Evergrande and the perils of investing in non-democratic states

The financial market topic of the day seems to be China Evergrande Group (aka Evergrande), and the news on 15 September 2021 that China’s Ministry of Housing and Urban-Rural Development had informed lenders that Evergrande---the second largest property developer in China---will not be making its principal and interest payments on outstanding debt from 21 September 2021.

Reuters is, however, reporting today that Evergrande will, in fact, make interest repayments on its domestic Chinese bonds, which has assuaged markets somewhat. There is no further visibility on whether Evergrande will meet its obligations on its USD and HKD denominated bonds.

This entire episode echoes the default risk dramas that swirled around another large USD bond issuer, China Huarong Asset Management, in April 2021 when its failure to lodge its accounts on time triggered speculation that it would renege on its debts.

The fears are amplified by the fact that both Chinese companies were perceived to be implicitly government-guaranteed, or too-big-to-fail (Huarong is 64% owned by China's Ministry of Finance), and have issued higher-yielding debt in global markets that has been gobbled up by many brand-name fund managers.

We have a pretty simple and yet far-reaching Environmental, Social & Governance (ESG) criterion, which is that we cannot invest in securities issued by companies based in non-democratic countries. As basic as this sounds, I am not aware of many other investors applying it. This prevents us from allocating to bonds issued by any Chinese entities even though they often pay attractive interest rates, seem to be ostensibly low risk, and frequently have appealing growth prospects.

A further well-documented concern for us has been extreme geo-political risk, and, more specifically, the possibility of major power conflict in the Indo-Pacific region between China, the US, and its allies, including Australia, Japan, and the UK, amongst others. We handicap this depressing scenario at a toss-of-the-coin probability, which is in the ball-park of most of our China advisers.

While in the event of a full-scale, high-intensity major power conflict, most asset-classes are likely to be adversely affected, and real hedges are going to be hard to find, it is instructive for investors to think through the consequences of these contingencies ahead of time. One obvious second-order risk is Chinese entities walking away from their foreign liabilities, and the spectre of the US potentially cancelling liabilities held by its adversaries.

As we are watching this from afar, I have enclosed below a brief summary prepared by one of our credit analysts...

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So what has happened with Evergrande?

Evergrande has been facing a liquidity crunch since its access to credit was curtailed in late 2020 following the Chinese government’s crackdown on large, highly-indebted property developers (known as the ‘Three Red Lines’ policy). 

As a result of this policy, restrictions on developers’ access to debt were imposed if they were to fail three financial criteria. No increase in debt was permitted if a developer failed all three rules. 

Evergrande failed all three criteria at the time the policy was implemented and was not, therefore, permitted to source liquidity from conventional sources, such as banks or high yield bond markets. It has since increasingly relied on suppliers, customers and employees to fund the completion of its development pipeline and meet its payment obligations.

According to Evergrande’s 2020 annual report, it had RMB1,951bn of liabilities (equivalent to over US$300bn at exchange rates at the time of writing), comprising primarily of RMB829bn of trade and other payables (~US$129bn), RMB717bn of external borrowings (~US$111bn), RMB210bn of tax liabilities (~US$33bn) and RMB186bn of contract liabilities (~$29bn). The size and nature of its off-balance sheet commitments are unclear at this stage, although they may be significant given Evergrande’s critical funding needs. 

Since the publication of its annual report, the share of payables owed to suppliers is expected to have increased as a proportion of total liabilities given the aforementioned restrictions on external borrowing. 

Evergrande has also obtained sizeable financing arrangements from its 3.8 million-strong workforce, who were promised attractive returns in exchange for providing liquidity to it. Suppliers and employees have begun protesting at the company’s headquarters in Shenzen in recent months, demanding payment of the sums owed.

While the majority of the funds borrowed from banks and capital markets investors were issued to domestic investors (~76% of total, comprising of RMB544bn), there is no doubt that many large Western investors participated in Evergrande’s USD-denominated and HKD-denominated high yield debt issues. Having said that, we speculate that most of the USD and HKD investors are actually Chinese as well.

The potential collapse of Evergrande has raised fears of contagion across the Chinese property market and economy due to the potential for a sharp decline in real estate values. Such a decline could precipitate a sharp increase in non-performing loans for major banks with exposure to the housing sector as well as substantially damage consumer sentiment given the adverse wealth effect for property owners/investors (real estate accounts for ~40% of household assets in China). Yet analysts at Goldman Sachs, Citi, UBS, RBC, JP Morgan and S&P consider that the risks of contagion are overblown, and have criticised the characterisation of this situation as a ‘Lehman moment’ for the Chinese economy.

Although the market value of equity and debt issued by Chinese property developers has fallen sharply in recent days, the damage is expected to be limited primarily to a handful of sectors as investors assume Chinese regulators socialise some of the losses through managing the restructuring process. Today the company reported that it would be servicing the interest coupons on its locally issued debt with no further news yet on whether it will meet its USD and HKD obligations. 

Chinese banks were asked to undertake stress tests for an Evergrande default scenario earlier this year. The published results of these stress tests imply that systematically important banks have meaningful capital headroom to absorb losses stemming from an Evergrande default, even in a tail-risk scenario of significant weakness in the housing market and spillovers impacting other sectors in the economy.

RBC points to other examples of market intervention (such as Baoshang Bank in 2019, HNA Group in 2020 and China Huarong in 2021) where regional governments took responsibility for the majority of these company’s liabilities and replaced previous management. 

Given the government’s objective of reducing speculation in housing assets and improving the affordability of housing for hundreds of millions of middle-class Chinese citizens, a potential restructuring or ‘bail-out’ is likely to inflict some losses on private-sector players in order to avoid the moral hazard conundrum whilst shoring up consumer confidence.

While foreign investors have limited direct exposure to Evergrande, investors are concerned about a potential slowdown in the Chinese economy under a severe Evergrande default scenario given the country’s increasing importance to the global economy. Commodity prices linked to China’s growth are likely to be most directly impacted if an orderly outcome is not achieved within a reasonable timeframe and housing activity remains subdued. Companies with meaningful exposure to Chinese customers may also experience a slowdown. However, spillover from these sectors to the broader global economy is expected to be contained. 

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