Macro Analysis /
China

Evergrande, Chinese debt and the implications for emerging markets

  • Evergrande's missed coupons seem trivial in the context of China's economy but are a symptom of a bigger problem

  • Arguments for paying the bonds, but that defers the problem and government bailout is inconsistent with state policy

  • Key risks to EM: higher risk aversion, portfolio contagion, slower China growth. Better risk pricing a long run positive

Evergrande, Chinese debt and the implications for emerging markets
Stuart Culverhouse
Stuart Culverhouse

Chief Economist & Head of Fixed Income Research

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Tellimer Research
7 October 2021
Published byTellimer Research

After Evergrande missed a couple of coupon payments and risks falling into a potentially large and messy default, we take a wider view of the situation, seeking to put it into the context of the Chinese corporate debt market, and ask what it might mean for emerging markets. We leave analysis of potential recovery values to others.

Evergrande (EVERRE), China’s largest property developer and said to be the world’s most indebted property company, has missed two coupon payments on its US$ bonds in as many weeks. The company missed a US$83.5mn interest payment on the 8.25% 2022 on 23 September, followed by the non-payment of a US$45.2mn interest payment on the 9.5% 2024 on 29 September. Both payments could still be made before the end of their 30-day grace periods, and default on the two bonds avoided. Chinese authorities have already told the company to avoid a default.

As a result, prices have slumped further, to sub-30 levels, but in reality the bonds have been under pressure since June. Longer bonds are indicated in the low 20s.

EVERRE bond prices (US$)

Indeed, paying the relatively insignificant sum of US$139mn seems a small price to pay to avoid default, and a potentially wider and uncontrolled debt crisis. And if the company isn’t able to pay, surely the government would step in?

Beijing has the resources (should they want to), with FX reserves of US$3.3trn for example, and could still decide to provide the required lending – through directed lending from state banks for instance – rather than suffer the consequences.

Hopes that the company might pay rose on Monday (4 October) after news that it had agreed to sell a controlling stake in a subsidiary to raise the cash needed to cover debt payments, although whether this happens remains to be seen.

One might even be forgiven for asking what all the fuss is about. The first US$84mn default (and now add another US$45mn) is trivial in the context of a US$15trn economy and US$10trn corporate bond market.

And it is not even the first default on overseas bonds in China this year, or in recent years. Other Chinese companies, especially property developers, have defaulted on dollar bonds. For instance, two of the biggest defaults so far this year have been under Tsinghua Holdings, at a tech division of Tsinghua University, which defaulted in January on a US$1.05bn repayment, which cross defaulted to another US$0.95bn in other bonds, while China Fortune Land Development defaulted on a US$530mn principal payment in February and again on another US$940mn principal payment in July.

However, it is not that simple.

Fantasia adds to the mix

The situation took another turn for the worst this week after reports on Tuesday that another property developer, Fantasia, defaulted on a US$206mn principal payment due on Monday (4 October). The bond reportedly has no grace period and risks cross-defaulting to the rest of its bonds. The company has US$4bn in US$ bonds.

Although its total debt is much smaller than Evergrande, the timing of Fantasia's default will add to growing concerns about the state of the Chinese property developers and the risk of a deeper systemic crisis with global consequences, given the size of China's economy, not least because Fantasia's default was unexpected. While its longer bonds had been signalling distress since June, this week's maturity was still priced closed to par on Friday 1 October.

Fantasia bond prices (US$)

Two reasons not to pay the bonds or for a state-backed rescue for Evergrande

We think there are two key reasons against paying the bonds or a state-backed rescue for Evergrande.

1) Kicking the can

First, making the payments only defers the problem. Another US$148mn in interest on three bonds falls due on 11 October. In addition, according to reports, a principal payment by Jumbo Fortune of US$260mn, which is guaranteed by Evergrande, was due on 3 October. Even if the company can make the missed payments after all, will it be able to manage future payments?

Evergrande (and its borrowing entities) has US$20bn in international bonds according to our calculations and total reported debt of US$300bn according to Bond Radar. Evergrande faces US$6bn of overseas bond maturities in 2022, of which US$3.5bn comes due in March and April.

Paying some US$140mn now may therefore buy a bit more time, but without a credible plan it is hard to see how these future payments will be met. Better to bite the bullet now. A piece-meal approach to each payment will just perpetuate uncertainty and weigh on market sentiment.

Bondholders may also be prepared to wait during the grace period, and even afterwards, but failure to pay could see cross-default to other bonds. The debt problem could therefore quickly escalate.

Evergrande complex: outstanding USD bonds

And Evergrande’s problems have been well flagged, although the market reaction to the two missed dollar interest payments suggests it caught the market by surprise. Evergrande group companies even issued US$6bn of bonds in January 2020, in two tranches, with coupons of 11.5% and 12% on two-, three- and four-year maturities. The high coupons no doubt signalled some distress. Its bonds were also rocked by media reports last September (2020) that the company had asked for government support. And, after ensuring the economy's recovery after Covid through policy stimulus, Chinese officials have repeatedly warned of the risk of a property bubble.  

So it is not just about US$140mn. The bigger fear is that the default would extend to the rest of Evergrande’s offshore bonds, although that too, at only US$20bn, seems a drop in the ocean. But the company’s total debt is significant, at 2% of GDP.

2) A matter of policy

Second, while Beijing no doubt has the resources to support Evergrande (and most other domestic companies), it may not have the willingness. And it doesn't necessarily have to. Unlike – for example – Huarong Asset Management, the state-owned bad bank, which recently got bailed out by a group of state-owned companies following record losses, Evergrande is a private company and may not be seen as so strategically important.

A government rescue for Evergrande would seem inconsistent with Beijing's Three Red Lines policy, outlined in August 2020, which requires overindebted real estate companies to reduce leverage – the result of which has brought Evergrande to this point as its funding options narrowed. According to the policy, any developer that fails to meet any of the three red lines would face limits on their ability to take on new debt – regulators therefore required banks to cut off Evergrande's funding. Bailing out Evergrande would offer little incentive to other problem companies to reduce leverage.

This policy stems from Beijing’s desire to clamp down on borrowing in the real estate sector and deflate a property bubble, a policy that the government feels it has space to pursue now the post-Covid recovery has been assured.

In addition, the government has over recent years sought to back away from the widely held belief in the market that it would bailout any state-owned enterprise (SOE), or other systemic or politically connected companies, putting in doubt the notion of a state guarantee (implicit or explicit). The government’s willingness to let companies go is intended to remove the presumption of state support.

Hence, while Evergrande has overborrowed, and extended its activities to non-core areas, government support for the real estate sector has also faded.

Warning signs

And despite the surprise market reaction, there have been warning signs.

Indeed, the IMF warned earlier this year in its 2020 Article IV (published in January 2021) that "a housing market correction or funding pressure in the highly leveraged property sector could pose financial stability risks... Property developers already entered the Covid-19 crisis with significant leverage, accounting for 12% of total corporate debt and significant foreign currency debt through offshore USD bond issuance at end-2019."

Does it matter?

But does it matter if Evergrande does default? Is this just a China problem?  

Given the size of the Chinese economy and its debt market, a missed coupon or two, or even Evergrande's possible default, might seem trivial. But it is because of China's size that default could cause ripples elsewhere. Until recently, this has not resulted in wider contagion, but we are now seeing Evergrande’s problems spill over to global markets.

And while Beijing may seek an orderly default (if such a thing existed), and has the resources to limit its impact, preventing it turning into a wider crisis, there is a risk the authorities lose control and the situation spirals.

Indeed, comparisons have been made with Lehman's collapse, although we wonder if a better comparison is with Dubai's debt crisis (2009), where we see some commonalities: i) property is at the centre; ii) the wrongly held belief about state support; and ii) uncertainty about the true debt situation.

Our five concerns

We highlight five concerns:

1) Who might be next and how far it will go? The problems at Evergrande, reinforced by Fantasia's default, will raise questions over who might follow, and if the state chooses not to rescue Evergrande, that would send a strong signal that most of the others, which are smaller, will be allowed to fail too; although Beijing may draw a line if the biggest and strongest developers are drawn in and risks a systemic crisis, but it seems unlikely that larger real estate developers will face similar financial distress.

There is a wall of debt coming due from the property developers in coming months and in 2022, which - absent clarity over how this will be handled (either by the companies themselves or the authorities) - will continue to feed market anxiety.

As to the potential size of the debt problem, this is unclear. Other property developers, by definition, are less indebted than Evergrande, although the accumulation of less indebted ones adds up. We haven't got data on the sector's total debt and its composition. But we have identified cUS$111bn in US dollar bonds across 23 property developers we know of – Evergande is 17% of the total. This includes Country Garden, Greenland, and Kaisa. Several developers such as Country Garden, Vanke, China Resources Land, and China Overseas are still trading at or above par. 

Principal outstanding of selected Chinese real estate cos

In addition, there are concerns about the true extent of the debt problem amid reports of guarantees and off balance sheet debt. Debt could be much higher than is reported.

2) Reassessing Chinese credit risk. The withdrawal of the presumption of state support (moral hazard risk) should lead to a reappraisal of the creditworthiness of Chinese borrowers on a stand-alone basis (corporates, financials, local government financing vehicles (LGFV), etc) and lead to a wider repricing of Chinese credit risk. This could lead to portfolio losses for global investors (depending on the extent of foreign ownership) and to slower investment flows into China.

In addition, offshore bond defaults will also test the strength of keepwell provisions, a pledge to keep offshore subsidiaries solvent but without any payment guarantee, and a feature of the Chinese bond market. If such provisions are not seen as providing the level of security that investors had hoped, this could also lead to wider reassessment of creditworthiness.

China's High Yield (HY) real estate (RE) index has already fallen to five-year lows. And the correlation of daily returns between the HY real estate index and the HY market is high, at 97%. So property will drag down the overall HY index.

China real estate bond index

Indeed, yields on China HY bonds have spiked higher as a result of this uncertainty and reassessment of credit risk. The yield on Bloomberg's China HY index has risen to 16%, exceeding the peak we saw during the height of the global market sell-off during pandemic in March 2020.

Yield on China High Yield bonds (%)

Whether this marks the property or HY sector as offering value is however debatable until we have better visibility on how Beijing intends to get out of the crisis and also on the true extent of the debt situation (amid fear it is much bigger than reported).

3) Slower Chinese GDP growth. Although real estate only accounts for 7% of GDP according to China's national accounts data, its economic significance may be much larger. The property market as a whole (real estate production and property services) is estimated at 29% of GDP on some measures. A property market slowdown could therefore lead to slower overall GDP growth, and risk turning into a hard landing. China's real GDP is expected to grow by 8.3% this year, according to the Bloomberg consensus, falling to 5.5% over 2022-23. Slower Chinese growth would have repercussions for EM (lower export demand and commodity prices).

4) Distributional impacts and social consequences. If not to bailout Evergrande's bondholders, Beijing may need to intervene to protect certain groups, such as households (who bought unfinished apartments) and domestic savers (who invested in property companies in their wealth management plans). The perception among those most affected by the property crisis that they are being ignored or not treated fairly could risk unrest.

5) Increased global risk aversion, which we're already seeing in global markets. Increased uncertainty about the extent of the property crisis, and Beijing's response to it, and any resulting flight to safety could lead to tighter EM financing conditions (rising spreads and weaker currencies), lower capital flows to EM, and lower asset prices, although it is not clear how long this will last. Portfolio contagion could also result as investors seek to cover losses and reduce exposure to risky assets, which would magnify the direct impact from the property sector's plight. Weaker Chinese corporate bonds would also weigh heavily on the EM corporate bond index, in which it has a big weight. But a longer-lasting impact may be portfolio rebalancing to account for slower Chinese GDP growth over the medium term, if this materialises.

Evergrande’s default has shaken global markets and contributed to a period of risk off and volatility, from which they have yet to recover. In the immediate days following Evergrande’s first default, EM hard currency sovereign bonds fell 1.3%, with the yield rising 20bp, while EM corporate and global High Yield fell 0.7% and 0.8% respectively. Global equities have also fallen with the World Index -1.2% and S&P -1.0%, although EM equities have held up better (-0.2%). US 10yr yields have also risen 20bp. However, over this period the market has also repriced expectations over US Fed tightening following the FOMC meeting on 22 September, so it is difficult to disentangle all the dynamics.

But China's sovereign dollar bonds have taken this in their stride. The yield on the US$ '30s has risen by 20bp to 1.6%, with the price down 1.5pt, although the spread over USTs is unchanged at c11bp, which suggests markets aren't overly concerned about the wider repercussions for China - which has the resources to bailout the sector or to mitigate the impact of defaults, without weakening the sovereign's balance sheet.

Global ramifications and resolution

Allowing Evergrande to default could therefore trigger a wider debt crisis in the Chinese corporate debt market with potentially global ramifications.

Given the forgoing, we highlight three key channels of risk to EM:

  1. Higher global risk aversion

  2. Portfolio contagion

  3. Slower China growth

While we expect the Chinese authorities will intervene if the crisis threatens domestic financial (and social) stability, we think they will be reluctant to do unless it is deemed absolutely necessary. That said, state policy may still determine how the situation is resolved and it is not clear to us if the desired outcome will be positive or negative for foreign bondholders (either ensuring bondholders are made whole or forced to take losses in a restructuring).

The authorities could effectively let foreign bondholders lose out, engineer a takeover of the assets (via a cheap acquisition price), and get the off-plan construction completed, thereby avoiding systemic risk. This might be analogous to a Bad Bank, which takes over the assets, or they get parcelled up (by type/province) across existing stronger developers.

But on the other hand, if Beijing thinks strategically that it needs foreign investors (despite its own deep pockets) and cares about its market reputation, it might be loathe to treat bondholders badly or unfairly, and just pay the bonds – similar to Dubai where they paid the bonds and "burned the banks", although China is in a stronger position than Dubai, which was more reliant on foreign capital. Beijing could force restructuring on domestic banks in exchange for regulatory forbearance. 

Rising Chinese defaults

China's corporate bond defaults now exceed last year’s level, with three months still to go, with defaulted bonds covering a total amount of US$34bn in principal as at end-September according to Bloomberg data (the figures are based on the initial issued amount and exclude interest in default). The figure excludes Evergrande (which is still in its grace period) and will have increased after the Fantasia default.

The defaulted debt comprised US$7.2bn (equivalent) in principal in the overseas debt market and US$27bn in onshore bonds, according to Bloomberg data. The Fantasia default on the 4 October maturity will not have pushed up the headline figure by much, as it was only US$206mn (and US$500mn in original principal), but triggering cross-default would increase the principal amount in default on offshore bonds by US$4.3bn (that is, taking the total offshore default to US$11.5bn in principal and increasing the overall amount in default to at least US$38bn).

This compares to a total in default of US$30bn in principal in 2020, of which offshore defaults covered US$8.6bn. Offshore defaults were more than double the amount in 2019.

Chinese bond defaults have been on a rising trend since 2018. The increased incidents of default come in part as struggling state enterprises have been allowed to fail and more recently from the distressed property developers, which seem to make up most of the recent defaults.

China's corporate bond defaults (US$ bn equivalent)

Until now, one of the biggest defaults this year was China Fortune Land Development Co, a developer of industrial parks. The company failed to pay US$530mn in principal on an overseas bond in February, which cast doubt over its US$4.6bn in overseas bonds. The company defaulted on another bond maturity in July, with a principal amount of US$940mn (we do not know if there has been cross-default to the company's other overseas bonds, but we understand they are in technical default due to breach of covenant according to Bloomberg).

According to some data gathering by Bloomberg, defaults on overseas bonds this year cover 16 bonds across nine companies (to end September, excluding Evergrande, which is in its grace period, and Fantasia, which is past the cut-off). Two companies account for 60% of this (Tsinghua Holdings and China Fortune Land Development) and as a demonstration of China’s looming distress, some of the defaulted bonds were issued as recently as 2018-19, and one was issued in January 2020. The defaulted bonds also include two convertibles. Property developers account for over 30% of the defaulted principal amount.

However, given amortisation on some of these bonds, we calculate the outstanding amount of defaulted bonds is lower, at US$6.1bn; and the stock of defaulted principal is lower still given that two of these defaults have already been subject to restructuring (consent solicitation or exchanges, generally resulting in three-year maturity extensions). However, this would increase to US$6.3bn including the defaulted Fantasia bond (and US$10.0bn if all its bonds are included based on outstanding amount and not initial issue size).

That said, the amount of bonds in default may be even higher, at some US$10.6bn, if we include those companies with defaulted bonds that also have bonds in technical default due to breach of covenants.

Chinese offshore bond defaults in 2021

Still, cUS$10bn in foreign bond defaults is tiny in the context of the US$1trn offshore bond market, let alone the overall corporate bond market. An Evergrande bond default, across all its foreign bonds, would increase the amount of offshore bonds in default dramatically, pushing it up to US$30bn, but it would still be a small share of the market.

Investors will however focus on the debt service profile in coming weeks to see who the next candidate for default might be as they wait for clues as at how the crisis will be resolved. Based on our screen of 23 developers, upcoming maturities include 18 October (Sinic US$244mn), 27 October (Seazen Holdings US$100mn), 8 November (Central China Real Estate US$400mn), and 18 November (Zhenro US$200mn). Sinic is already trading at defaulted prices (25c on the dollar) after recently failing to pay some domestic debt obligations. Fitch cut its rating to C from CCC on 5 October.

Issuance boom and bust

At the same time as China pulled back from state support for companies in distress, bond issuance boomed. A debt crisis may be the inevitable result of such a borrowing binge; and a lesson we’ve seen elsewhere.

China's share of international EM bond issuance* (US$ bn)

Chinese issuance has been as high as 30% of total EM international bond issuance (sovereign and corporate) in recent years.

China's share of international EM bond issuance (%)

But signs of a debt crisis may have been apparent for some time. The number of Chinese corporate bond issues priced at a yield of 10% of more grew sharply in 2019. According to our calculations, based on Bond Radar data, 34 deals in 2018 were priced at 10% or more (11% of the total number of deals), rising to 71 (21%) in 2019 and 74 (21%) in 2020. So far this year, 44 deals have been priced at this level (16% of the total).

China's distressed bond offerings

In fact, rising corporate defaults might be expected, as the domestic market matures. Chinese corporate default rates seem low by international standards, averaging around 1% over 2018-20 according to S&P, even after the policy shift in Beijing, and well below the global corporate default rate which hovers around 3%.

Silver linings

But there might be some silver linings:

  1. There might be some comfort that if the most indebted property company is already in default, how much worse can it get? Other problem companies would be that bit smaller and hence potentially less disruptive – although the accumulation of many smaller companies could still be problematic.

  2. Allowing Evergrande to default may be seen by investors as removing moral hazard risk, leading to better risk pricing and standalone credit risk, rather than trying to guess political favourites and the likelihood of state support. This would help the longer-term development and maturity of the Chinese corporate bond market, notwithstanding this short-term shock.

  3. Other emerging markets may benefit from the displacement of capital flows from China. Capital outflows from China will have to go somewhere, so could end up in other emerging markets.

Indeed, given the size of China's economy, and debt market (the second biggest in the world after the US), any retreat may only prove temporary as the market is too big to ignore, with foreign participation already low (estimated at only 3% by S&P). And S&P argue that at only 130-160% of GDP, albeit double what it was five years ago, compared to 220% in the US, the Chinese bond market is still undercapitalised and has room to grow – better a crisis now than later we think!

Meanwhile, inclusion in global bond indices, after China’s onshore market was added to the Bloomberg Barclays Global Aggregate Index in 2019, should also help its development.

I am grateful to my colleagues Hasnain Malik, Nirgunan Tiruchelvam and Rahul Shah for helpful comments and suggestions.