how it is being done.
Evergrande did raise around $145 million in recent days by selling a roughly 5.7% stake
in Hong Kong-listed HengTen Networks Group over the last three trading days, according
to their regulatory filings.
Apart from HengTen, Evergrande also sold its UK-based electric motor making business Protean
in the last week.
This should scrape together enough cash to make this payment.
Now of course the dollar denominated bondholders are not the only people looking for money
from Evergrande.
More than a million home buyers are waiting for unfinished apartments, and the company
may owe money to just as many construction workers, painters, landscapers and other employees.
It is worth noting that 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 – dollar denominated bonds have no legal claim on onshore assets.
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.
It seems at the moment that Xi is more intent on punishing the wild developers than protecting
offshore bondholders.
Ashmore Group, BlackRock, UBS and HSBC are large owners of these dollar denominated bonds,
and recent news articles say that Goldman Sachs Asset Management have been buying (but
I’m told not much by people in the space).
A lot of the investors who hold these bonds will be rich Chinese people who hold dollar
bonds in their offshore bank accounts or family offices.
So it is not all foreigners that are involved…
The Ministry of Housing and Urban-Rural Development in China has instructed local subsidiaries
across China to supervise funds for Evergrande’s property projects in special escrow accounts.
Under this oversight, the money must first be used for construction to ensure project
delivery.
So, this possibly tells you where the focus is.
Additionally, Beijing appears to have urged Evergrande’s founder to help repay Evergrande’s
obligations with his personal wealth.
Limited liability being less of a thing in China.
It’s unclear whether his fortune is big and liquid enough to make much of a dent in
Evergrande’s liabilities, which are over $300 billion dollars.
Bloomberg estimates his net worth at around $8 billion, right now, but it may be significantly
less.
At the moment Evergrande’s dollar denominated bonds are trading at deep discounts to par
value as investors brace for what could be one of China’s largest-ever debt restructurings.
Now obviously the best way to deal with this sort of issue would be for Evergrande’s
founder to post a twitter poll asking his followers if they think he should pay the
bond holders or not, but that doesn’t seem likely at the moment – I don’t think he
is on twitter...
Money is becoming harder to come up with for risky Chinese borrowers right now as the cost
of borrowing has soared, fewer people are buying apartments, and the value of property
in many Chinese cities is falling.
Property companies have $40 billion of payments to make to foreign investors alone over the
next two months, according to one estimate.
While Evergrande is in a sticky situation right now, things only get worse next year.
The company faces large principal repayments in March and April, these will be much harder
to meet than the interest payments it has grappled with in the last few months.
For the moment, they are likely just trying to buy time with the hope that the government
in Beijing will loosen up on the three red lines before it is too late.
It is worth noting that Reuters is reporting that some offshore bond holders have not received
interest payments that were due a few days ago on Nov. 6th issued by Scenery Journey
Ltd – which is a unit of China Evergrande Group, it is not clear right now what has
happened with that payment, but the firm may already be in default.
You probably noticed that a lot of the news flow around Evergrande died down after the
company made a debt payment on October 22nd.
But what we are seeing now is that Evergrande’s financial problems have set off a broader
panic that contributed to a wave of defaults amongst other developers.
And their troubles appear to be growing.
Fantasia, Sinic and China Properties Group have all defaulted-on debts recently and Kaisa
just joined that list of developers on Friday.
Kaisa’s whose shares were suspended in Hong Kong on Friday, was the first Chinese developer
to default on offshore debt back in 2015.
Their bonds maturing next year are trading at 32 cents on the dollar.
There are obvious worries that the financial issues faced by all of these developers are
making home buyers even more reluctant to buy property in an economy where real estate
has been a major driver for growth.
Just recently Evergrande announced that home sales had fallen by 97%.
The fallout from this debt crisis has up until recent days been largely contained to junk-rated
developers.
But better-quality borrowers, such as those in the technology and banking sectors, are
now seeing the sharpest debt selloff since April, when fears of a liquidity crunch at
Huarong ignited doubts over the level of support Beijing would offer to indebted state-linked
firms.
Sino Ocean Group – which is part-owned by the finance ministry in China, has seen its
bonds slump, despite the firm being rated investment-grade and that it holds more than
50 times the cash and cash equivalents of Evergrande.
Chinese junk bond yields have been soaring over the last few months, yields are now above
27 per cent.
What this tells you is that it is pretty much impossible for junk-rated Chinese companies
to refinance their debts.
And that then means there are bankruptcies in the pipeline.
The key questions here are - which of these firms has sufficient liquidity to make it
through?
And, how much pain will the central government tolerate before easing credit conditions?
Interestingly a lot of smart investors are buying up Chinese government bonds right now,
this is based on a few things – they are trying to get ahead of any flight to quality,
where, as investors cut risk they will move to government bonds – a lot like what happened
in the United States during the Global Financial Crisis, where government bonds did well.
They are also betting on the Chinese currency moving up based on trade flows and trying
to get in front of a lot of sovereign wealth funds who are diversifying away from dollar
and euro denominated bonds into Chinese government bonds which are yielding 2.5 – 3%.
So, let’s get back to the Federal Reserve’s concerns, to what extent would it matter if
Evergrande collapsed?
Well, when questioned about the Fed’s warning in the financial stability report, Jerome
Powell said that the problems seem particular to China and that he did not see a parallel
with the U.S. corporate sector, so it is possible that the Fed is just mentioning a risk, but
they are not overly concerned.
They did warn about Meme stocks in the same report.
The main worry that people have is if the Evergrande meltdown is China’s “Lehman
moment”.
Right now, it doesn’t appear to be, mainly because the selling in China remains concentrated
in the affected sectors – we are not seeing a broader panic.
So, What is China doing, and what might they do going forward?
In recent years, Chinese authorities have attempted to control property price increases
to avoid the risk of asset bubbles in a sector that accounts for the majority of household
wealth in the country.
This does not appear to have worked very well, Chinese property prices have rocketed, and
homeowner debt is huge.
Now that the real estate industry is contracting and developers are defaulting, officials in
some regions appear to be acting to prevent price declines.
A group of homeowners in Wuhan protested last month after a developer cut prices by 30 per
cent at a project where they had recently bought homes.
In Hebei province, home prices had been rising near the site of the upcoming Winter Olympics
but have recently fallen.
In September, local authorities introduced rules citing “double stability” that prevented
newly built homes being sold for less than 85 per cent of their original asking price.
Historically this type of price control has not worked and just causes markets to freeze
up.
The Chinese economy is doing all right at the moment, as China benefits from the demand
created by government stimulus in the US and around the world.
Exports rose 27 per cent last month compared with a year earlier, marking the 13th straight
month of double-digit growth.
The contribution of the property sector to GDP growth in China is just too important
for Beijing to ignore.
We shouldn’t expect to see bailouts of investors in dollar-denominated bonds, but we might
see things like reserve requirements and mortgage rules being loosened in order to stimulate
demand.
OK, so how likely are we to see this hit global markets?
Well, a lot of course depends on how the Chinese government deals with these problems.
China’s real estate activity is slowing, the developers have large debts and some of
them like Evergrande are diversified into other areas of the economy – they are not
just property companies.
A slowdown in China’s housing market could lead to broader unemployment and a drop in
the Chinese stock market.
This could spread through global trade channels and be bad news for the metals and mining
complex internationally, as China is a huge buyer of commodities.
If the Chinese property meltdown does cause a full-on recession in China, then U.S. businesses
with lots of Chinese exposure could get hit.
We don’t really need to worry too much about global banks, as they have not been allowed
much access to the Chinese market.
In truth the rest of the world is reasonably insulated from a Chinese slowdown because
China limits access to their markets.
In the event of a big sell off you might even see investors move their money out of emerging
markets and into the United States in a flight to safety.
A credit event for Evergrande seems pretty much unavoidable, they have huge payments
due, which they are unlikely to be able to meet.
The extent to which we see international contagion will relate to whether Evergrande restructures
or liquidates.
Right now, a restructuring looks like the most likely outcome.
If you haven’t yet watched my video on Evergrande and the Chinese Economy, you should watch
that one next.
It explains how the rise and fall of Evergrande relates to certain economic choices made by
Chinese policymakers over the last three decades.
Have a great day, and talk to you soon, bye.