Evergrande’s problems are highly unlikely to create a systemic risk.  The company does have a large debt burden, but it is insignificant given the scale of China’s financial system.  Evergrande’s total liabilities are roughly equal to 1% of total bank loans outstanding in China, and to about 0.6% of aggregate credit outstanding.  Moreover, according to the company’s financial disclosures, Evergrande’s total assets are greater than their total liabilities.

These comments come from Matthews Asia, managers of the BMO Asian Growth and Income Fund and LGM, managers of the BMO Greater China Class Fund

Evergrande – Q&A with Andy Rothman, Matthews Investment Strategist

Are Evergrande’s problems a reflection of systemic weakness in China’s residential property market?

China’s housing market is generally sound and has not been generating the kind of financial system risks that developed in the U.S. during the decade prior to the Global Financial Crisis, in part because China’s regulators have learned from our mistakes.  Chinese banks have not been permitted to make irresponsible mortgage loans, and homebuyers are required to put down a lot of cash.  There is very little mortgage securitization and most banks hold mortgages through maturity, so they have a clear incentive to avoid lending to risky borrowers.

Recently, however, Chinese regulators have become concerned about debt levels among developers, and put in place new regulations to manage that potential risk.  Those regulations have led to slower growth in new home sales, which has stressed some developers, including Evergrande.

Tighter government policies led to a similar slowdown in 2014, which contributed to conditions which led one developer to restructure, and another to default on dollar-denominated bonds. 

Will the company’s inability to complete apartments for which buyers have already made down payments lead to social unrest?

We expect that the Chinese government to take an active role in managing the restructuring of Evergrande with a focus on completion and delivery of existing residential projects.
Similarly, we expect the restructuring to prioritize protection of retail investors in Evergrande’s wealth management products.
This would be consistent with the government’s continuing focus on maintaining social stability.   

Perspective from Satya Patel, Portfolio Manager and Asian Credit Specialist

[In terms of Evergrande] “There are a few things I’ll mention.  One is that much of Asia was on holiday on Monday & Tuesday, so some of the moves we’ve seen in both stocks and bonds were no doubt driven by technicals.  Dealers didn’t want to take on risk starting late last week because they’d have to hold it for 4-5 days through the holiday, so that led to thin liquidity and a bit of a vacuum that tends to exaggerate price moves.  It’ll be interesting to see how Asian markets open back up now for the rest of the week.  Whether it goes up, down or stays the same, I think that’ll be more indicative of market direction than the last 2-3 days were.

Third, to answer his question directly, the answer is I don’t know for the very short term (however we define it – the next few days or 1-2 weeks).  There’s uncertainty in the market right now so I think investors will remain cautious. Evergrande is due to make a coupon payment on Thursday, and given their liquidity situation I can’t imagine why or how they’d make that payment (I suspect that’s a consensus view).  Evergrande is going to continue to be a story in markets for the next several quarters as the company goes through its restructuring.  I think policymakers in China will be much quicker to ensure that there’s adequate access to liquidity in the property sector.  The turning point in the market will be when investors can look through to the medium term and start to gauge where the risks are for a permanent loss of capital in some of the lower quality developers (not the ones we invest in).  Prices have fallen enough that you can argue there’s value if you can get comfortable that a particular company won’t default.  For now, I think we need more news and policy certainty to be able to call the bottom in the sector.

Is Evergrande defaulting a big deal?

Yes in terms of size (current estimated liability is USD300bn, however we would not be surprised if the final audited number when a liquidator is appointed to be a multiple of the liabilities disclosed in the financial statements). However, it should hardly be a surprise that Evergrande defaults. It has been the most leveraged developer in the world for many years. It has been in trouble even before its IPO, a fact well known across the market.

How big is the systemic risk to the financial system and overall Chinese economy?

  • Property and its related upstream and downstream sectors (home appliance, furniture, construction materials, etc.) are the key drivers of GDP accounting for almost 30-40% of GDP.<
  • The stress in the property developers also caused slower land sales, which put significant pressure on some local governments which are heavily relying on land sale for fiscal funding. A few of them (Hebei, Shandong, Anhui) are already asking for help from the Central government.
  • Apart from Evergrande, there are a handful of other smaller developers are also on the edge of defaulting. As widely expected, the priority of cash deployment is to complete sold projects, pay workers and suppliers. Banks and bond holders would be the last in the order.
  • The Banking sector has been used as a buffer for economic shortfall and crisis management since 2008, to make sure the rest of the economy remained stable. So far they have been “effective” in absorbing and digesting trillions of bad debts in the last 10 years. As of 1H2021, China banking industry as a whole has set aside Rmb5.4tn (USD830bn) provisions, and it has in total Rmb20tn (USD3bn) equity. It doesn’t seem to be a lot if things turn really ugly. But the key difference Chinese banks have, compared to western world, is that the liquidity won’t freeze like what happened post Lehman, there is no trust issues as the whole system is virtually backed by the government. This is helpful so that they can buy time to sort things out.
  • While the government has to step in to coordinate the rescue plan, it is very likely those cash rich state owned enterprises and private companies would have to chip in. We would be mindful of companies which are prone to national service.