All eyes last week were on Evergrande, the world's most indebted property developer. With debts estimated at some $300bn and no spare cash, there were worries that interest payments on its bonds would not be paid.
So there was a collective sigh of relief on Wednesday, when China’s real estate giant managed to pay its interest payment on a domestic bond.
But worries resurfaced on Friday when the deadline for payment of an offshore bond came and went without a murmur from the company.
As the firm enters a 30-day grace period before it potentially defaults, investors are left in limbo.
According to the Financial Times, Evergrande’s dollar bonds were trading at about 30 cents on the dollar on Friday, while Hong Kong-listed shares in the company fell up to 6.7%, meaning they are down more than 80% this year.
As many will know from our own property bubble in the 1980s and the global financial crisis, property has a nasty habit of causing financial trouble. It’s the one investment that most people seek to make, at least once in their lives. It also tends to be irrevocably linked to debt, which is perhaps the problem.
Julian Chillingworth, CIO at Rathbones, explained: “China has been battling a dangerously inflated property boom for many years now. Developers borrowed heavily from investors all around the world, using the cheap debt to finance countless apartment blocks and houses thrown up all over China. Demand for these homes, both as abodes and investments, was huge.
“However, many companies overstretched themselves, repaying maturing debt with ever more debt as they chased sales growth. This has finally come to a head with Evergrande, China’s largest real estate company, sending a very public mayday call after new government rules stipulated that over-leveraged developers must repay old debt before issuing any more.
“The government is trying to stop runaway price inflation in homes and encourage developers to become more financially responsible. It seems to have had the desired effect on property prices, but it may also destroy developers rather than bring them to heel.
“Property is crucial to so many people’s lives. There are the builders, architects and tradesmen whose livelihoods are erecting the buildings, fixing them, modifying them, renovating them. It is the single-largest investment most people make and the place that keeps their family safe. This psychological impact should never be downplayed.”
Market opinion is divided on whether the government will rescue Evergrande or let it fail as a warning to the rest.
Julian Chillingworth commented: “There are so many more developers in a similar position, if Evergrande turns into a messy blow-out, the fallout would likely bury them as well. Not only that, but most of the creditors are local construction companies, subcontractors and Chinese citizens who have put up hefty deposits to secure homes off-plan. Letting those people down would be a political nightmare.”
The people at Alquity think the company will default, but there the impact will be controlled. “This crisis has been a long time in the making,” they said. “Current market pricing, in our view, implies that investors agree that Evergrande's default is already a foregone conclusion – the only unanswered question what it will mean in terms of market as well as economic impact.
“An uncontrolled default on the company's financial obligations could have wider implications in terms of financial markets, i.e. a default would potentially trigger a widespread contagion across domestic financial markets, which eventually could feed back into a negative loop weighing on China's growth prospects.
“This outcome is definitely one President Xi Jinping and his government will want to avoid. However, it is also in the President's interest to discourage other overstretched borrowers from applying for government bailouts in the future.
“Therefore, as long as Evergrande's case remains unresolved, volatility could persist, but we do not expect a fully blown systemic crisis. Given China's managed economy and controlled financial ecosystem, as well as high levels of domestic savings and foreign exchange reserves, the government has plenty of levers to pull to ensure that this does not happen.”
Emiel Van Den Heiligenberg, head of asset allocation at Legal & General Investment Management, agrees with Alquity: “Evergrande accounts for 6.5% of liabilities in China’s property sector, and its sales make up roughly 10% of all property transactions in the country,” he said. “Evergrande could therefore pose a systemic risk, but so far stress in the financial sector has been localised. Interbank spreads are not elevated and the renminbi has held up well.
“Evergrande’s problems could still affect the broader economy beyond the financial channel. People are no longer buying off-plan properties from the company; if this feeds through to Evergrande’s building activity, it could leave a noticeable impact on GDP. August property sales and starts were already in contractionary territory, and GDP is under pressure from COVID-19 outbreaks and lockdowns.
“We believe the authorities have the levers to steady the ship, however, and will do so soon.
There is a manageable path forward, in our view, but China’s history of managing delicate situations in financial markets is not unblemished, so this remains a risk to watch in the weeks ahead.”
Rob Brewis, co-manager of Aubrey Global Emerging Market Opportunities, which is on the Chelsea Selection, concluded: “Beijing has been well aware of Evergrande’s rising debt ratios for several years and has been trying to cajole the developer into de-gearing. Unfortunately, for want of the means, the founder of the business, Xu Jiayin, has continued down the “I am too big to fail” route. This has finally come home to roost. The company’s debt is huge and will take a decade or more to unravel.
“The government’s priority is to manage the process without creating too much of a stir. The last thing the new “Common Prosperity” initiative needs is the distraction of large numbers of people who have put down deposits on unfinished projects or have invested in some bank wealth management products with exposure to the group being left penniless.
“Much of the debt will be with government banks who will, no doubt, manage the bad debts down over many years. It will be a massive headache, but not in any way a systemic risk. We would have seen that in broader bond markets, or indeed the currency, but there has been nothing.”
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and commentators and do not constitute financial advice.