Weekly Market Compass: Kristina Hooper and her global team summarize what has happened in the Evergrande situation, what the next steps may be, and how this impacts their view of the markets.
The China Evergrande situation captured the world’s attention in a big way last week. In this blog, I take a step back and summarize what has happened so far, what the next steps may be, and how this impacts our view of the markets.
What has happened?
For more than a year, Chinese policymakers have been focused on reducing financial and economic risks through reform. Concerned about rising real estate prices and rising debt levels in China’s real estate sector, policymakers introduced a deleveraging campaign in August 2020 to improve the financial health and stability of the real estate sector. The campaign is focused on “three red lines” — caps on debt that must be met by mid-2023 by real estate developers1:
- Liability to asset ratio (excluding advance receipts) cap of 70%
- Net debt to equity ceiling of 100%
- Cash to short-term debt ratio of no lower than 1
Chinese property firms were given a three-year transition period to meet those debt requirements through deleveraging. If they did not meet one or two of the “red line” requirements, significant limits would be placed on the extent to which they could grow debt. However, if they could not meet all three of the requirements, they would not be allowed to grow their debt at all.
Since then, most real estate developers have lowered their debt levels. Evergrande embarked on a number of measures to lower its debt but has faced difficulty, with some assets being sold at fire sale prices. As recently as April, Bloomberg reported that Evergrande had fallen behind other property companies in making progress towards those three red line requirements and had not met any of them.2
In June, Evergrande revealed that it missed servicing some commercial paper on time. On Aug. 24, Evergrande issued a public statement warning about its difficulties in servicing debt and asking for assistance from the Chinese government. The firm also said construction at some of its developments had halted due to missed payments to contractors and suppliers. Last week, Evergrande was able to make interest payments on its debt to domestic bondholders but not its debt to foreign bondholders.
In addition, bond ratings agency Fitch downgraded its economic growth forecast for China last week, largely due to its concerns about the “slowdown in the property sector.”
Why is this important to investors?
Evergrande is one of the largest real estate developers in China, but it is also a conglomerate that makes electric vehicles and owns amusement parks and a soccer team. It is a major property owner, a major employer, and has a high level of liabilities.
In November 2018, the People’s Bank of China reported that Evergrande was one of the few financial holding conglomerates that could cause systemic risk to China. If Evergrande were to go bankrupt, there would be serious negative ramifications for all businesses it owes money to, as well as its debt holders, its shareholders and its employees. Evergrande’s failure could also create some form of contagion that extends well beyond China.
How have markets reacted?
Early last week, global markets sold off as concerns grew that Evergrande would not be able to make its interest payments. There was even fear that Evergrande could be another Lehman Brothers, in that its failure could trigger contagion in global markets. This panic resulted in a major sell-off in Asian markets, which extended to markets across the globe.
We think markets misinterpreted the Evergrande situation in likening it to the failure of Lehman Brothers. With Lehman, U.S. policymakers did not act to prevent a crisis, despite warnings about growing debt levels and risks to the real estate sector. Instead, policymakers were called on to remediate a crisis —- but then chose not to in the case of Lehman.
In the current situation, Chinese policymakers were proactive in the face of rising debt levels and higher real estate prices, promulgating tighter regulations in the form of the three red lines. We believe China is well prepared and equipped to manage this problem, given that it likely assumed one or more real estate companies might encounter difficulties as a result of its debt caps.
Evergrande worries subsided as the week progressed — the company was able to make one of its interest payments and the People’s Bank of China intervened with a liquidity injection. Although most Asia Pacific indices were down for the week, the S&P 500 Index, the FTSE 100 and even the MSCI World Index finished the week higher.3 And other market signs suggest concerns have subsided, at least for now:
- There has been very little movement in the China interbank lending rate.4
- The U.S. dollar rose last week and stands at the upper end of its recent trading range, but it is still well below where it stood when China devalued its currency in 2015 and where it was when the COVID-19 outbreak first emerged.5
- U.S. high yield credit spreads closed the week essentially where they started the week, with spreads very tight.6
- U.S. financial conditions tightened modestly but remain near the easiest on record.7
What is our take on what is happening?
We believe investors need to put this situation in perspective. While past performance doesn’t guarantee future results, we have dealt with issues similar to this before, and it is important to remind ourselves that these events proved to be blips in a longer upward march for equities.
A case in point is the eurozone debt crisis. It began on Jan. 10, 2010, with the European Union report on Greek accounting irregularities. In the three years following the start of the crisis, the S&P 500 Index rose 10.9%, the MSCI Europe Index rose 7.0%, and the MSCI World Index rose 7.7% on an annualized basis.8 For the five-year period following its start, the S&P 500 Index posted an annualized return of 15.4% the MSCI Europe Index had an annualized return of 8.8% and the MSCI World Index gained 10.0%.8
What is our outlook on the situation?
With regard to Evergrande, we believe the company is unlikely to be allowed to fail, but that it is likely to undergo a dramatic restructuring. Overall, we think that Chinese policymakers are likely to provide more clarity and enact more forceful measures in the coming days and weeks to stave off systemic risks. This should provide a backstop for Chinese markets and signal that authorities will not permit a property and financial system collapse. We could see more short-term liquidity injections, and we believe there could even be additional fiscal stimulus via an accelerated local bond issuance for infrastructure projects or a cut to the reserve requirement ratio in the coming weeks to stave off faltering economic growth and diminishing confidence in the country’s property market.
Additionally, we think that authorities may implement measures to protect retail customers of Evergrande’s pre-sold residential units and wealth management products to head off social disturbances. This could also bolster confidence in the real estate sector, an important part of China’s economy.
With regard to China, there have been concerns for many years about the rapid growth of debt, especially in the corporate sector. However, we think that China is better placed than most developed countries to either avoid or recover from debt crises. While it is true that Bank for International Settlements (BIS) data shows China’s non-financial sector debt-to-GDP ratio reached 289.5% in 2020 (up from 139% in 2008), this needs to be put into perspective.9
First, that same ratio for all countries covered by the BIS was 289.9%, so China is now in line with the global average. 9 Second, China’s debt ratio remains below that of countries such as the U.S. (296.1%), the UK (304.4%), France (374.4%) and Japan (418.9%).9
It is also important to remember that China has a number of advantages when it comes to dealing with high debt ratios and debt crises:
- Its economy is growing faster than developed world counterparts, which is helpful in controlling debt/GDP ratios.
- Chinese government debt is only 67% of GDP, which suggests there is scope for the government to absorb some of the debt currently owed by the corporate sector.10
- The central bank has more policy ammunition than many other large-country central banks (one-year policy rates are 4.35% and the reserve requirement ratio for major banks is 12%, both of which can be cut, thereby potentially easing financing conditions and boosting the supply of credit).11
- China’s debt is a domestic affair, whereas a country such as the U.S. is in large debt to the rest of the world. This makes it hard for the rest of the world to force a debt crisis upon China (though such a situation could occur for other reasons). China finds itself in this position because saving continually exceeds investment and it has built up large overseas assets (China’s net international investment position was +15% of GDP at the end of 2020, while for the U.S. it was -67% of GDP).12
- Hence, China owns a lot of overseas assets and it has used its foreign exchange (FX) reserves in the past to repair the banking sector and could do so again. (FX reserves stood at $3.2 trillion in August 2021, which amounts to about 8% of banking sector assets, though that is down from 25% in 2007).13
China’s banking sector has traditionally been conservatively funded, with liabilities around 90% funded by deposits (versus less than 80% in the U.S.).14 However, that ratio has slipped in recent years to stand at 83% in mid-2021, whereas the U.S. ratio has climbed in the last year to 88% (though the Chinese deposit/liability ratio is still above what was seen in the U.S. for most of the last 20 years).15 Further, the non-performing loans ratio remains below 2% and the capital-to-asset ratio was 9.24% in 2020, which has only been bettered in 2019 (the U.S. capital-to-asset ratio was 11.02% in 2020).16
Finally, there has been much concern expressed about the growth of shadow banking in China, the assumption being that it will bring instability. Financial Stability Board (FSB) data suggests that shadow banking assets in China have grown from 0.3% of GDP in 2006 to 56.3% of GDP in 2019 (shadow banking is defined by the FSB as non-bank financial entities involved in credit intermediation that may pose financial stability risks).17
That is certainly a big increase, but the ratio has stabilized since peaking at 65.7% in 2017.17 It leaves China in a similar position to South Korea (56.2%) and the UK (52.6%), while below Japan (62.6%) and the U.S. (79.8%).17 It is also worth bearing in mind that shadow banking in the U.S. peaked at an assets/GDP ratio of 129.9% in 2007. 17
Last week, International Monetary Fund Chief Economist Gita Gopinath explained, “China has the tools and the policy space to prevent this turning into a systemic crisis.”18 We would agree.
What is our resulting investment view?
Everything that we see here reinforces our view that investors should maintain a balanced, diversified portfolio rather than shifting out of regions or sectors that are directly exposed and where valuations have corrected significantly — such as China itself or China-facing supply chain economies, sectors or firms — and into already richly valued regions or sectors. Instead, we would consider a relative value approach to geographic, sector and firm-level exposures to the changing regulatory and business operating environment globally and in China itself.
What are the risks to our view?
There are three main focus areas that the market will be watching in the coming weeks and months:
- The short-term specifics of the resolution of Evergrande’s balance sheet problems;
- The medium-term implications for China’s real estate sector and its macroeconomy;
- Last but not least, the longer-term implications for the rest of the world.
Short-term specifics of Evergrande’s balance sheet problems. We are monitoring the offshore dollar bonds, ongoing restructuring and policy signals. We believe many market participants are concerned about whether dollar bondholders will be treated equally with domestic holders, for better or worse.
At the time of this writing, no decision appears to have been made and debt service payments are now delayed into the grace period. The lack of information is fanning market uncertainty. But the good news is that the authorities’ moves to manage the main problem — the domestic repercussions — reduce the risk of global contagion. We expect that as the domestic debt problems are resolved, along with social and financial system issues, the treatment of the offshore dollar bonds will be addressed.
The market seems to view the treatment of the offshore dollar bonds as a signal of China’s intentions about the treatment of domestic and foreign investors in general, reflecting a long history of discrimination between residents and non-residents in many countries. But we believe the issues are much more nuanced. Both foreign and onshore investors own domestic and offshore debt, which we believe means that any decisions by the Chinese authorities, Evergrande’s creditors in general, and its eventual management will not be as simple as categorizing different classes of creditor as subordinated or preferred. Instead, we expect the market to focus on the signalling around the decision, and we expect regulators, managers, and creditors in general to act in the best interests of the Chinese economy and society as whole rather than for or against any specific creditor by residency.
While markets seem to have calmed, there is always the potential for fears to rise again. And so will also want to monitor the global markets’ reaction to the evolving situation.
Medium-term implications for China’s property sector and overall economic growth. China has already shifted from an explicit formal growth target to a more qualitative idea of better, more inclusive growth that puts greater emphasis on values and income distribution rather than maximizing growth. Many Chinese leaders have expressed the view that property sector investment and speculation is a risky business at an individual level and for society as a whole. The authorities have also tightened regulation of various technology sectors, online gaming, and education — all of which have been highly profitable but have also exacerbated inequality and other social problems, just as they have in most countries around the world. These are common challenges, but many countries are choosing different ways to address them rather than a shared approach.
We expect China’s approach to reduce excessive investment and speculation in real estate, which may lower the growth rate but should also reduce leverage in the financial sector as well as the housing finance system. We do not see this as a major risk for the household sector as such, because all the available evidence, especially China’s very high savings rate of about 45% of GDP for Chinese households19 — suggests that household leverage, though it has been rising, should be manageable at a macro level.
We expect global markets may continue to be rattled as China develops its regulatory framework, but we also expect these changes to result in significantly lower concerns about China’s financial system, debt ratios, and the fear of a crisis.
Longer-term implications for growth. We expect all of this to translate into slower but more stable growth in China, but at the cost of less uplift to growth in the rest of the world, particularly regions that are reliant on rapid growth in investment and construction as well rapidly rising, concentrated wealth in China. Emerging markets, especially commodity exporters and those heavily integrated into China-facing supply chains, and the eurozone stand out, relative to the U.S., the UK, and some large emerging markets that have a trade deficit (India or Turkey, for example) rather than a trade surplus with China. Among countries with a surplus with China, those that are more exposed to the construction, investment and infrastructure cycle through metals and minerals exports (e.g., Brazil, South Africa, Australia) may be more directly exposed than say energy exporters such as Russia or Saudi Arabia.
None of this is to say that China’s growth will slow suddenly or sharply. The People’s Bank of China and the government remain in a strong position to stabilize growth and have the will to do so. We also expect the authorities to continue to focus on financial, economic and social stability, all the more so given the 20th Party Congress of the Chinese Communist Party in November 2022.
However, as China’s demographic transition to a rapidly ageing population with an already shrinking workforce combines with a more measured approach to growth and inequality in China itself, many of China’s trading partners may need to adjust to lower export volumes and possibly export receipts.
In turn, we believe this implies that, over the longer term, domestic policy decisions in those countries — both about managing their economies in the short term, as well as driving productivity growth in the longer term, will matter more to their economic and financial performance than the global growth environment, including China’s own cyclical position.
With contributions from David Chao, Paul Jackson, Arnab Das and Brian Levitt
1 Source: The Straits Times, “China’s three red lines for home developers,” Oct. 18, 2020
2 Source: Bloomberg News, “Evergrande Fails ‘Three Red Lines’ Test as Peers Improve,” April 12, 2021
3 Source: Bloomberg, L.P.
4 Source: China Foreign Exchange Trade System, based on the 3-month Shibor (China Shanghai Interbank Offered Rate)
5 Source: Bloomberg, L.P., based on the U.S. Dollar Index. The U.S. Dollar Index measures the value of the U.S. dollar relative to majority of its most significant trading partners.
6 Source: Barclays, based on the Bloomberg Barclays U.S. High Yield Corporate Option Adjusted Spread. This index is an unmanaged index considered representative of fixed-rate, noninvestment-grade debt. Option-adjusted spread is the yield spread which must be added to a benchmark yield curve to discount a security’s payments to match its market price, using a dynamic pricing model that accounts for embedded options.
7 Source: Goldman Sachs, based on the Goldman Sachs U.S. Financial Conditions Index, which is a weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads, with weights that correspond to the direct impact of each variable on GDP.
8 Source: Bloomberg, L.P. 3-year period: Jan. 10, 2010 – Jan. 9, 2013; 5-year period: Jan. 10, 2010 – Jan. 9, 2015
9 Source: Bank for International Settlements, as of 2020
10 Source: Bank for International Settlements as of 2020
11 Source: Bloomberg, L.P. as of Sept. 24, 2021
12 Source: Invesco calculations based in International Monetary Fund data, as of Dec. 31, 2020
13 Source: Bloomberg, L.P. as of August 2021
14 Source: People’s Bank of China and U.S. Federal Reserve (based on quarterly data from 1997 Q1 to 2021 Q2)
15 Source: People’s Bank of China and U.S. Federal Reserve (based on quarterly data from 1997 Q1 to 2021 Q2)
16 Source: China Banking Regulatory Commission for non-performing loans ratio, and World Bank for capital to assets ratios, as of June 30, 2021
17 Source: Financial Stability Board, as of Dec. 31, 2019, latest data available
18 Source: Reuters, “IMF says China has tools to avoid Evergrande’s problems becoming systemic crisis,” Sept. 21, 2021
19 Source: CEIC, as of December 2020