Evergrande—Too Big to Fail?
The recent issues with China Evergrande Group have raised concerns over the broader health of China’s real estate market, the potential risk to its financial system and, more broadly, whether this could trigger a global financial problem. In our latest Q&A, Portfolio Manager Teresa Kong, CFA and Investment Strategist Andy Rothman provide their views and insights.
Do Evergrande’s financial problems represent a risk to China’s financial system?
Teresa Kong: We believe Evergrande’s financial problems are highly unlikely to create a risk to China’s financial system. The company does have a large debt burden, but it is insignificant given the scale of China’s financial system. It's worth noting that, in recent years, two companies with similar magnitude debt burdens, Anbang and HNA, were successfully restructured without creating systemic damage. As in the past, we expect the government to take an active role in managing the restructuring of Evergrande to mitigate the risks, by ensuring that its current liquidity problem does not become an insolvency problem and a bigger crisis of confidence in the Chinese financial system.
Are Evergrande’s problems a reflection of systematic weakness in China’s residential property market?
Andy Rothman: China’s housing market is generally sound and has not been generating the kind of financial system risks that developed in the U.S. during the decade prior to the Global Financial Crisis, in part because China’s regulators have learned from our mistakes. Chinese banks have not been permitted to make irresponsible mortgage loans, and homebuyers are required to put down a lot of cash. There is very little mortgage securitization and most banks hold mortgages through maturity, so they have a clear incentive to avoid lending to risky borrowers.
Recently, however, Chinese regulators have become concerned about debt levels among developers, and put in place new regulations to manage that potential risk. Those regulations have led to slower growth in new home sales, which has stressed some developers, including Evergrande.
What’s the possibility for a contagion effect?
Teresa Kong: In our view, Evergrande’s problems are unlikely to cause systemic problems and the likelihood of this devolving into a global financial problem is miniscule. Our base case is that Evergrande will undergo a restructuring that might result in loss to some stakeholders. The next couple of quarters could also result in additional demand for liquidity on the part of the property ecosystem from materials suppliers to contractors. This means that China will have to use some tools to ensure that there’s sufficient system-wide liquidity. However, we do not expect this to spiral into a financial crisis. The main reason is that Evergrande is not a strategically important financial institution with so many interconnections with other financial institutions that would undermine the liquidity of China’s financial system.
In which scenario could Evergrande’s issues pose a global finance problem?
Teresa Kong: Evergrande’s saga debunks the notion of “Too big to fail.” To create systemic problems, size has to be coupled with strategic importance and interconnections with a country’s liquidity system. “Too big and strategic to fail” does exist in China as it does in the rest of the world, such as systematically important financial institutions like the largest banks in a country. However, in this case, we expect the issues surrounding Evergrande to be largely contained to within China. The negative sentiment resulting from the default of a large enterprise in China may temporarily spillover into the rest of the Asia high yield universe.
Will the company’s inability to complete apartments for which buyers have already made down payments lead to social unrest?
Andy Rothman: The Chinese government’s focus on inequality and housing affordability has led them to take steps to restrict the availability of mortgages, which has cooled the property market. New home sales rose by 17% year-on-year (YoY), on a square meter basis, during the first eight months of this year, but sales fell YoY during July and August, and that weaker performance is likely to continue in the coming months. The median price of new homes in 70 large cities rose 3.9% YoY in August, down from 4.6% in July and 5.1% a year ago.
Tighter government policies led to a similar slowdown in 2014, which contributed to conditions that led one developer to restructure, and another to default on dollar-denominated bonds. Social unrest was avoided then, and given our expectations that the government will take an active role in managing the restructuring of Evergrande with a focus on completion and delivery of existing residential projects, we do not expect social unrest this year.
Teresa Kong: The Chinese central government has already appointed the provincial government of Guangdong to take an active role in managing the restructuring of Evergrande. We expect the government’s and all of the stakeholders’ advisors to work together on a restructuring. The government’s priority will be first and foremost on social stability. This means the priority will be on ensuring home buyers who deposited their down payments get their homes and retirees who bought wealth management products issued by Evergrande get their full principal. Next in line would be the onshore liability holders, many of whom have senior claims on assets. The last on the priority list will likely be the offshore liability holders, like the institutional investors of their offshore bonds who should be fully aware of the risks. Given these bonds are already trading at 20-30 cents on the dollar, the market is already pricing in a high likelihood of a material haircut (lost on their principal). This prioritization would be consistent with the government’s continuing focus on maintaining social stability.
Are there any direct or indirect exposure in the Matthews Asia portfolios?
Teresa Kong: We have no direct exposure to Evergrande in our fixed income portfolios. We have exposure to other property companies in China which are substantially less leveraged and have good corporate governance in our view. Thus we do not expect the fallout from Evergrande to have long-term effects on our holdings. In the short term, we expect price action to remain volatile and pose good opportunities for us to add, given that we had trimmed our property positions ahead of the latest bout of volatility.