The big questions about Evergrande
How did this come about?
Property prices and rents in Chinese cities have risen sharply in recent years. Most recently, the government tried to curb speculation in order to stabilise prices.
The new “common prosperity” push (see our assessment "China's battle against inequality") has already led to a decline in property sales in July. At the same time, a reduced willingness to support highly indebted companies can be inferred from the change of course. The potential introduction of a property tax would also cool the market.
Evergrande's problems have been known for a long time, and its credit ratings are low. Other highly indebted companies such as Huarong or HNA have also run into difficulties. So the Chinese leadership has experience in winding down over-indebted companies. However, the dimension of Evergrande is much bigger.
Why is that so important for investors?
Because of the scale of Evergrande, there are short-term risks to the Chinese economy and financial system in the event of a disorderly default. The real estate sector has been a key growth driver, accounting for nearly 30% of GDP. A collapse in China's growth would also have an impact on the global economy.
The direct impact of a possible default on the global financial system, however, is unclear. The financing structure is extremely opaque, which makes it difficult to assess the consequences. The debt, estimated by various sources to be around USD 300 bn, was raised through bonds, bank loans and also the shadow banking system.
European and American banks are likely to have only isolated - and manageable - exposures. Due to the low credit rating, only very risk-conscious investors should be involved.
The situation is different in China: Evergrande has largely financed itself through the local market. China's big banks have set aside provisions for bad loans, but individual and smaller institutions could well be hit hard. A large part of the bonds are likely to be held by local investors outside the financial system.
What happens next?
China's political leadership is likely to be aware of the seriousness of the situation. The aim could be to break up the Evergrande Group. Evergrande is already selling its good bits. In this way, the government is continuing on its already chosen path of breaking up monopoly structures in the real estate market as well.
What could a solution look like?
We assume that the Chinese leadership will intervene, but attention will be paid to the exact form it takes. The authorities will try to prevent a spillover into other sectors by breaking up Evergrande to release liquidity. At the same time, Beijing is likely to try to protect private property buyers who have already paid for their flats and are making mortgage payments but are waiting for completion. The government is thus likely to ensure the completion of real estate projects.
A sale to private companies has already failed. It is conceivable that interventions will be made through the Guangdong provincial government instead of the central government. The greatest damage would thus fall on the creditors.
A major impact would be a long and severe slump in property prices and sales. This must be averted. In the short term, China could deviate from its actual course of cooling the real estate market through stricter lending.
Based on this scenario, we confirm our tactical positioning. We keep the equity quota at neutral. At the last Investment Committee meeting, we selectively increased Chinese equities within the thematic allocation targeted at stocks which should benefit from the new political course. Similarly, within the underweight bond allocation, we confirm the underweight of emerging market bonds in favour of an exposure to Chinese government securities and policy banks). High-quality bonds issued by Chinese borrowers have recently benefited from the stock market turbulence.
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