The case of Evergrande

Chinese property developer Evergrande is on the brink of collapse. This heretofore had appeared to be merely a local problem, but concerns about a (Chinese) financial crisis have since spilled over to western financial markets this week. Below is a brief assessment of current developments.

 

Who or what is Evergrande?

“Evergrande” sounds big not just in name only. The company, in fact, is the second-largest real estate developer in China and has built up to 600,000 housing units per annum in the People’s Republic in recent years. At the end of 2020, it was involved in almost 800 ongoing property development projects throughout China. Evergrande’s business model is to purchase building plots with borrowed money and to erect giant housing complexes that it sells to interested buyers on advance payment (usually before ground is broken). Taking on debt has been a constant part of Evergrande’s business model. The company currently carries a debt load of USD 300 billion. Around USD 50 billion worth of liabilities fall due for repayment this year.

 

Why are there problems at this particular point in time?

Chinese regulatory authorities have instituted a set of new rules in recent months to cool down the real estate market in the People’s Republic. The new financial engineering regulations for construction companies especially include “three red lines”: (1) the ratio of liabilities to assets must be lower than 70%, (2) the net debt-to-equity ratio must not exceed 100%, and (3) short-term debt must not exceed a company’s available cash on hand. This tightening of the regulatory screws was a disaster for Evergrande – the company already overstepped all three red lines back in April. It therefore cannot engage in new borrowing and is having difficulty repaying maturing loans.

A chain reaction with worldwide consequences as in autumn 2008 is unlikely to occur.

How have the financial markets reacted?

The “Evergrande case” was heretofore merely a local problem that only mattered to financial centers in China and Hong Kong. Evergrande’s stock price had already been in a tailspin for months and has since lost around 85% of its value year-to-date. Meanwhile, the company’s bonds outstanding have been trading at only around 25% of their nominal value at last look. Fears that other (likewise highly indebted) property developers could also enter a downward spiral already sparked substantial corrections in their stock and bond prices as well. Those concerns spilled over to Western financial markets at the start of this week. The Swiss Market Index and Germany’s DAX index, for example, fell by up to 3% in intraday trading on Monday, briefly dropping to their lowest level since three (SMI) or four (DAX) months ago. In the USA, meanwhile, the correction has reached almost 5% (within a span of two weeks) as measured by the S&P 500 index.

 

Will the government of China bail out Evergrande?

Government leaders in Beijing want to curb real estate speculation and have clearly communicated in recent weeks that they view home ownership as a “social good” and not as an investment asset. They are striving to reduce the debt loads of heavily leveraged real estate developers and to steer their business models onto a sustainable path to minimize risks for buyers, suppliers, employees, and the financial system in general. Against this backdrop, there probably won’t be a large-scale bailout operation. On the contrary, the government likely will be inclined to allow loan defaults (to a limited extent) to set an example and send a clear warning to the real estate sector and (foreign) investors that they shouldn’t rest assured that Beijing will always be there with a fire extinguisher to arrange a rescue in every crisis.

 

Could Evergrande trigger a domino effect?

China’s financial system (and its real estate market in particular) is still relatively walled off from the rest of the financial world. Although it is enormous, with total assets amounting to almost USD 50 trillion, foreign investors hold only a small 2% stake in China’s banking sector. A chain reaction with worldwide consequences of the kind caused by the bankruptcy of the Lehman Brothers investment bank in autumn 2008 is therefore unlikely to occur. However, the government of China, too, is aware that Evergrande and the like pose a systemic risk. It might let some property developers slip into insolvency, but will probably want to avert a disorderly full-blown collapse, not least because social unrest would quickly loom otherwise. That’s why in the context of a potential unwinding of Evergrande, it will probably try hard to find a way to complete the myriad half-built construction projects to at least secure a bailout for the middle class.

The current developments in China are unlikely to leave more than a skid mark on the earnings figures of most of the Western companies affected.

Does this mean that the uproar is a tempest in a teapot?

It’s (unfortunately) not so easy to dismiss. The real estate industry, by some estimates, accounts for up to one-third of China’s economic output. Efforts to downsize property developers could slow China’s economic growth at least in the near term. Moreover, major dislocations in the real estate sector could further mute consumer sentiment. Chinese economic growth and Chinese consumer spending are both key factors relevant to earnings nowadays for companies in Europe, the USA and Japan. This connection makes the local “Evergrande problem” at least indirectly relevant to Western asset markets and investors. The luxury goods and automotive industries as well as materials suppliers and equipment makers for China’s construction industry are examples of sectors with considerable exposure to China. The current developments in China are unlikely to leave more than a skid mark on the earnings figures of most of the Western companies affected, but this risk alone is already enough to prompt investors to take profits on their stock, as recent days have shown.

 

What are the implications for Kaiser Partner Privatbank’s investment strategy and tactics?

We view the developments surrounding Evergrande as a trigger for (only) a short-term correction on Western equity markets. Now that the S&P 500 index, for instance, had risen more than twofold within the last 18 months alone, the market was vulnerable to a (long overdue) consolidation. We therefore do not see an acute need to adjust our tactical asset allocation. In the context of picking individual securities to invest in, we had already sharpened our focus in recent weeks on stocks with a quality bias and defensive attributes. From an overarching strategic standpoint, we already mildly reduced the equity quota in our strategic asset allocation at the start of this year because equity markets tended to be on the overvalued side and in view of lower future return expectations. As a result of those actions taken, the impact on our balanced portfolios has been minimal to date with a drawdown of no more than a little under 2%. Our mixed mandates thus remain comfortably in positive performance territory year-to-date with gains ranging from +7% to +9%. Since the government of China’s risk appetite and future developments on the Chinese bond market are difficult to forecast, we will reduce our exposure to this segment. With such a balanced positioning and by actively adding in hedges here and there, we consider ourselves well girded on the whole to face the typically somewhat more volatile autumn season on the stock markets.

 

You have further questions? Please feel free to contact us. 

 

Oliver Hackel, CFA Senior Investment Strategist

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