In focus

Q&A: what could a collapse of Evergrande mean for markets?


Who is Evergrande and why is it in the headlines?

Evergrande Group is China’s second largest property developer in sales terms.

Neither the debt or equity of Evergrande have been favoured by our investors for some time.

The company is a notable issuer in the Asian high yield market but its index size is modest. In major equity indices its representation is tiny, and it is also small in emerging market corporate bond indices.

The implications from its potential failure – which has been the subject of intense speculation over the past few weeks – could be significant though. China’s real estate sector contributes 29% of total GDP. As such there could be ramifications for Chinese financial markets and the economy, while there have been some concerns over wider contagion to other global markets.

Uncertainty over the outlook for Evergrande comes amid a backdrop of broader government policy actions. Regulatory focus has more recently been on areas such as the internet and private tutoring industries, but policy changes applicable to the real estate sector go back much further.

In the immediate term, rising uncertainty over the future of Evergrande, exacerbated by the impending debt restructuring, has resulted in widening credit spreads and tougher market access conditions.

How have markets responded?

Over the past few weeks, declining property sales and disappointing progress with asset disposals has seen the company’s position further deteriorate. Persistently negative news flow combined with weak market sentiment has resulted in a downward spiral, and the company’s funding channels have all but closed, significantly undermining investors confidence in Evergrande.

The company’s stock has fallen by 85% year-to-date. Month-to-date it is down -48%, and the MSCI China index is down 5.7%. The yield on its 5-year US dollar denominated bond has soared to over 560%. The outlook for Evergrande remains highly uncertain. Events are fluid but the market speculation suggests that the company could miss interest payments on its loans which were due this week.

Why is Evergrande at risk of collapse?

Tom Wilson, Head of Emerging Market Equities:

“Evergrande’s debt position has been building for a number of years. In terms of liabilities (shown below), Evergrande is a huge outlier compared to the wider real estate sector. The company’s problems have come to a head following the deleveraging framework the government imposed on the largest property developers in August 2020. Developers were required to bring their debt levels below certain metrics or “red lines”.

"These began to bite in recent months and, in its latest earnings report, Evergrande had already warned that its cash flow had deteriorated to the extent it might default. As a result the current situation is not entirely unexpected.”

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Could there be spill-over implications if the company were to collapse?

Robin Parbrook, Asian Equities Fund Manager:

“Evergrande sold more than US$100 billion worth of properties in a year, and has a total liability of over US$300 billion.  Its default could drag down many of its business counterparts in the supply chain, and could push up the Chinese banking system’s non-performing loan ratios. A default by Evergrande could also lead to a significant delay in delivery of those housing units and could have social implications as well.

"This default has been widely predicted and we believe will have been at least partly anticipated by the Chinese authorities.  We therefore believe that government intervention to prevent a disorderly collapse is very likely, however this is still likely to be very painful for equity holders and foreign bond holders.”

David Rees, Senior Emerging Markets Economist:

“Various indicators suggest that construction activity has already weakened dramatically in recent months and it could remain depressed if Evergrande and other developers do not have the ability to deliver units that have already been sold.

"The government may well step in to avoid this triggering declines in property prices, which in turn could cause pre-sales of new projects to dry up adding to strains in the sector. However, there is a clear risk that confidence will take a knock and weigh on the already weak consumer recovery.”

How might policymakers in China respond?

Roy Diao, Head of Asian Fixed Income:

“We believe some form of government facilitation is likely to maintain order during debt restructuring or even a potential default scenario. There have already been signs of this as the Chinese government has centralised court cases against Evergrande in a Guangzhou court to a bid to reduce operational disruption, and also coordinated stakeholder negotiation to resume construction work on some property projects. As policymakers already have experience in prior large restructurings such as Anbang Insurance, we expect an Evergrande credit event could be managed by regulators without incurring material contagion risks to the broader economy.”

Tom Wilson: Head of Emerging Market Equities:

“The government has so far remained silent on their response to Evergrande’s problems. We think it’s unlikely that the government will either simply bail out the company, or let it collapse in a disorderly fashion, rather we believe that it will seek to limit the economic fallout and rescue certain creditors.

“The Chinese property development market business model is one of pre-sales. As a result, Evergrande’s default will leave a large number of home buyers stranded without the apartments they’ve already paid for. We therefore expect the government to divide up Evergrande’s projects and ask state-owned enterprises (SOEs) or quasi-SOEs to take over. This is already happening, for example, in Shenzhen. Banks may have to take impairments against their Evergrande loans but, in the long run, losses should be limited as loans should mostly be collateralised. Finally, provincial authorities will also likely support Evergrande’s contractors and suppliers.”

Is there a risk of contagion to other global economies?

David Rees, Senior Emerging Markets Economist:

“The direct impact on other economies would be likely to come through a decline in demand for commodities if construction activity were to further weaken. That would be a particular concern for those economies such as Brazil, Chile and South Africa that export industrial metals to China. Problems at Evergrande could have an indirect impact on other economies, mainly in the emerging world, if it were to dampen sentiment and trigger a “sudden stop” in capital flows but we are not yet at that point.”

Tom Wilson: Head of Emerging Market Equities:

“Given the size and characteristics of the problem, and China’s ability to handle it, we see limited real economy spill over effects to other emerging or global markets. As Evergrande is China’s largest high yield bond issuer, we have already seen some impact on Asian and global high yield debt spreads, but this should be temporary. In the event of a more protracted downturn in the Chinese property market, certain commodity prices might be negatively impacted.”

How does this adjust the outlook to investing in China’s real estate markets?

Andrew Moore, Head of Real Estate, Asia Pacific, Schroders Capital:

“There is certainly some nervousness in the real estate investment market. Evergrande’s default is still very much playing out in real time, with further bond payments due today.

“We expect the government to manage this issue, as it has previous defaults, but contagion cannot yet be ruled out. The effective yield on non-investment grade bonds sold by Chinese companies jumped to 15.8%, according to Intercontinental Exchange’s index, quoted in Mingtiandi and SCMP. This is up from 10.5% on 30 June.

“At the moment banks are still very much open for business. However, it seems likely that they will be cautious in making or extending loans at this time. Some Hong Kong SAR developers are exposed to Evergrande and may well be facing pressure that could force them to look to sell some of their real estate assets.”

Robin Parbrook, Asian Equities Fund Manager:

“On the equity front, as Evergrande concerns and worries about contagion to other lower tiered developers remain elevated, overall sentiment to the real estate sector remains depressed. As there have been concerns about developers not being able to settle liabilities with their suppliers, market sentiment for the downstream players in the real estate supply chain i.e. home appliance and furniture suppliers etc remains downbeat as well.

“We continue to hold an unfavourable view of the Chinese property sector, as the sector is highly regulated with tightening polices implemented in various cities in China. The China government's on-going efforts to deleverage the property industry could also put also continued liquidity pressure on the industry.”

Roy Diao, Head of Asian Fixed Income:

“We continue to closely monitor developments in China real estate and have been actively adjusting our exposures to this segment. Rising credit dispersion within the sector has become more apparent and lower rated developers with weaker credit profiles are likely to be most at risk in this environment. We stay highly selective and cautious within this sector, and focus on higher quality issuers (primarily BBB and BB) deemed more likely to tide over current volatility.”