You will need to forgive the title of today’s post sounding a bit like a Harry Potter novel or some sort of Hollywood inspired series involving mythical creatures and an ominous mountain. The funny thing is that its probably not any less a spectacular story. Let’s rewind.
You said HOW BIG?
Who is Evergrande? They are a Chinese conglomerate with interests in everything from property to mineral water and a football club. Throw in solar panels, pig farming and baby formula into the mix and that’s not all. Not only are they diverse, but they are BIG! Not only were they ranked 142 in Fortune’s Global 500 in 2018 when they were also ranked as the worlds most valuable real estate brand!
As at last year, they had around 565 square kilometers of development land on the books. That’s about two-thirds the size of Singapore, half the size of Hong Kong or 250 times the size of Monaco. You get the point. But is it too big to fail?
Hitting the Fan!
Over the last few weeks, the market has been absorbed in concerns regarding the debt crisis looming at Evergrande. It has around $300bn of outstanding debt. The Pandemic has NOT been kind, slowing sales. Some lay the blame on the Chinese government’s crackdown on leverage in its corporate sector.
Regardless of what germinated the problem, the issue of rising debt levels globally has been on the macro agenda for a long time. Chinese leverage has been a ‘flashpoint’ for years. Is this the straw that breaks the camel’s back?
Maybe not. Of the $300bn odd of total debt, only around $20bn is owed internationally. The rest is domestic. Yes, there are some large international holders of Evergrande debt, with big names like Blackrock, Prudential, UBS and RBC all in the mix. But given the scale of the external debt, I would go out on a limb to say, the risk of a wider global contagion is limited.
So far, the move on global high yield spreads has been muted if not non-existent. Given the equity centric nature of our readers, I illustrate this using the JNK ETF which references high yield (Junk?) bonds. This is a short term chart over the last 3 months. We’re back to levels prior to the recent Evergrande news flow.
Already, the Chinese authorities have injected around CNY90bn ($13.5bn) of cash into the system domestically to allay fears of an imminent contagion among other lenders, suppliers, etc. While agreements have supposedly been reached to allay the current interest obligation, there is another $47.5m worth of dollar bond interest due next week and it remains to be seen what terms are reached with international investors.
Bear in mind that not only are there bond holders to consider, but that Evergrande also had a range of wealth management products which effectively took depositors/investors money as a form of funding. These will also be exposed to any fallout.
What does the fallout look like?
When a group this size hits the skids, there’s more at stake than just equity and bond holders. Let’s contextualize the potential fallout if left unchecked. At present there are over $200bn worth of presold apartments still to be completed. There are the outstanding WMP’s which will hurt domestic Chinese savers. Evergrande also employed over 120 000 people.
But are we surprised? Evergrande stock has slid since its 2018 peak around HK$32 to current levels of HK$2.27. Even before the pandemic, the stock was over 30% off its highs.
The debt build up has been monumental. The charts below reference the Evergrande 8.25% coupon USD bond due in 2022. After trading at close to par through 2018 up to the pandemic, the bonds cracked the 75c/$ mark. It recovered thereafter and as recently at Q2 this year was back at par again. But then the wheels fell off. They currently trade around 22c/$.
If you’re brave enough, the YTM is currently close to 500%…although bond holders will likely have to restructure and/or take a haircut. Remember, Bond holders rank ahead of equity holders hence why the bonds are around 20% of par vs. equity which is around 7% of peak comparative levels.
So what’s this mean for me?
If there is limited to no global contagion, it will just be another cautionary tale in terms of the peril of overindebted entities, whether those are corporate or sovereign. Debt is a remarkably powerful tool if used correctly but equally remarkable in its destructive power if abused…and there is A LOT of abuse going on globally. Readers will know I am relatively conservative when it comes to my views on debt.
More importantly, I think that this saga will shine further light on the Chinese realignment of its economic and social priorities. The form of ‘bailout’ of Evergrande is important in the nuance. Affordable housing is a key issue in China and I would assume that home buyers (not speculators) may be protected. Similarly, WMP holders (savers) may be sheltered.
China may also be more partial to restructuring on favorable terms for suppliers and downstream exposures in its economy to alleviate the impact on jobs. However, China will also likely want to send a message regarding leverage.
Authorities have spoken about the build up of leverage in the Chinese system and deleveraging has been core to the reform agenda. As such, if it is able to send such a message while limiting the lasting fallout and contagion risks, it will be a win and will keep the ball rolling regarding corporates getting their act together in China.
Whether China is as amenable to global investors will need to be seen especially in the vein of recent rhetoric and action on this front.
Closing thoughts
I have long said that the Chinese are in the middle of a very long-term realignment of its economy and society. The actions by President Xi illustrate a confidence on his part in terms of his political security.
Structural reforms are hard and need a strong leader to get across the line. Xi is testing this in what is effectively the world’s largest and most important political experiment.
The irony is that the very actions China is embarking on to improve the health of its corporates and economy were espoused as ‘Washington Consensus’ not too long ago, yet they have rankled global players in the process. I try to look through the narrative and polarization.
I think it’s a painful and messy process, but China is ‘coming of age’. Who survives the process and in what form if fluid and as ever highlights the importance of managing your risk VERY actively!
I’ve written about China alot! For some of my previous posts on China, check out the archive here.
