Contagion Risk From China Evergrande Likely Low
Fears that a default by China Evergrande Group could trigger a financial crisis has led to some weakness in global equities in recent days, with the MSCI All Country World Index falling 3.5% from its peak. 1 While Evergrande is likely to default and require a major restructuring, we view fears of a broader financial crisis as overblown.
Evergrande Group, one of China’s largest real estate developers, is scheduled to pay more than $100 million in interest on its onshore and offshore bonds on Thursday. Evergrande’s announcement today that it has “resolved” the $36 million interest payment for onshore bonds has helped improve market sentiment, but the company has not clarified whether the $84 million interest payment on offshore bonds will be paid.
While global markets are now focused on Evergrande, the distress faced by the company has been known for some time. The company’s total liabilities amount to more than $300 billion, accumulated from its heavy reliance on debt and its aggressive expansions into non-core businesses over the past decades. The company’s stock price has fallen more than 85% this year and its offshore bonds trade around 26 cents on the dollar. The crisis that Evergrande faces arises from recent government policies to control leverage in China’s real estate sector, and in particular, the “three red lines” for property developers that stipulate a ceiling of a 70% liability-to-asset ratio, 100% debt-to-equity ratio, and 100% short-term debt-to-cash ratio.
Although default and restructuring are likely for Evergrande, we suspect it will occur in a controlled manner similar to other heavily indebted entities the government has recently forced to restructure. Namely, the restructuring of HNA group, Wanda, Anbang, and Huarong, none of which added meaningful stress to the banking system. While the government has adopted a hardline stance on property developers, it retains the flexibility to relax the “red lines” if needed to prevent widespread stress in the sector.
Nonetheless, the remaining question is how much pain will bond holders face, especially offshore bond holders. Evergrande is estimated to have $20 billion in offshore debt and currently accounts for just 2% of the Asia offshore high-yield bond market (as proxied by the J.P. Morgan JACI Corporate Non-Investment Grade Index), and a default is already priced into the bonds. However, current regulations surrounding the treatment of offshore bond holders in the event of an onshore restructuring remain uncertain. If Evergrande’s offshore bond holders are subject to unfair treatment this could trigger a broad-based repricing within the Asia offshore bond market. But Chinese companies outside of the property sector are not reliant on offshore funding, and so any stress here should be manageable.
Overall, Evergrande defaulting is not China’s “Lehman moment,” and it should not trigger a financial crisis in China. Pressure on property developers is likely to remain because of government policy objectives to reduce leverage in the sector and increase housing affordability. Given that real estate activity is a meaningful part of the economy, the push for more affordable housing may slow growth, but this is a trade off the government is comfortable with amid its “common prosperity” push. Global markets should focus more on the potential for slower growth in China than a financial crash.
Aaron Costello, Managing Director, Global Investment Research
Vivian Gan, Investment Associate, Capital Markets Research