As the situation with Chinese property developer Evergrande Group spilled into the mainstream media at the end of September (and continues to linger in headlines in October), increased volatility has hit global equity markets.
So, what’s the deal? Why are equity markets upset? And is this something you should be concerned about? Given that Evergrande is not a household name here in Canada, let me explain.
Who is Evergrande?
Evergrande Group is one of China’s largest property developers. It reaches broadly across China geographically and economically. It has thousands of subsidiaries and developments in every Chinese province. The company also has many far-flung businesses unrelated to property, including Evergrande New Energy Vehicle Group, an electric vehicle manufacturer.
The issue? Easy cash stopped flowing
In it’s most recently filed financials (June 30, 2021), Evergrande reported nearly 2 trillion RMB (CAD$375 billion) in liabilities on its balance sheet. Estimates put off-balance sheet liabilities even higher. For perspective, this is approximately 2% of China’s gross domestic product.
On the asset side of the balance sheet, Evergrande reported 1.4 trillion RMB in inventories and only 88 billion RMB in cash and short-term investments. While accounting rules allow inventories to be categorized as current assets, half-built apartments in the suburb of a fringe Chinese city aren’t exactly equivalent to cash (although Evergrande has been trying to do just that, offering apartments to creditors in lieu of cash).
This model works if cash comes in faster than it is going out. There are obvious liquidity risks if that’s not the case. So, Evergrande borrowed from everyone – banks, bond markets, customers, suppliers, and employees – to keep the cash flowing.
However, long aware of the risks presented by an over-leveraged housing sector, the Chinese government started to make borrowing a bit more difficult for property developers. In 2020 the government instituted its three red lines for leverage test (liability-to-asset ratio of less than 70%, liability-to-shareholder equity ratio of less than 100% and cash-to-short-term debt ratio of more than 100%) that property developers must adhere to. Evergrande failed all three tests.
This situation is not unique to Evergrande, as we’re seeing other Chinese developers in a similar cash crunch, Fantasia Holdings Group for example.
Is this really China’s Lehman moment?
We’ve been monitoring the developments prior to the volatility and for the most part, it was a tangential story to markets. However, it didn’t take long for the “China’s Lehman moment” headlines to appear in the media. To be fair, almost all these articles go on to argue, correctly in our view, that this is not the case.
The collapse of Lehman Brothers was a surprise to most. It was thought to be a safe counter party, and participants did business with them uncollateralized thinking the risk was a lot lower than it actually was. As such, its collapse cascaded through the financial system putting losses on counter parties that were ill prepared.
In contrast, Evergrande’s challenges are very well known. Its investments have always been considered speculative. Its bonds have been junk rated since 2009. MD has no holdings in Evergrande securities, because simply, it was known to be high risk with limited prospects for commensurate returns. One would hope that investors (hedge funds and high yield bond funds) would have understood the risks and positioned accordingly.
It is not the global financial system that stands to lose on Evergrande, at least directly. Those who stand to lose the most are Chinese banks and creditors, including many everyday Chinese citizens. For example, people that have paid for apartments that have yet to be completed and the construction workers and contractors who remain unpaid.
An uncontrolled implosion of Evergrande is not likely
With a strong push towards common prosperity, and a desire to illustrate the strengths of the Chinese governance system, a messy financial crisis is likely not something Beijing will allow to happen. The government has the resources to manage the situation – state-owned developers can take over projects and state-owned banks can roll over payments.
The question is less about will or can Beijing act to preserve financial stability, but rather how does the government balance financial and social stability. How will the government remain firm in their commitment to reign in the moral hazard which has, in many ways, led to the current excess investment into Chinese property, making housing unaffordable to new buyers.
That said, things seem to be playing out as anticipated, with the Chinese government looking to ensure that Evergrande continues to complete projects and pays money owed to wealth management products sold to retail investors in China. State-owned banks have jumped in to prevent the liquidity issues from getting worse, with one state-owned bank even buying into Evergrande’s own bank. We saw Evergrande shares halt trading on October 4th.
We believe that the fallout will mostly be contained to China and our expectation is that the situation will not lead to a systemic global event.
While we have no direct exposures to Evergrande, we do have indirect exposure to the potential fallout. This comes from allocations to other Chinese and emerging market securities. Another key consideration is how this will shift the long-term growth of China, given that it has been so reliant on property development, and is something we will continue to assess.
The MDPIM Emerging Markets Equity Pool would have the most exposure given its asset class focus. It’s underweight Chinese Real Estate, with no exposure to Evergrande, but it is overweight financials. In particular, we own Chinese banks that could, and likely will, face losses related to Evergrande. With that said, the risk of excess leverage within China is well known, and as such, the sector’s valuations are highly discounted.
For example, China Construction Bank a 1.5% weight in the pool, trades at 4 times next years earnings and has an indicated dividend yield over 7%.1 In comparison, Canadian banks currently trade around 10-to-12 times forward earnings.1 That level of discount provides a nice cushion for bad news.
We are also overweight emerging market local currency bonds in the MDPIM Strategic Yield Pool. However, this would entail an allocation to Chinese government bonds opposed to corporate bonds, which would not be at risk of the Evergrande situation.
In addition to security exposures, we do tactically manage regional equity exposures. On that, we’ve been underweighted emerging market equities relative to developed markets in our portfolios.
For more information, please contact your MD Advisor*.
1 As of October 15, 2021.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.