Ever (Not) Grande
Investors will have seen the US market falls on Monday (Monday night for Aussie investors) in reaction to the spiralling debt default story that is China’s largest property developer Evergrande.
According to reports in the UK’s Financial Times, Evergrande has 778 different property development projects underway in 223 different cities and owns 1.5 million partially completed buildings (including the land on which they are constructed). As an aside, one would think this should provide some collateral for the US$300 billion in defaulting debt. At this stage, China’s largest and most indebted property developer, has announced it has suspended interest payments on its alleged more than $300 billion pile of debt.
Fears of financial market contagion – a not insignificant amount of the debt is held by bond funds in the US and Europe – are understandable. But as we see below, a relatively small proportion of total debt held by banks is represented by Evergrande paper.
Nevertheless, there must be some merit to the concerns because Evergrande’s paper is trading at 20 cents in the dollar and debt issued by Evergrande’s developer peers are trading at 50 cents in the dollar. Meanwhile the US markets tumbled in reaction to the purported crisis.
Rather than add to the ink lakes being expended writing about the US market’s reaction to the evolving news about Chinese property developer Evergrande’s woes, I repeat here some of the thoughts from UK research house and broker Redington…with highlights my own.
“…As most commentators agree, Evergrande’s problems are not idiosyncratic. There are another 5 or 6 large developers poised just behind them – indeed, the woes in the Chinese High Yield market are almost entirely driven by the sector, which dominates the market for sub-investment grade credit in China. The “three red lines” policies…have effectively divided the sector in two – those players that can meet the restrictions and those that can’t – the ones that can’t are effectively trapped in a liquidity spiral. The debt of the next tier of developers is now trading at 50-60c, and JP Morgan believes that there could be a further $30bn of defaults this year across 11 names – which would represent a 23 per cent default rate for the sector.
“There are two key questions:
“Why is Evergrande paper trading at 20c when the company (allegedly) owns 1.5 million of part-completed buildings and the land underneath them.
“How much debt is at risk out there and is there a risk of a truly systemic issue here?
“On the first point, some commentators are arguing, sensibly, that surely the level of collateral should support a higher level of recoveries. The FT reports 778 different projects underway in 223 different cities, remarkably. Of course, it was only last week that China demolished 14 half-finished buildings in Kunming, with locals citing illegal construction and quality defects – so it is quite possible that the bond market is worried about the quality of the collateral. The second concern is that with this amount of stock on the market, any rapid realisation would be sure to send prices lower. Beijing must know real estate prices have to come lower, but it’s how that’s managed to avoid spiralling risks to the remaining stronger property developers.
“The second question is harder to answer. There are reports that the company owes high-interest debt to its own employees, raised just earlier this year – presumably another way to contort its way around the “three red lines.” The company certainly owes around $30 billion of hard currency denominated debt, while another ~$10 billion of retail investment products and possibly as much as $200 billion of onshore borrowing, from banks and other financial institutions. But JP Morgan’s Asia team estimates that bank exposure to Evergrande makes up just 0.22 per cent of bank lending, with even the company’s largest lender only holding 0.80 per cent exposure. This lack of transparency may be another reason for market uncertainty. If JPM is correct, it seems very unlikely that Evergrande, or even the next few dominos, represent a major systemic risk…”