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Ever (Not) Grande

23092021_Evergrande

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…”

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Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than two decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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Comments

  1. I agree. I think the closest parallel to China 2021 is the Japanese property bubble in the early 90s.

    When the Japanese bubble popped, it didn’t cause a global crisis. This is because most of the debt belonged to Japanese institutions and was funded by Japanese savings. China today is in a similar situation.

    Like Japan, China’s economy will stagnate for decades. This is inevitable when you consider China’s terrible demographics, enormous debt pile and the economic drag exerted by a corrupt and capricious ruling elite.

    However, China (unlike Japan) has a fixed exchange rate and an overvalued currency. As such, China’s HKD – USD currency peg will come under extreme pressure. We may see a currency crisis on top of economic stagnation.

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