Evergrande and Chinese Real Estate: From no way home to homecoming
The fate of China Evergrande continues to hang in the balance. While the headlines have somewhat subsided, risks and uncertainty continue to linger on. Our overall view remains cautiously optimistic on the sector and we consider bottom-up security selection to be as important as ever. The tail risks have clearly increased, but it remains manageable and valuations have priced in more downside risk. In this blog, we summarize the most recent developments and discuss investment implications on the China USD corporate bond market.
Evergrande’s problems isn’t exactly breaking news
Defaults are a normal part of the high yield market and Chinese developers are no exception. Every year we typically see a handful of Chinese developers go into default or trade at distressed levels. China Fortune Land Development and Tahoe Group are two recent examples that announced a debt restructuring plan before Evergrande’s problems were raised. Notably, Kaisa Group was a relatively larger developer to default on its overseas debt in 2015.
What makes Evergrande different is its size and scale. Although its market share is less than 5%, it’s the second largest developer in a fragmented market, with about USD 300bn in financial obligations. The firm has also ventured into non-property businesses that include all-electric vehicles (EVs), a soccer team, a bank, and other ancillary businesses. Evergrande’s troubles rose primarily as a result of its excessive leverage, as reflected in its weak credit rating (single B bucket) since 2015. The trigger point of the event is the government’s recent drive to reduce systemic risk by limiting the ability of companies to pile on leverage. In others words, Evergrande’s issues shouldn’t really come as a surprise to anyone.
Despite its size, an Evergrande default is unlikely to pose a systemic risk or cause a hard landing in the Chinese economy
Government policy initiatives like the “Three Red Lines ” and caps on the banking sector’s exposure to real estate are meant to reduce systemic risk, not to increase it. If unintended consequences emerge for broader economy, our base case is that these policies would take a pause. The government’s policy on the real estate sector is anchored on the philosophy that ‘property is for living, not for speculation’. We believe it’s not the policymaker’s intention to cause a hard landing in the sector - caused by collapse of confidence by homebuyers. Property sales were weak in September (Figure 1), and we expect continued weakness in the next few months. The decline was mostly driven by a decrease in volume as selling prices remained largely stable. We observe that homebuyers can differentiate between high quality and low quality developers, and we are seeing indications that some banks slightly loosened mortgage lending. We believe these developments can drive a recovery in the property sector sometime in early 2022.
Figure 1: China residential property sales y/y (unit %)
On the macro front, our base case is for monetary stance to remain largely neutral, with minor fine-tuning through open market operations. The People’s Bank of China (PBoC) has been providing quick and proactive liquidity injections as needed to maintain orderly functioning of the funding markets. We also expect fiscal spending of RMB 9 trillion from August to Dec 2021 to cushion the impact of a resurgence of COVID-19 variants and regulatory policy tightening. This fiscal spend will be highly targeted towards sectors that continue to promote the government’s growth and innovation agenda such as new technologies, scientific advancement and environmental protection.
So what’s next for Evergrande and the property sector?
On Evergrande, our base case is an orderly, drawn out restructuring of the company with a government agency to act as facilitator. We anticipate a long, drawn out process where operations on existing projects are to resume after some delay considering the large number of projects run by Evergrande, while investors and bond holders would take the losses.
- The government’s priority is to protect homebuyers, suppliers and contractors, with the aim of preventing contagion to banks, construction, home furnishings and the overall property sector. This is particularly important considering the recent shortage in energy and the fragile economic recovery after reopening from COVID lockdowns. We expect most homeowners to be made whole on their purchases, although delivery could be delayed. This can be achieved in China mainly because property development projects are typically ring fenced. Proceeds from bank loans and pre-sales of projects typically sit in the project level bank account to be used for construction payments to vendors and suppliers. As each project is considered a standalone entity, its operations can be taken over by other property developers, local governments, or Chinese distressed asset management companies (such as Huarong and Cinda). While we acknowledge that the government’s policy to curb leverage constrains developers’ ability to take on property projects, some stronger developers and property management companies have financial headroom to take over these projects at the right price.
- Its impact to the banking system is likely limited and manageable. Evergrande accounts for only around 0.4-0.6% of loan book of major banks, with the highest being 0.9%. Banking system exposure to the whole property development sector was 6.6%. Furthermore, banks generally have first lien on the property. The major state-owned enterprise (SOE) banks have fortress balance sheets that could serve as one of the backstops that could prevent limit or prevent contagion.
- We don’t expect the government to bail out financial investors of Evergrande as this runs counter to their objective of developing its capital markets to better price risk and allocate capital to the most productive uses. This requires the market to value bonds based on the underlying strength of the issuer rather than implied or perceived government support.
Cautiously optimistic on USD China corporate bonds, but execution is key
The performance of China USD bonds so far this year has been mainly driven by two factors. First, the emergence of the COVID-19 Delta variant and its impact on economic activity in light of China’s zero-COVID policy approach. Second is concern around how an Evergrande default may lead to refinancing difficulties for similarly highly indebted developers leading to more defaults in the sector. Within China USD credit, there’s been a bifurcation of returns between investment grade (IG) and high yield (HY), and between property and non-property HY names. Investment grade names have seen some modest and selective spread widening, primarily in the real estate and SOE sectors. Spreads of JPM CEMBI (Corporate Emerging Market Bond Index) Broad Diversified China High Yield index have widened massively, mainly driven by B Chinese developers, reflecting elevated risk of more defaults in the sector. The events around Evergrande and its impact to the China bond markets is a reminder that how one invests in China is critical to achieving desired outcomes.
The banking sector remains stable due to limited and falling exposure to real estate, strong earnings cushion and robust capital levels. Other sectors we like include insurance, utilities, infrastructure, and autos. We are cautious on sectors that continue to pose regulatory risk including property, online gaming, weak local SOEs that have higher carbon emission and weak Local Government Financing Vehicles (LGFVs) that have less strategic importance. In the real estate sector, the risk of a contagion from Evergrande to other developers is mixed as the government’s policy is causing a divergence of credit fundamental across developers. Those that continue to reduce leverage will see improvement in credit fundamentals and potential upgrades. Those that struggle with excess leverage could find it more difficult to refinance debt and may also be in danger of default or restructuring. This underpins our preference of developers with better credit quality. In the longer term, we expect more consolidation and as a result greater stability in the real estate sector.
We believe that an unconstrained, benchmark agnostic approach to investing in China provides the greatest flexibility to capture opportunities and mitigate risks in the current complex environment. With the volatility in markets come opportunities to overweight oversold issuers with stable fundamentals and, more importantly, underweight those that are vulnerable to policy, refinancing or contagion risk. Bottom-up security selection is more critical than ever and diversification remains the most effective way to maximize risk-adjusted returns.
The assessment of the company mentioned herein is for illustrative purposes only. The inclusion should not be interpreted as a recommendation to buy or sell. J.P. Morgan Asset Management may or may not hold positions on behalf of its clients in the aforementioned securities. Past performance is not necessarily a reliable indicator for current and future performance.
1“Three red lines” requires developers to maintain the following leverage metrics: liability-to-asset ratio (excluding advance receipts) of less than 70%, net debt to equity ratio of less than 100% and cash-to-short-term debt ratio of more than one. If the developers fail to meet any the “Three Red Lines”, regulators would then place limits on the extent to which they can grow debt.