fbpx

China Evergrande FUD – would this spark off a global market crash?

China, Stocks

Written by:

Alvin Chow

Problems don’t seem to end in China. The regulations have plagued the markets in the past year and now the indebtedness of China’s second-largest property developer has gone out of control.

There’s an increasing fear, uncertainty and doubt (FUD) that this might be a repeat of the Lehman Brothers collapse in 2008 (remember the sub-prime crisis, where Lehman Brothers and Bear Stearns died and many other banks were on the brink of extinction?), but this time it is happening in China.

The problem with social media today is that everyone can broadcast their views easily with just one click. We have many conspiracies and assumptions floating around, from the bears to the non-issue bulls. It is hard to know who is right. But one thing’s for sure: fear is spreading fast.

I know most of us are keeping an eye on this Evergrande problem and we want answers because we hate uncertainty. Unfortunately, I can’t give you certainty.

Instead, I can give you more information about the developer and share with you different viewpoints so you will not be biased. Then you will be able to decide objectively.

A little history of Evergrande (and the China property market)

The saying “Asians love properties” is an understatement. We Asians like to buy our own homes, and if we had more money, we would buy more houses to rent out – as though property investing is the holy grail of investing. The PRC Chinese are no different, except they take property investing to another level – the rich come to Singapore to buy properties by floors, not by units.

I was in Shenzhen a couple of years ago and a local shared with me the prices of the properties there. I was surprised that they were much more expensive than Singapore’s properties (and he bought a house in Hong Kong for his kid who got married). Yet, they were advertised as though they had a massive discount. I wondered how they can afford it considering their GDP per capita (Shenzhen: US$22K) was lower than Singapore’s (US$65k). Most likely, the rich are buying in bulk while the poor can only dream about owning properties.

China is a country that doesn’t want to have a huge gap between the rich and the poor, because it is a communist country after all (see common prosperity). The government knew there was a craze in property ownership all along, but they can’t outrightly contain the demand. In fact, real estate increased the middle class’ wealth and propelled China’s economic growth (in 2019, total sales of the real estate market reached almost 16 trillion yuan and accounted for nearly 10% of China’s GDP vs. 3% for Singapore). If the government takes away properties, they take away the China Dream. The country cannot afford to do that but they need to control the demand.

One example of control is when the Chinese government initiated numerous property cooling measures and based on the last count, they added 300 measures in Jul 2021! This makes Singapore’s property cooling measures look like child’s play.

Hui Ka Yan is definitely in the right business. In 1992, he founded China Evergrande in Guangzhou and started with small projects. His first project was an immediate hit, all 323 apartments were sold in half a day! Evergrande built on its early success and went on to land grabbing and made aggressive developments. It was an opportune time as the Chinese affluence was rising and more people could afford properties.

Evergrande went for IPO in Hong Kong in 2009 when the world was in the midst of recovering from the Great Financial Crisis. It managed to raise HK$70.5 billion and was the country’s largest private real estate company back then. And Evergrande’s success once made Hui the richest man in China.

With great wealth, comes flexing – not all managers can control their desires and allocate capital efficiently. Evergrande made many non-property related investments over the years and most have not done well economically:

  • Guangzhou Football Club (sold part of it to Alibaba)
  • Evergrande New Energy Vehicle Group to make electric vehicles (SEHK:708)
  • Hengda group have two major theme park brands “Hengda children of the world”, “Hengda water world”, and Hainan has a large tourist complex “Chinese island of Hainan to spend”
  • Heng Teng Network, a media company (SEHK:136) (sold to Tencent)
  • Shengjing Bank
  • Hengda Bingquan mineral water
  • Hengda music
  • And more…

At present, Forbes named Hui Ka Yan the 52nd richest in the world with a net worth of US$10.6 billion. Not bad, considering that Evergrande’s share price has collapsed (his net worth was US$27.7 billion in April 2021).

What are Evergrande’s issues?

Some said it started with the three red lines policy issued by the Chinese government in 2020:

  • Liability-to-asset ratio (excluding advance receipts) of less than 70%
  • Net gearing ratio of less than 100%
  • Cash-to-short-term debt ratio of more than 1x

Evergrande and Guangzhou R&F were two major developers that continued to breach all three red lines in Apr 2021.

Evergrande has been raising money by issuing more shares and selling off non-core assets:

  • Oct 2020: Raised about half of $1.09 billion via share placement
  • Jun 2021: Sold partial stake in China Calxon Group for $386m
  • Aug 2021: Sold HengTen to Tencent for HK$3.25b
  • Aug 2021: Sold partial stake in Shengjing Bank for $154m

But it wasn’t enough. It still has US$300 billion worth of liabilities and many parties to please:

  • Suppliers (construction, painters, materials etc)
  • Customers who are wondering when they will get the completed units as construction stalled
  • Bankers and bond holders as their loans are maturing
  • Investors who bought their wealth management products (more details later)
  • Handling of the few staff who did insider trading before the meltdown (more details later)
  • Government breathing down their necks

It is not a situation anyone wants to be in and it seems to get worse each passing day.

Firstly, the company’s most immediate concern now would be the maturing debts that they need to clear. If they aren’t able to do, they will receive default status and it will kick off a series of events that will tie their hands further. Eventually, they will go bankrupt.

To give you some numbers, US$83.5 million is due on 23 September 2021, and failure to pay within 30 days may result in default status. There’s another 232 million yuan coupon on an onshore bond due the same day.

Evergrande faces a total of $US669 million in coupon payments until the end of 2021. Fitch, a credit rating agency, has flagged Evergrande as a ‘probable’ default.

The second problem is that Evergrande was very innovative in using off-balance-sheet financing methods. They raised money by packaging loans as “wealth management products” that promised as much as 13% interest p.a. and sold them to individuals. More than 70,000 people have bought these products and $6.2 billion is now due. In Evergrande’s books, these products are not listed as liabilities.

Since China is a communist country, you better not bully the people. Hence, Evergrande is never going to get away with not repaying the promised amounts to those who invested in these wealth management products.

Third, early this year, Evergrande admitted to front running and insider trading by six executives. In their official statement, they said:

“As of May 1, 2021, a total of 44 people, who were then senior executives … held 58 investment products of Evergrande Wealth. From May 1 to September 7, … 6 people redeemed 12 investment products in advance,”

Evergrande has demanded the six staff to return the funds or else they will impose severe penalties. I wonder where these six people are right now. Similar to the second problem, the Chinese government is not going to let a few well-paid executives get away with what they did at the expense of the man on the street. This is a problem the company must resolve as well.

How will Evergrande or the China Government resolve this?

Evergrande plans to sell more assets in order to raise money:

  • In talks with Xiaomi to sell Evergrande New Energy Vehicle Group
  • In talks to sell Evergrande Property Services Group
  • Potential IPO of its mineral unit, Evergrande Spring
  • In talks with Yuexiu Property Co. to sell the office tower in Wan Chai with a price tag of more than $2 billion

In addition, Evergrande would be using its real estate units to pay off suppliers, contractors, and investors.

For example, Skshu is a painting company (SSE:603737) and had received ¥235 million in payment from Evergrande. Out of the total amount, around ¥220 million were in the form of unfinished real estate units which could take till 2024 to complete. But Skshu has already been selling some of these units in order to get cash.

Evergrande also offered investors of their wealth management products a repayment option in the form of discounted real estate instead of cash. They gave generous discounts – 28% discount for residential units, 46% for offices and 52% for stores and parking lots. I guess such attractive discounts have to be given to entice the investors to choose property units over cash.

For investors who opt for cash, they will be repaid 10% of their principal and interest each quarter and it will take 2.5 years to complete the repayment.

We can see that Evergrande is currently dealing with the problems and they look resolvable.

The Chinese government has not been open about what they are going to do with Evergrande’s issues. The most notable action they made was having its central bank, the People’s Bank of China boost liquidity by injecting a net 190 billion yuan last week.

If Evergrande’s problems are resolvable, why is there a big hoo-hah?

The fear of contagion

Some believe that Evergrande’s problem is not limited to the company alone, as it will set off a domino effect to the other property developers and banks. Eventually, it will cripple China’s entire economy.

First, the high-yield bond (aka junk bond) market is often the first to react when bad news hit. It was reported that Evergrande accounted for 16% of China’s high-yield dollar bond market, which is pretty substantial. The good news so far is that the crash is limited to the real estate high-yield bonds and not to China’s overall high-yield bond market.

You can see from the chart below that the Iboxx China Real Estate High Yield Bond Index crashed in June 2021. Moreover, its level is even much lower than during Covid last year.

As for the overall dollar-denominated China high yield bond index, it is down but still comfortably above the Covid low.

Second, other China real estate developers may face default risk too. Below is a chart compiled by Messari, which ranks Chinese developers by the degree of leverage:

Guangzhou R&F Properties and Greentown have even higher leverage than Evergrande. The attention is focused on Evergrande because it is much larger than the other two.

The share prices of the top 5 property developers by leverage have plunged significantly; their year-to-date (as of 21 September 2021) returns were:

  • Evergrande -85%
  • Yuzhou -62%
  • Guangzhou R&F -57%
  • Sunac -55%
  • Greentown -15%

Hence, the overall risk aversion is currently happening to the broad China real estate development industry since investors are pricing in potential problems other than that of Evergrande.

Third, the problem may cascade to the banks as they were responsible for lending the company money. Evergrande has a long list of principal bankers:

Reuters reported on a leaked 2020 Evergrande document that showed liabilities extending to more than 128 banks and over 121 non-banking institutions. On the one hand, it seems like many banks will be impacted. But at the same time, we can say that it won’t be that bad if each bank takes a small pie of Evergrande’s debt. The only concern is that the problem is not limited to Evergrande; banks will have to write off more debts of other developers.

In particular, Ping An Insurance has been probed by the China regulator regarding its property investments. The company stated that its real estate exposure was lower than the regulatory cap. Citi estimated the property exposure is about 4.9% of its investment portfolio. Ping An has already taken a hit on China Fortune and it has substantial stakes in China Jinmao, Country Garden and CIFI. Ping An Insurance share price has collapsed by 44% this year.

Basically, we do not know if Evergrande’s problem will spiral into a systemic problem that will bring down China’s GDP. And when this happens, the world will have a huge anchor on its GDP growth and it will reverse Covid recovery efforts.

What may happen next – BEAR case

There are enough bears and you might have come across some of their narratives.

Michael Burry, the guy who shot to fame with the Big Short, is well respected for his controversial contrarian view about the market. On Twitter, he shared two threads about Evergrande and you can read them yourself to avoid any loss in translation.

Here’s the first:

And here’s the second:

Let me summarise for you: He is arguing that it is a systemic issue and he is betting on a contagion. He highlighted the same issues that have been mentioned in this article – the spread of the problem to other developers and banks.

@INArteCarloDoss went on further to say that the spread has reached commodity players, especially iron and steel companies and miners, like BHP Billiton and Rio Tinto. He believes that China is facing a thorny issue that has been going on for years and they won’t be able to resolve it quickly. He even postulated the possibility of a US market crash due to the Evergrande issue.

@THeLastBearSta1 even suggested the conspiracy theory of Tether (USDT, a stable coin in the crypto world) buying Evergrade’s commercial paper. And if true, it could affect the entire crypto market, especially if Tether cannot hold the USD peg, the confidence of stable coins would be wiped out.

What may happen next – BULL case

For every bear, we have a bull. I will give you two to balance things up:

The first:

The second:

The bulls would definitely take an opposite stand – there’s no contagion.

Here are some points worth mentioning:

@asiahodl said that big high profile companies in China have failed before and the damages were contained. She cited three examples similar to Evergrande, where the company made many non-core investments during the height of their success and had to undo everything when the debt collector knocked on their doors.

Remember HNA? The conglomerate had several stakes in airlines, airports, Hilton, Deutsche Bank, 245 Park Avenue, Old Mutual, just to name a few. It declared bankruptcy and life went on (except the founder fell to his death in France).

Dalian Wanda is another comrade of Evergrande – they diworsify. Dalian Wanda acquired AMC Theatres, British yacht maker Sunseeker, Australian cinema chain Hoyts, film company Legendary Entertainment, football club Atletico Madrid and more. The company now is a shadow of its former glory as it discards its assets. Its boss, Wang Jianlin, has since lost US$32 billion trying to save the company. In this case, the problem also didn’t spread.

What @asiahodl is saying is that: why should this time be different?

What I think

Initially, I thought the Evergrande issue was going to be contained. But there was a sudden outburst of media coverage about the case and it scared the stock markets around the world (and even the cryptocurrency industry). I was scared too and thought the crash was imminent. But I knew I did not have enough information so I did fact-finding, which I presented to you in this article.

Considering all things, I side with the bulls more than the bears, based on the information I had at the point of writing. I find that the bears are exaggerating in some points and they tend to be biased on the short side (with names like “The Last Bear Standing”). And I think a lot of the contagion possibilities are still conjectures. Yes, we have seen some impact on property developers and banks but that’s all; it didn’t affect other industries. This is why I find some of the bears’ arguments too stretched.

Most importantly, I built a portfolio of stocks with a long-term view. Even if it indeed cause a crash, I would still be holding on to the stocks as long as the businesses are still strong. I am not a macro trader because I have no edge in the game. I can’t really foretell a bear market. But that’s just my opinion, what do you think?

1 thought on “China Evergrande FUD – would this spark off a global market crash?”

  1. Well written article! Agreed on the point that most media coverages were in the bear-camp. As with stock investment, the focus should be in the business. Unfortunately, market sentiments determine the share movement. Only investing in good businesses with the right perspective would reap the (financial) benefits in the long run.

    Reply

Leave a Comment