In a world of headlines and 30 second attention spans, the crisis engulfing China’s second largest property developer, Evergrande, certainly brings back painful memories of the Lehman Brothers collapse and the Global Financial Crisis (GFC). But is this an accurate depiction of what is to come or merely another round of scaremongering?
There is definitely one key similarity – both started in the housing markets. The GFC was triggered by the collapse of the US housing boom and in particular, lax lending standards. As we will all recall, this then led to a banking liquidity issue as no one knew who was holding the so-called toxic debt. Once again, the Evergrande situation started in the property sector but that is where the similarities end.
There will be lasting economic effects from what is going on in China, but it will not result in a global impact to the extent that we witnessed during the GFC.
To many pundits, that may be a bold statement but to get there, we need to look past the headlines and dig into the details. I understand why some commentators do not dig too deeply. China is after all an opaque market, but if you are willing to do some research, you can find some clues as to what is really happening.
The Details
Evergrande has approximately US$300 billion in debt on its books at the moment and it has recently missed key interest repayments – so this is a case of where there is smoke, there is fire. The key aspect to consider though is that only US$20 billion of this debt is held against the corporate entity by offshore bond holders. The balance of the debt has been issued via hundreds of smaller loans by Chinese institutions.
While US$20 billion is a large amount, it is not going to bring down the global debt markets. This debt was issued out of Hong Kong and was generally purchased by numerous high yield bond managers. The key here is that the level of debt and who holds it are widely known. This debt has also now been written down to US$0.26 in the dollar, so any losses are already a known quantity.
The next aspect to consider is whether the Chinese issued and held debt poses any concerns? Here, we need to consider how we got to this situation in the first place.
The Background
In previous times of financial difficulties, such as 2003, 2008 and 2015 the Chinese government favoured a policy of effectively bailing out corporates that were considered too big to fail. In essence, exactly what Western nations did during the GFC. The problem however, was that this developed a race amongst Chinese corporates to simply be the biggest so that they too could be bailed out in the future.
Over the course of the past decade, the Chinese property market has been booming and there has been a real drive to become rich through property development. Interestingly, the property market is still yet to see a dramatic fall in prices triggered by the potential collapse of Evergrande.
Part of the reason is that new properties purchased ‘off plan’ are usually much cheaper than existing ‘used’ properties. This anomaly stems from the fact that the government places caps on the sale prices of new units before releasing the land to developers and providing development approvals.
One by product of this affordability scheme saw investors scrambling to buy off-plan units as they knew they could sell them at much higher levels in the secondary market. This loophole has now been somewhat closed by the government as it’s now enforcing a 5-year holding period before a property can be resold.
To a large extent, Evergrande followed two similar strategies. Firstly, it purchased as much land as it could in order to become ‘too big to fail’ and it also tried to take advantage of the strong property market by delaying the construction of new homes as long as possible to take advantage of rising prices.
Evergrande financed the land acquisitions on a parcel-by-parcel basis as opposed to obtaining a group wide loan. This means that each time they purchased a new land parcel they obtained a loan from a local bank and used the land purchased as the security. This is a very important distinction between this crisis and the Lehman crisis in that the debt has not been syndicated and sold to investors.
Critically, most corporate debt issued in China is also for 1 or 2 year terms so it is very common to see debt rolled over on a regular basis.
The Trigger
Earlier this year the central bank issued the “Three Red Line” policy which essentially forbade banks from lending to developers with too much debt compared to assets and who didn’t generate enough cash to cover their short-term liabilities. This was specifically designed to target developers who were holding onto large land banks.
As I noted earlier, approximately 93% of the debt issued is held by local Chinese banks and they are holding land as security. It is understood that the value of this land has, in the majority of cases, held its value. In the past week we have seen many instances of Chinese corporations being encouraged by the central government to purchase these parcels, refinance the loans and get construction started. This is basically a liquidity crisis engineered by the central bank against specific developers.
Why the central government push and isn’t this just another bailout?
One of the key drivers of the Chinese government is a happy populace and in the case of Evergrande, there are thousands of citizens who purchased off-plan who now fear that they have lost their deposits. By imposing a liquidity squeeze, Evergrande will be forced to sell its land holdings to other developers who, being in a healthier financial position, will be able to obtain financing to complete the housing projects. Citizens will get the houses that they have paid for.
It is clear that this situation has been a conscious decision of the central government and is a warning to other corporates that the old strategy of ‘too big to fail’ will no longer hold. The government will force the sale of Evergrande’s assets to other developers to protect its citizens and any domestic lending losses will be absorbed by the numerous lenders.
While it is in effect a form of bailout, and there are likely to be more developments in the coming weeks, Evergrande will most likely be allowed to fail as a warning to others. Offshore holders of the corporate debt will be the largest losers, but it will not be large enough to create a systematic global failure.
There will also be a domestic economic impact in that growth will continue to slow in China, but this has been on the cards for some time. Speculation in housing construction will also slow but houses will still be constructed where there is genuine demand. The main impact I envisage for our domestic equities is the continued pullback in the iron ore price as the demand for steel declines.
Andrew Aylward is Chief Investment Officer at Keep Wealth Partners.
Keep Wealth Partners Pty Ltd (AFSL 494858). This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from a financial planner who can consider if the strategies and products are right for you.
