Evergrande, a Chinese property giant nursing more than $300 billion in debt, is seen as likely to default next week. Global investors don’t seem too worried, but the looming crunch still has potential to shake up financial markets, analysts warned.
“While Evergrande’s bonds and shares have sold off, spillovers to other assets, both in and outside of China, have so far been limited, suggesting that investors are confident the country’s authorities will limit any financial contagion,” said Thomas Mathews, markets economist at Capital Economics, in a note.
Fears of a bursting property bubble have long been a concern for investors when it comes to China. A heavily leveraged real-estate sector makes up more than 28% of China’s economy, according to the Financial Times.
And Evergrande’s dire situation is sparking debate over how Chinese authorities should respond. Meanwhile, holders of Evergrande’s approximately $19 billion in dollar-denominated bonds are left to wonder what will become of their investments. And shares of Evergrande
have plunged 83% in Hong Kong.
Global markets have been largely unswayed. Major U.S. stock indexes were on track for weekly losses, with the Dow Jones Industrial Average
down 0.1% and the S&P 500
on track for a 0.5% decline. Those modest losses, however, have been largely attributed to worries equities were overdue for a pullback amid uncertainty over the toll of the spread of the delta variant of the coronavirus.
Should investors be paying more attention to the Evergrande situation?
FitchRatings, a credit ratings firm, on Sept. 7 downgraded Evergrande’s rating to CC from CCC+, indicating they saw some sort of default as probable. Evergrande is one of China’s top three property developers, although the residential housing market is highly fragmented, Fitch analysts noted in a Sept. 14 report.
Evergrande’s market share in 2020 was only around 4%. Fitch said the risk of significant pressure on house prices in the event of a default would be low, unless the restructuring or liquidation of its assets becomes disorderly. “Fitch believes this is something the authorities will want to avoid,” the analysts wrote.
But faith in that scenario may have been shaken after Reuters reported that the editor of the state-backed Global Times newspaper had warned that Evergrande shouldn’t assume it’s “too big to fail.”
Analysts at UBS, led by Kamil Amin, said in a Thursday note that the potential for market spillovers will depend on whether Evergrande restructures or fully liquidates. The analysts wrote what they remained confident that a restructuring remained the most probable outcome.
“In the event of a restructuring, we expect the bonds to bounce off their lows and contagion to be broadly limited,” they said.
But in the event of liquidation, there would likely be a “high degree of contagion,” they warned. The spillovers would occur, they said, through three channels:
- Investors getting extremely low recovery values, something which would lead to a material loss of investor confidence in the broader property sector and Asia high-yield offshore market and create spillover into the broader Chinese financial assets.
- A domino effect of credit events, given that both banks and nonbanks with large exposures to Evergrande could potentially go under or be forced into restructuring. This would again create spill over into other Chinese financial assets and drive underperformance of financials in particular across both [developed market] and [emerging market] credit/equity markets, led by those names with direct exposure either to Evergrande itself, its subsidiaries or its creditors.
- A full liquidation would involve Keepwell Agreements (a written guarantee by a parent company that it will maintain the solvency of a subsidiary) not being adhered to — something which we think will force rating agencies to recalibrate their methodologies and remove multiple rating uplifts and assumptions of state support across non-property sectors both within the offshore U.S. dollar market as well as the onshore market. This could lead to added selling pressure and drive large liquidity distortions across both Chinese offshore and onshore bond markets, with potential for spillover into EM credit, given that several EM credit accounts do tend to hold Chinese offshore bonds as a part of their Asia high-yield exposure.
Why do investors seem to be ignoring the potential for spillover effects? The lack of concern reflects expectations that, ultimately, “the Chinese government will end up paying for it,” said Tom Essaye, founder and president of Sevens Reports Research, in a Friday note.
“One of the best ways to think about China is that it’s a country, but it operates
like one large company,” he said. While there are “private” banks and corporations, in the end the Communist Party effectively “owns anything and everything” if it wants to, he wrote.
“And because of…