The biggest worry in the financial market now is not the US tapering or China tech crackdown, but the possibility of default of China Evergrande Group (中国恒大集团). The report of China Evergrande’s situation is on the news every day, but many Singapore investors are not even familiar with the name. This article gives you a quick summary of what is happening and why it rocks the financial markets.

Evergrande’s situation and the default implication is complicated. Many say the default of China Evergrande will become the “Lehman Moment” – the start of a global financial crisis. According to research, even after selling some of the assets, Evergrande still has a hand in more than 778 real estate projects in over 233 Chinese cities. The company is thought to owe money to 128 banks and 121 non-banking institutions.

If you recall, the collapse of the Lehman Brothers triggered the Global Financial Crisis (GFC) in 2008. With $300 billion in liabilities and links to myriad banks, will Evergrande send shock waves through the financial system and cause another financial calamity? Or will Evergrande be another AIG and some other American banks that were too big to fail by the central government?

What’s Evergrande?

Evergrande is the second-largest real-estate developer in China. It was founded by Hui Ka Yan (许家印) in 1996 in the southern city of Guangzhou, formerly called the Hengda Group. Evergrande Real Estate owns more than 1,300 projects in more than 280 cities, according to a company website.

The group now goes far beyond homebuilding, with investments in electric vehicles (Evergrande New Energy Auto), an internet and media production unit (HengTen Networks), a theme park (Evergrande Fairyland), a soccer club (Guangzhou F.C.) and a mineral water and food company (Evergrande Spring), among others. It reported an adjusted core profit of 30.1 billion yuan ($4.7 billion) for 2020.

What started the trouble?

The quick expansion of Evergrande’s business was through borrowing. Evergrande is the world’s most indebted developer. But the liquidity issue started in recent years. Evergrande reportedly sent a letter to Guangzhou officials in August 2020, warning officials that payments due in January 2021 could cause a liquidity crisis and potentially lead to cross defaults in the broader financial sector. The crisis was averted soon after when a group of investors waived their right to force a $13 billion repayment.

If you look at the chart of Evergrande’s bond (take 23Mar2022) as an example, the bond has faced sell-off multiple times but always recovered miraculously.

It is often said that if you owe the bank $1m, you are at the mercy of the bank; but if you owe the bank $1 billion, the bank is under your knees. Evergrande owe $300 billion!

What is wrong this time?

There are many reasons but I think the macro environment plays. China government has always been wanting to clamp down on the real estate market which was the hardest rock to crack. Chinese are obsessed with property investment and there are too much at stake.

The real estate developers are all overleveraging and post a systematic risk to the financial system. However, the trade war started by Donald Trump, Hong Kong protests and the Covid-19 pandemic forced China government to lower the priority of deleveraging.

It seems this year, the China government has put this thing back on the table. They set “three red-lines” to force the real estate sector to deleverage and improve their financial health.

Read this UBS report if you are interested in understanding the “three red-lines” more.

As a result, Evergrande outlined a plan to cut its $100 billion debt pile roughly in half by mid-2023, including a series of assets sales and stock offerings. But they simply have too much debt to repay.

Evergrande has raised about $8 billion this year as of August, selling shares in its EV unit, HengTen, an Hangzhou property firm and a regional bank. It’s also said to be exploring a listing for its tourism business and possibly the water business too. None of those offers quick fixes, however, because any sales probably wouldn’t be completed before next year. Meanwhile, the company’s debt has been repeatedly downgraded; Fitch Ratings said on Sept. 8 that a default seemed probable.

What about more borrowing?

Traditionally, real estate developers can always issue new debt to pay off the old debts. And that is exactly what the US Fed was doing too. The problem is that when there is a sudden loss of confidence, nobody will buy your bond anymore.

Evergrande is Asia’s biggest issuer of junk bonds, but they haven’t sold a single dollar note since January 2020 as it looks to reduce its debt load. In any case, Evergrande is under pressure from the government to cut borrowing in recent years.

Hui Ka Yan is famous for his connections. He has always been able to tap some fellow tycoons in the past. Mr Hui has close ties with real-estate empires run by members of the Big Two Club, so-called because of their fondness for a Chinese poker game. The group includes

• Chinese Estates Holdings’ Joseph Lau,
• New World Development Co billionaire Henry Cheng and
• C C Land Holdings’ Cheung Chung Kiu.

In all, the three poker pals were involved in at least $16 billion of transactions with Evergrande over the past decade. Another benefactor emerged in July when Asia Orient Holdings Ltd., led by secretive tycoon Poon Jing, added to its big position in Evergrande bonds.

But given China’s “anti-rich” sentiment now. This source of borrowing could be put to test.

How fast will Evergrande default?

Given the current bond price of about $25 to $100 par, the market seems to be pricing that the bond will default as soon as this week as there are some coupon payment is due.

However, the absolute coupon payment is not much. It needs to make $669 million in coupon payments through the end of this year. Some $615 million of that is on Evergrande’s dollar bonds. We will know the moment of truth by the end of the week.

If Evergrande somehow steers out of this crisis, the real test is 2022. Next March, $2 billion of Evergrande’s outstanding bonds come due, followed by $1.45 billion the following month. While Evergrande has repaid all its public bonds this year, refinancing in 2022 would be challenging if the developer’s access to capital markets doesn’t recover in time.

What is the chance of a government bailout?

Evergrande is called the “king of debt” and was always regarded as too big to fail in the high yield bond space. At this moment, the central or provincial governments or state-owned enterprises could step in with some sort of lifeline or forced restructuring.

Beijing was said to have instructed authorities in Guangdong to map out a plan to manage the firm’s debt problems, including coordinating with potential buyers of its assets. Regulators in September signed off on a proposal to let Evergrande renegotiate payment deadlines with banks and other creditors, paving the way for another temporary reprieve.

As as I said earlier, the market has priced in the worst scenario.

It’s a dilemma though. A bailout would be seen as condoning the type of reckless borrowing. If we look into history, the US bailout of the banks during the global financial crisis only encouraged the corporate debts to reach new highs now.

However, allowing a big, interconnected company like Evergrande to collapse would reverberate across the financial system and also be felt by many millions of Chinese homeowners and those who bought Evergrande’s financial products. We have already seen disgruntled Evergrande investors protesting at their headquarter. And how about those uncompleted properties and homebuyers?

I think social stability and the pain and discontent from the general public are Beijing’s key considerations. The China real estate sector directly contributes 10-15% of China’s overall GDP growth and therefore is systemically important to the Chinese economy. Furthermore, most local governments rely on the property market, which is the largest revenue source for local governments.

So I think it’s unlikely that the Chinese government will allow more widespread defaults across the sector, which is set to have a significant impact on overall economic growth and social stability.

The other interesting thing is that Hui Ka Yan seems to be in a good relationship with the central government. After the suspension of ANT IPO in November last year, Jack Ma has disappeared from the public eyes.

But while Evergrande was under fierce pressure to clear its debts, Hui Ka Yan was seen at Communist Party’s centenary party on 1st July in Beijing. Attending such a high-level gathering is a sign of the network and influence of the billionaire.

How about spillover effects?

Outside the property sector, many people are talking about the potential spillover effects from an Evergrande default. The area most discussed is the Chinese banking sector, which has historically loaned money to Evergrande.

I think the impact in the Chinese banking sector will be limited, as Evergrande’s total bank borrowings account for only around 0.1% of loans in the system, though a few small and medium-sized banks with higher concentration could face greater pressure and potentially need some degree of recapitalisation.

What is not widely discussed is the impact on the price of commodities, such as metal and copper, which are mainly used by the building industry. I think they deserve a close watch.

Above all

Contagion worries have fueled a global stock market sell-off in the past few days as nobody knows the extent should Evergrande really default. Asian high yield bonds already experienced a free fall.

If you are currently invested in Asian High Yield bond funds or ETFs, at this point in time, the funds’ exposure to China Evergrande would have reduced significantly. What used to be 5-6% of the index, the exposure would have dropped by roughly a third as the bonds are now trading below 30 cents on the dollar. In a worst-case scenario, you may be more compensated if Evergrande really defaults.

Evergrande is a reminder of the importance of diversification which I always stressed but was not valued in a stock market bull run over the past year.

Every crisis is an opportunity. For the yield-seeking investor, the Asian high yield bond sector may even look attractive.

If you are currently holding on to the bonds issued by China Evergrande, I think that at current prices, the incentive to sell the bond is low as the haircut level under a debt restructuring will not be lower than its current price. Thus, you may want to continue to hold your position in the bonds.

Personally, I feel the fear may be overplayed. I have my reservation about how bad the situation is because all parties are incentivised to avoid a liquidation scenario. The recent bailout of Huarong shows it is not so easy for the central government to allow systematic risks to upend the financial markets. But we will let the market show us the moment of truth.

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