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Evergrande: Maybe Not a Lehman Moment but Risks Are Real

28 September 2021   |  

As one of China’s largest property developers, Evergrande’s size and precarious financial position pose real risks for China’s authorities, economy and financial markets. In 2018, Chinese regulators had already identified Evergrande as a company that could cause systemic risk. And in 2020, regulators imposed debt ratio limits (“three red lines”) on large property developers, which played a role in bringing Evergrande to its current financial reckoning. The situation also comes amid China’s regulatory campaign, which is compounding market volatility.

However, based on all of the information we have at this point, we believe Evergrande is unlikely to spark a Lehman type moment—if China’s authorities properly manage the situation. Though Evergrande’s nearly 2 trillion yuan (approximately $310 billion) in liabilities is large in absolute terms, the amount is small relative to China’s GDP (more than 100 trillion yuan) and total bank loans (more than 160 trillion yuan). In addition, China’s banking sector has been absorbing 2 trillion to 3 trillion yuan of non-performing loans annually. Furthermore, China has a recent history of successfully restructuring companies (Anbang, Hainan Airline and Huarong). Those companies had significant amounts of debt with more complicated corporate and debt structures.

We believe the government’s response so far shows a willingness to single out aggressively leveraged companies in order to boost long-run financial system resilience. This may be a way for China to take a step forward in developing its financial markets. Instead of engineering a bailout and forcing state owned banks to help resolve the situation, China would likely be better off using a more market-oriented solution.

In our view, taking care of Evergrade’s customers and suppliers is just as important in Chinese authorities’ minds. New construction is largely funded by customer prepayments while Evergrande relies on thousands of suppliers and contractors (many being small businesses). Local authorities in regions where the company operates are being tasked with ensuring development projects are completed (or customer prepayments are returned) and suppliers are paid. Evergrande’s failure could cause further weakness in the property market, additional failed businesses, a weaker economy and public unrest. We believe the company’s project development operations could be carved out and managed in order to help complete projects and mitigate damage.

Another important matter to watch is whether Evergrande treats domestic and foreign investors differently. An interest payment to domestic investors was due September 21 while a payment to foreign investors was due September 23. The domestic payment was declared resolved, although it’s not clear if an actual payment was made. The payment to foreign investors has yet to be made, but Evergrande has a 30-day grace period to pay investors before it officially defaults. If domestic bondholders are given preferential treatment, China risks alienating foreign investors.

Within equity markets, Evergrande’s potential default is directly affecting real estate, construction and parts of the financials sector, while the ripple effects are further impacting Chinese and global equities. Amid the volatility, valuations could appear more compelling in some industries—particularly those most impacted by recent events. However, investors should be careful in the near term, especially given uncertainties regarding China’s ongoing regulatory campaign.  

We believe the prudent approach is to maintain a long-term perspective. In our view, compelling sustainable investment opportunities exist among well-known technology companies, innovative health care names and smaller businesses operating in cutting-edge industries.

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