Executive summary
In recent weeks, investors have been concerned by the liquidity crisis of Chinese real estate developer Evergrande and its potential spillover to global financial markets. This has triggered increased volatility, a pullback in valuations in the Chinese property and finance sectors, and a general sell-off of Chinese, Asian and global securities. The Acatis Qilin Marco Polo Fund is not invested in the Chinese property sector nor in the Evergrande company.
From our perspective, Evergrande is not China’s Lehman moment and we don’t believe there is a high systemic risk to global markets. While the government wants to signal the end of uncontrolled “wild west” growth in real estate and might not bail-out Evergrande, it will, if required, step in quickly and forcefully to contain the spread into the overall property and financial sector. The majority of Evergrande’s debt is held by state-owned Chinese institutions and the government has the means to control this situation.
Overall, China continues to set stage for a new socio-political growth model that better balances it’s social development with its growth aspirations to become the largest global economy with an open capital market by 2028. Evergrande will not stop this momentum.
Background
Evergrande Group is China’s second largest real estate developer with side businesses across a wide range of industries including electric vehicles, health care, consumer products, etc. It is currently unable to make interest payments on part of its $309 billion of debt. According to the EIU, Evergrande owes money to 171 Chinese banks (primary lenders include Mingsheng Bank, Agricultural Bank and Industrial & Commercial bank of China) and 121 financial institutions. UBS estimates that foreign investors of Evergrande dollar denominated bonds account for $20 billion of its liabilities.
What caused this?
Evergrande’s liquidity crisis stemmed from its rapid expansion fueled by loans and the government clamp-down on the property sector. In the last year, the government began to seriously tackle the “Three Mountains” (spiraling costs of housing, education and healthcare). Concerned about a real-estate bubble, Xi Jinping railed that “houses are for living in and not for speculation”. Regulators capped the amount of mortgages and property loans that banks could make. It also introduced price controls on rentals and sales of new homes in major Chinese cities to rein in skyrocketing home prices.
In parallel, the government last year introduced “Three Red Lines”, metrics aimed to curb property developer’s debt ratios with respect to their cash flow, assets and capital levels. The overall impact was to force developers to deleverage. As a result, developers like Evergrande were forced to discount and sell homes to boost sales and shore up cash. Given the slowdown of the housing market, Evergrande was unable to meet its debt payments on time, leading to a cash-flow crunch and tumbling stock prices.
Is Evergrande China’s Lehman Moment?
From our perspective, Evergrande is not a Lehman Brother’s moment. First of all,Evergrande’s liabilities of $309 billion are half that of Lehman Brothers and have substantial real estate assets securing them. Secondly, US and global financial institutions held the majority of Lehman’s commercial paper and asset-backed securities (sub-prime loans that were securitized) which triggered a global credit crunch and financial meltdown. The majority of Evergrande’s debt is held by Chinese institutions. Third of all, Chinese regulators have indicated their willingness to intervene, particularly as over half of the borrowings are from Chinese banks which are state-owned.
Potential outcomes
Buy time: We believe the regulators will request state-owned banks to roll-over loans to give Evergrande more time to repay. In the meantime, Evergrande will continue to try to sell off its other businesses and assets. The People’s Bank of China will likely continue to ease liquidity. It injected US$14 billion on Friday and another $15 billion on Saturday into the banking system. It may reduce the reserve requirement ratios by another 50 basis points. Banks have already set aside loan loss provisions. In addition, the government has compelled Evergrande executives to publicly sign a pledge that it will complete construction on unfinished property developments, in order to quell potential social unrest.
Bail out: It is possible but unlikely that the government will directly bail out Evergrande given the government’s commitment to deleverage the real estate sector. Regulators had previously bailed out Huarong, a state-owned financial institution responsible for managing distressed assets in the banking sector, which held US$238 billion in liabilities. The regulators assembled a group of strategic investors including state-owned enterprises including Citic, China Life Asset Mgmt and China Insurance Investment to inject $7.7 billion yuan and recapitalize the company. Authorities in Guangdong have already rejected a direct bailout request by Evergrande’s founder. Nonetheless, several state-owned enterprises including Shenzhen Talent Housing Group and Shenzhen Investment, both owned by Shenzhen regulators are in talks with Evergrande. However, no deals have been reached yet.
Bankruptcy and restructuring: In the event of bankruptcy, investors will get a percentage of what they are owed according to some level of hierarchy. Likely, state-owned banks will get paid first, followed by state-owned enterprises. Homeowners, private investors, employees who bought wealth management products from Evergrande and foreign bond investors will likely be further down the line and take significant haircuts on what they are owed. At the moment, Evergrande has started to repay some of its investors and suppliers with discounted properties in lieu of cash. Regulators might actively encourage or coordinate the sale of Evergrande’s assets. Very likely, Evergrande’s property business and projects will be split across other property development companies, and its land reserves sold off.