Research China: The Evergrande situation and what we expect

Bottom line: We expect the turmoil related to Evergrande to get worse before it gets better. But we believe the Chinese government will eventually intervene as the alternative could be a financial crisis with very severe effects on the Chinese economy and the Chinese people. The government needs to strike a balance between on the one hand show that irresponsible behaviour has a price and reduce moral hazard issues in the credit market and on the other hand not allow a financial crisis to unfold. The Chinese mini-crisis adds another headwind to Chinese growth this autumn.

Background

The Chinese property sector is around 25% of Chinese GDP if both directs effects from construction as well as indirect effects from upstream and downstream industries included. The developer market is highly fragmented with many players. Evergrande is the second largest developer but only has a total market share of 4%.

Some developers, including Evergrande, have very high debt levels after many years of expansion and some of the companies used very creative financing tools as supplement to normal debt and bank loans. Most of the debt is domestic but offshore bonds have also been issued. Evergrande has debt worth USD300 bn equivalent to 2% of Chinese GDP.

After many years of growing debt levels, China put fighting financial risks on top of their agenda five years ago. In 2020 they tightened rules for developers putting limits on the debt and increasing requirements on liquidity (the so-called “three red lines” regulation).

The new regulation has created challenges for the most leveraged developers. Evergrande is one of them. When the housing market cooled down significantly this year after policy tightening, Evergrande has faced a liquidity crisis. For more info on Evergrande see box below.

On top of bank loans and issuance of bonds some financing for developers are through Wealth Management Products sold directly to Chinese citizens. There is a rising risk that they will start redeeming their money when possible and thus cut off a funding channel. Losses on these products could also lead to widespread protests.

How bad are markets hit?

Chinese stock markets have taken a big hit with offshores equities trading close to lowest levels in six years. Developer stocks have declined significantly over the past week and high yield financing costs are the highest in a decade at 14%. We believe the domestic contagion has reached a point where intervention from Beijing is needed to stop the snowball that has started to roll.

Until this week contagion to global markets has been limited but in recent days global risk sentiment has been hit. S&P500 dropped 1.7% on Monday.

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