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What’s going on with China Evergrande Group?

ARTICLE  | 

Source Source: FactSet, as of 9/21/2021

 

It’s been anything but smooth sailing this year for Chinese stocks. A series of regulatory overhauls that began in earnest last November tightened government control across a swath of industries. The moves stemmed from president Xi Jinping’s publicly stated goal of “common prosperity” — not-so code for communist wealth redistribution.

One key regulatory change directed at the real estate market, which was intended to mitigate systemic risk to the financial system (dubbed the “three red lines”) sets limits on the amount of leverage firms are permitted to employ. China Evergrande Group, one of the country’s largest real-estate development firms and the most heavily indebted publicly traded real-estate development or management company in the world1, breached all three. Consequently, it was restricted from tapping the financial markets for liquidity, its major source of funding.

Its cash crunch was no doubt accelerated by the COVID-19 pandemic, which hindered property sales for months and therefore choked off much-needed cash flows to service the company’s sizeable debt. Still, while headlines surrounding the Evergrande crisis have taken center stage in the lead-up to debt payments coming due this week and provided a ready excuse for global stocks to take breather from their record climb so far this year, its parlous financial condition was well-known. Its stock price began its decent more than a year ago (freefalling to near zero over the past couple months), while its bonds were quoted at around about one-quarter of their par value, clear indications that the market was aware of the gathering storm.

On Wednesday, China Evergrande’s main onshore unit said in a filing that an interest payment on a key yuan-denominated bond “has been resolved via negotiations off the clearing house.” Payments on offshore, dollar-denominated debt are also being prioritized by the firm in a bid to stave off bankruptcy. While the immediate default crisis appears to have ebbed, at least temporarily, there is still uncertainty. Though few, if any, credibly view the situation as comparable to Lehman Brothers collapse in 2008, the possible fallout has investors assessing the potential knock-on effects given not only the company’s footprint in China’s real estate market, but the various other industries into which it expanded in recent years, particularly wealth management products (another avenue by which it generated cash flow to support its primary business).

As shown in the chart, the ongoing ambiguity surrounding China’s regulatory environment, now compounded by fears of potential Evergrande-born contagion, has dragged on the performance of the broader MSCI Emerging Markets Index. We believe concerns about the broader impact of an Evergrande Group implosion — should it occur — are not misplaced, though they are perhaps overdone. What happens in China is likely to stay (mostly) in China. According to Fitch Ratings, a default by Evergrande could expose many other sectors to heightened credit risk, though it expects fallout in the banking sector to be manageable2. S&P Global Ratings said an Evergrande default “will neither lead to a tidal wave of defaults nor mere ripples from a pebble in a pond but something between the two3.”

Ultimately, the circumstances suggest China’s government might be inclined to let market forces come to bear on Evergrande and its subsidiaries. However, it has already taken steps to support the broader financial system and reassure market participants. Per Barron’s, “The People’s Bank of China also pumped a further 120 billion yuan ($18.6 billion) into the banking system, easing investors’ nerves. Add to that reports that Chinese authorities are preparing the groundwork for a potential restructuring and it seems Wall Street may be right that this isn’t another Lehman Brothers moment4.” The company is, after all, not a state-owned enterprise; and the situation was accelerated, if not brought on, by new government-imposed regulations. Either way, we expect officials to take any necessary steps to maintain investor confidence and the integrity of its financial system. As for long-term U.S. investors, we view this as a potential buying opportunity, though the situation is likely to drag out with volatility along the way. Accordingly, we recommend a dollar-cost-averaging approach.


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