Commentary on Political Economy

Wednesday 14 October 2020



Evergrande highlights risks in China’s offshore bond market

An artist’s image of a new 100,000-seat soccer stadium that Evergrande plans to build in Guangzhou © VIA REUTERS

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As market jitters spread late last month over the state of China’s largest property developer, one source of comfort for some investors was the sheer size of the Evergrande group.

Even in an economy with the scale of China, Evergrande is a behemoth. And it is an heavily indebted one, with total borrowings of about $120bn at the end of June.

That, to many China analysts, makes the Shenzhen-based group too big to fail. It is so intertwined with the country’s banks and financial system that it would be too much of a broader danger to the economy if it defaulted on its debts. And it is not just a question of the size of Evergrande’s borrowings. Its debt is widely held, circulated through shadow banks into retail hands through wealth management products, as well as sitting on bank balance sheets.

For years China has been trying to get its banks to reduce exposure to property, get its shadow banking system under control and ensure its overly indebted firms reduce debt. But it is inconceivable that Evergrande will be allowed to implode, Lehman-style, given the effect on the banks, the macro economy, and even on social stability.

“Evergrande’s sheer size and extensive liabilities mean its collapse would be a systemic risk to China,” say analysts at Gavekal. “The firm’s ‘too big to fail’ status illustrates the balancing act the government faces as it tries to pressure developers to get their finances in order while avoiding defaults that would ripple through the Chinese economy.”

Confidence in the company was shaken after a letter began circulating online late last month that purportedly showed Evergrande asking for government help in averting a potential cash crunch. Big swings in the developer’s shares and bonds followed until a furious denial from the company alleging the letter was fabricated and a series of announcements helped to calm trading.

“The contagion wasn’t huge,” notes an analyst for a major international bank. “There was some sell-off initially but the market came back quickly.” One reason was the expectation of continued support from banks, even if some are scaling that back.

However, investors in the offshore debt of Evergrande should be wary. Much of the Evergrande risk that has built up isn’t actually in China — it lies instead in the offshore dollar bond market, where junk-rated mainland property companies raise money without the need for approval from Beijing and account for $210bn of the $270bn outstanding there, according to estimates from the ANZ bank.

That market has become especially attractive both for issuers and investors in a world where central banks in developed nations have driven rates to zero. Issuance slowed to $12bn in the second quarter but soared to $32bn in the third, while the conditions or covenants giving investors comfort reached their weakest level ever, according to Moody’s Investors Service.

Owen Gallimore of ANZ in Singapore says Evergrande is the single biggest borrower in the Asian high-yield dollar bond market, accounting for $23bn in issuance.

“We think Evergrande is systemically important but you can still treat (offshore) bondholders badly,” he said. “Bondholders don’t have collateral. They are in a perilous situation. China has learned with every restructuring to deal more aggressively with bondholders.”

The story of one of Evergrande’s peers is an example of the risks. At the end of 2014, top executives at Kaisa, a mid-tier mainland property company, became caught up in a corruption scandal involving officials in the local Shenzhen government. Both shares and bonds plunged on the news that the firm was ordered to freeze property sales.

Eventually the bankers came to the rescue, warning authorities that if the company had no means to generate the cash flow to repay them, they would have to write down the value of the loans, according to one person close to the company at the time. That, in turn, would impair their ability to extend credit to keep economic growth going. The government then eased the restrictions on the company.

The following April, though, Kaisa did default on its offshore bonds, the first time by a Chinese property company. This was a painful reckoning that was seen at the time as evidence of the unsustainability of the Chinese property debt mountain. After this setback, Kaisa staged a dramatic recovery in markets. It is now among the biggest borrowers in the offshore Asian dollar bond market, which is dominated by Chinese property developers. Kaisa also just issued a perpetual US dollar bond with very competitive pricing.

“The market has moved on,” Mr Gallimore said. But investors be warned — the risks have not.

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