Ebury: What would a possible collapse of Evergrande mean for the markets?
Analysts at international payments firm Ebury explain what the impact of the collapse of China’s leading property manufacturer Evergrande may be for financial markets this month.
What is Evergrande, why is it a topic in the news and what impact can its potential collapse have on the financial markets?
It is one of the largest real estate companies in China, it is ranked at number 122 on Fortune’s 500 list and among the largest companies in the world in terms of revenue. In China, Evergrande owns more than 1,300 projects in nearly 300 cities, and expanded its activities by investing – among other activities – in electric vehicles, food, beverages, sports and theme parks.
Unfortunately, much of the company’s success in recent years has been fuelled by excessive borrowing. Evergrande has raised debts of more than 300 billion dollars and has informed investors in recent weeks that it is experiencing cash flow problems and that it can default on its huge liabilities. There is an argument that the deviation of the company from its core business model is to blame for its failures, although its decline may be more related to China’s attitude to debt than to anything else.
However, the company’s dangerous economic hardship has caused some concern among market participants and fear that the impact on the Chinese real estate sector and the economy, or even a ‘Lehman-style’ collapse, could be a possibility. The news that Evergrande has agreed to an agreement to settle an interest rate of about 36 million dollars on one of its domestic bonds that would expire on Thursday, September 23, somewhat dampened investors’ concern. However, so far there has been no official announcement regarding the payment of 83.5 million dollars in interest due to a dollar-denominated bond on the same day. The company has, of course, a grace period of 30 days to make this payment.
Are fears about the impact of Evergrande exaggerated?
Despite the hysteria of the media, we believe that these concerns are exaggerated and that the consequences of a possible Evergrande collapse will be limited. Of the company’s 300 billion dollars worth of debt (which is equivalent to only 2% of China’s GDP), only a relatively small portion (about 30%) are liabilities in the financial market, with just over 11% (about 35 billion dollars) loans from Chinese banks. This represents only 0.12% of all loans to China’s banking system, which amount to over 30 trillion dollars. This suggests that the broader implications are likely to be minor, even in the worst-case scenario that the company had to default on most of its obligations with negligible chances of debt recovery.
While stress has spread to companies in the industry, Evergrande seems to be in a uniquely weak position. Due to the highly cyclical nature of China’s real estate market, the government introduced a new “three-line” policy last year to ensure low liabilities-to-asset ratios and net swap rates and a cash-to-short-term debt ratio of more than 1.
According to Bloomberg, as of April this year, almost half of China’s 66 major manufacturers met all three requirements, showing a significant increase since last December (21%). Evergrande, on the other hand, has violated all three. Moreover, a massive sale, in which Evergrande’s assets would be won, is unlikely in our view. Such an event will not be allowed by the regulatory authorities, and the market will be depressed while buying inventory at reduced prices can lead other manufacturers to violate the ‘three red lines’ rule.
The worst-case scenarios also assume that the Chinese authorities are not taking measures to mitigate the blow to markets and the domestic economy. While a complete bailout from Beijing is unlikely, we believe the government will help manage the collapse by restructuring the company’s debt. It is unlikely that the authorities will remain passive if the collapse of the company threatens the overall health of the Chinese financial system.
How have the financial markets reacted so far?
As is often the case, we have seen many scaremongering headlines, and yet the reaction in the financial markets has been rather limited. At exchange rates, risk currencies experienced a small sell-off early last week, although these moves were, almost without exception, relatively small . Even the Chinese yuan, which still shows limited volatility, has retreated by about half percent against the US dollar since mid-September.
The reaction in stock markets was slightly more pronounced, although the moves made were comparatively moderate and do not look like panic sales.The Shanghai Composite index has fallen only about 3.5% from the highest levels in the last six years and is still trading comfortably to be trading comfortably higher than in the previous month, although the close of Chinese markets on Monday and Tuesday last week may have limited losses. Hong Kong’s Hang Seng index, for example, experienced a bigger sell-off, falling to its weakest position since October. It is worth noting, however, that this indicator is already on a sell-off trajectory since February.
Overall, we believe that the consequences of the Evergrande collapse will probably be limited. While we believe that there will undoubtedly be repercussions in the real estate sector, the Chinese banking system is large enough and seems resilient enough to withstand the consequences. In our view, the main risk to growth comes from the slowdown in investment in real estate projects over the next six to twelve months or so. It is too early to calculate the magnitude of the possible slowdown in activity, but we believe that it is unlikely that we will see a negative impact on consumer spending, beyond the weakness caused by the disruptions caused by the pandemic.