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debt crisis, bond failures and investor risks

debt crisis, bond failures and investor risks

Emerald Bay housing project developed by China Evergrande in Tuen Mun District in New Territories of Hong Kong, China, Friday, July 23, 2021.

Lam Yik | Bloomberg | Getty Images

Chinese real estate giant Evergrande is on the verge of collapse, and analysts warn that the potential fallout could have far-reaching consequences spilling outside China’s borders.

“The collapse of Evergrande would be the biggest test China’s financial system has faced in years,” said Mark Williams, Asia’s chief economist at Capital Economics.

Here’s how bad its problems are and what’s in store for investors.

How did we get here?

After expanding rapidly for years and snapping up assets as China’s economy boomed, Evergrande is now snagged under a crushing $ 300 billion debt.

The world’s most indebted real estate developer has struggled to pay its suppliers and warned investors twice in as many weeks that it could default on its debt.

On Tuesday, Evergrande said its property sales are likely to continue to decline significantly in September after falling for several months, making its cash flow situation even more appalling.

The Chinese developer is so huge that the fallout from a potential failure could not only harm the Chinese economy, but spread to markets beyond.

Evergrande’s collapse would be the biggest test China’s financial system has faced in years.

Mark Williams

Capital Economics, Chief Economist in Asia

Banks have also reacted to its deteriorating cash flow. Some in Hong Kong, including HSBC and Standard Chartered, have refused to provide new loans to buyers of two unfinished Evergrande housing projects, Reuters said.

Rating agencies have repeatedly downgraded the company, citing its liquidity problems. Evergrande’s problems intensified last year when China introduced rules to curb developers’ borrowing costs. These measures set a ceiling on debt in relation to a company’s cash flows, assets and capital levels.

Its stock price has fallen nearly 80% so far this year, and trading in its bonds has been repeatedly stopped by Chinese stock exchanges in recent weeks.

What does Evergrande do?

Evergrande is everywhere. Its main business is in real estate, and it is China’s second largest real estate developer by sale.

  • Evergrande owns more than 1,300 real estate projects in over 280 cities in China.
  • Its property management arm is involved in nearly 2,800 projects across more than 310 cities in China.
  • The company has seven units in a wide range of industries, including electric vehicles, healthcare services, consumer products, video and television production units and even an amusement park.
  • The company says it has 200,000 employees, but indirectly creates more than 3.8 million jobs each year, according to its website.
  • Evergrande shares and bonds are included in indices throughout Asia.

Who will be affected?

The pool of stakeholders includes banks, suppliers, home buyers and investors.

Evergrande warned this week that its escalating problems could lead to broader standard risks.

It said that if it is unable to repay its debt, it could lead to a situation of “cross default” – where a default triggered in a situation could spread to other liabilities, which could lead to wider transmission.

A bank failure triggered by the collapse of major real estate developers was the most likely single scenario that could lead to a hard landing in China.

Mark Williams

Capital Economics, Chief Economist in Asia

Banks

The banking industry would be among the first to be hit if there are contagion effects on the larger real estate sector in China, Williams from Capital Economics said.

“A bank failure triggered by the collapse of major real estate developers was the most likely scenario that could lead to a hard landing in China. And the fact that financial markets are not currently signaling alarm does not mean they will not,” Williams wrote in a note last week.

2. Home buyers and investors

Protests from angry homebuyers and investors have erupted in recent days in some cities, and social unrest is among the concerns.

About 100 investors showed up at Evergrande’s headquarters in Shenzhen on Monday, demanding repayment of loans on overdue financial products – creating chaotic scenes, according to Reuters.

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In fact, sentiment is already spreading to high-yielding Asian bonds. Yields on Asian offshore bonds, dominated by real estate firms, have risen to an average of 13%, according to TS Lombard.

It also means offshore investors are losing an end, the research firm said in a note last week.

“The company’s guarantee of delivering all pre-sold projects is likely to lead to overseas stakeholders seeing little, if anything, from the ultimate sale of a developer’s assets in the event of a rescue,” said TS Lombard.

“Therefore, the prospect of an unequal swap, where the interests of lenders in rural households and banks are protected at the expense of equity and offshore bondholders,” the memo said.

Suppliers

The implications of Evergrande’s failure may also resonate with other industries whose suppliers are not paid. According to S&P Global Ratings, Evergrande may be trying to “persuade” its suppliers and contractors to accept physical properties as payment – in an attempt to retain cash to repay loans.

I think there will be some support measures from the central government or even the central bank trying to save Evergrande.

Dan Wang |

economist, Hang Seng Bank

In an August report, S&P estimated that over the next 12 months, Evergrande will have over 240 billion yuan ($ 37.16 billion) of bills and accounts payable from contractors for settlement – about 100 billion yuan of that amount is due this year.

A paint supplier to Evergrande, Shanghai-listed Skshu Paint, said in a case that the real estate company repaid part of its debt in real estate and unfinished.

The rating agency Fitch said that the banks may also have indirect exposure to Evergrande’s suppliers – the developer’s trade debt was 667 billion Chinese yuan, according to Fitch analysis.

Is Evergrande too big to fail?

The government is likely to step in because of the importance of Evergrande, according to analysts.

“Evergrande is such an important real estate developer, and it would be a strong signal if something happened to it,” said Dan Wang, an economist at Hang Seng Bank. “I think there will be some support measures from the central government or even the central bank that are trying to save Evergrande.”

But a restructuring may be more likely, according to other analysts.

“The most likely endgame now is a managed restructuring where other developers take over Evergrande’s unfinished projects in return for a share of its land bank,” Williams of Capital Economics said in a note last week.

It is likely that the government will prioritize home buyers and banks over other parties, he said.

“The politicians’ top priority would be the households that have handed over deposits to properties that are not yet finished. The company’s other creditors would suffer,” Williams wrote.

Investment bank Natixis said the Chinese government will avoid “systemic risks” ahead of the Chinese Communist Party’s National Congress in 2022, given its historical significance.

“However, this will also mean that China Evergrande’s debt crisis can snowball down the road,” the bank said in a note, adding that economic growth will not mitigate economic losses, as was the case in the past.

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