Chinese property developer Evergrande Group dominated headlines last week as it failed to make interest payments. Financial markets have been preparing for its possible collapse and some have suggested this could be a “Lehman moment” – drawing parallels to the American bank whose collapse kicked off the 2008 Financial Crisis. We don’t think this is likely.
To tackle the Evergrande issue we first need to look at recent developments in China, as Evergrande is caught in the cross currents of important Chinese policy changes.
Wealth inequality and China’s ageing population
The growing wealth gap between the rich and lower to middle classes is a global issue. In China, there is an especially pronounced wealth gap with the most billionaires in the world but a middle and lower class that is increasingly frustrated with the cost of property, education, and health care.
It is believed that rising costs to house, educate and care for children are behind the fall in China’s birth rate from 18 million five years ago to 12.5 million today – despite the removal of the one-child policy in 2016.
This declining birth rate will not only lead to declining population, but also a very unfavourable demographic mix as a shrinking working population will need to provide for a growing elderly population.
Source: Wind, National Bureau of Statistics
The Chinese government has acted this year to bring down the cost of education, health care and property through direct regulation and intervention. Intertwined with this was a move to remove the power and influence of China’s technology companies such as Alibaba.
China’s debt fuelled growth and long-term economic reform
For decades China has relied on investment in property and infrastructure to drive its economy. Every year China builds nearly 15 million new homes with the property sector accounting for 30% of GDP compared to 6% in the United States.
An unprecedented amount of property investment was required to build homes for the largest population migration of workers in history – 500 million people from rural to urban China over the past three decades.
Despite this, China appears to have over-invested in property with an estimated 20% of housing in China remaining vacant. This is because much was driven by property speculation and built by developers in smaller cities and locations that did not have the job opportunities to encourage workers to live there. Hence the formation of “ghost cities” documented in China.
In a similar vein, a lot has been poured into infrastructure investment that was not required. Local governments – desperate to meet GDP growth targets – built thousands of kilometres of roads and railways. Most of this was financed by land sales to property developers (assisting the property overbuild) and of course debt.
While this large investment was required in the highly populated eastern and southern parts of China, the less populated western and northern provinces overbuilt road and rail in their regions.
Until recently, China has not worried about this phenomenon as it has driven strong GDP growth and created jobs. But it has resulted in a very unbalanced economy and incredibly high debt among local governments, property developers and many other corporations.
Source: Bank of International Settlements *Data includes non-profit institutions serving households
China’s total domestic debt to GDP ratio has doubled in only 12 years to 280% in 2021 – one of the highest in the world.
Its non-financial corporate debt is also incredibly high at 165% with more in its international gateway of Hong Kong.
Source: Institute of International Finance
In most countries an economic disaster would ensue before debt levels go as high as they have in China. But China is not most countries.
The authoritarian government in China exercises incredible control in the economy to keep the system going. This takes the form of fast stimulus to counter economic downturns, supressed interest rates to reduce debt servicing costs for corporates, and the Government’s history of rescuing any companies that may default.
As a result, China has a lot of unproductive “zombie companies” that are a drag on future growth.
In recent years however China has moved to reposition its economic growth model to a more sustainable one and ensure China is not a repeat of the Japan economic collapse of the late 80’s and early 90’s. This involves:
- Reducing property speculation through tougher rules and tighter credit.
- Shifting infrastructure investment away from excess road and rail investment to new infrastructure such as 5G towers, data centres and electric vehicle related infrastructure.
- Encouraging lower debt levels
- Investing in technology and future industries
The transition of the economy from debt fuelled property and infrastructure growth to sustainable new growth industries is the right approach. But there will be many challenges for China to navigate through during the transition.
Evergrande
China Evergrande Group is China’s second largest property developer. It was founded by Hui Ka Yan in 1996 and listed on the Hong Kong stock exchange in 2009.
Its rapid debt fuelled growth is a snapshot of what has occurred in the broader Chinese property market.
Evergrande’s total assets have boomed from US$28 billion in 2011 to US$352 billion at the end of 2020. Most of these assets are property developments.
Liabilities, mainly in the form of debt and payables, were US$299 billion at the end of 2020. This, represented an incredible amount of leverage at 85% of assets. Only a very small decline in the value of its property assets would wipe out the skinny 15% of equity in the business.
Over the last decade, Evergrande has gotten away with its aggressive debt fuelled growth strategy as China policy makers have been quick to stimulate the property market on any weakness and provide credit to avoid corporate defaults. This has allowed Evergrande to survive where an equivalent in Western nations would have collapsed.
But as mentioned above, this approach by China is changing.
At the beginning of the year China began tightening credit conditions to cool down the property market and help control runaway commodity prices. As a result, property sales began to slow and house prices declined as developers discounted prices to clear inventory.
Evergrande group is well known to market participants following a high profile short-seller report in 2012 and various other close bankruptcy calls over the last few years.
The current property downturn may be its final blow as despite China’s slowing economy, policy makers are prioritising their long-term economic reform agenda over short-term economic stimulus.
Evergrande must sell properties to raise the cash to make payments to debt holders. To sell properties they need to follow other developers and discount their prices. But this quickly makes the value of their assets worth less than their liabilities.
Evergrande’s position is further weakened by the fact that it has a lot of developments in the smaller Tier 3 and Tier 4 cities where the property market has been much weaker than the larger Tier 1 cities like Shanghai.
In short, Evergrande is in serious trouble. At least in the absence of direct support from the Chinese Government to provide funds to repay bond holders.
It is quite likely that China is making an example of Evergrande by withholding support and sending a blunt message to other corporations that the rules have changed. The message is clear. The Government is no longer there to bail out companies and they must be more prudent with debt and investments going forward.
As markets came to terms with China’s reluctance to follow its previous path and pump credit and stimulate the property sector, the Evergrande stock and bond prices collapsed.
Source: Bloomberg
Fears that Evergrande is a “Lehman moment”
Last week markets took a dive as Evergrande headlines worsened. Some are calling this a “Lehman moment” for China, referring to the US bank whose 2008 collapse kicked off the US housing collapse and Great Financial Recession that was felt around the globe.
Evergrande has 200k employees and 1.5 million unbuilt homes that have been fully or partially paid for by the owners. It has US$95 billion of trade payables owed to suppliers such as steel, concrete, and glass manufacturers. And it has US$109 billion of debt, most of it due this year as well as money owned to investors in financing products.
The concern is that the collapse of a company of this size in such a leveraged economy will set off a domino effect as other leveraged companies that are owed money by Evergrande also collapse due to their missing payments to their own creditors. Not to mention the 1.5 million furious property owners who will suffer a huge loss of wealth if their homes are not completed.
Those predicting a Lehman moment see contagion then spreading as more property developers and banks collapse and the loss of wealth snowballs.
As mentioned at the beginning, however, we don’t think this is likely to be a Lehman moment. That view is based on the belief that:
- China is very aware of the risks to their levered economy. They will either bail Evergrande out, or more likely act to stop contagion spreading past Evergrande.
- China has the tools to prevent contagion. China is not a Western nation and has an authoritarian government with minimal offshore borrowings. This means the Chinese Government directs all policy and can act quickly and decisively to stop other companies collapsing. Actions it can take include:
- Give money to Evergande. As discussed above, we don’t think China will choose this option.
- Break Evergrande up and split its assets among other property developer and state owned enterprises. Those companies would be directed to complete the property developments and repay trade creditors
- Allow the Evergrande bond holders to lose their money but support other companies in making bond payments.
- Pump the economy with money to provide excess liquidity and stem contagion.
If necessary, China can create money to pump into the financial system as it has very little overseas debt and does not have to worry about depreciating its currency.
The risk of doing this too much would be its inability to maintain its currency peg to the USD. China would be reluctant to break its currency peg, but it would be a better than the alternative of allowing a Lehman style collapse.
This remains a last resort option that China can likely prevent through tight capital controls. If it did occur, we would likely see some significant short-term volatility then recovery as the markets realise China providing near unlimited liquidity is positive for growth.
The impact on New Zealand
Assuming China does contain the Evergrande fallout, New Zealand should not suffer large economic consequences. But even with a relatively controlled end to the Evergrande crisis, China is still experiencing a significant property downturn that will result in less property construction in the early part of 2022, and perhaps longer.
In the year to March 2020 New Zealand’s exported NZ$2.7 billion of logs to China. Most of this is used in the Chinese property sector.
It is possible that the Evergrande crisis will mark the peak of China’s new home construction. With slowing population growth, the maturation of China’s rural to urban population migration, and China’s policy taking a new direction, we may see less new home construction in the medium and long-term.
In addition, China’s ongoing COVID battle and the downturn in the property sector is likely to weaken China’s consumer sentiment. This may temporarily weaken demand for infant formula and milk powder.
This would impact New Zealand’s economic growth but is unlikely to be a major setback.
The impact on Australia
The weakness in China’s property sector will have a larger effect on Australia.
Australia exports near US$100 billion of iron ore a year to China’s steel industry with property construction accounting for over 30% of this.
The short-term picture for iron ore is also not helped by steel production caps placed by the Chinese government to reduce electricity consumption and improve air conditions ahead of the Beijing Winter Olympics in February (less power consumption means less coal generation polluting the air). This has contributed to the iron ore price fall from $220 to under $100 in two months.
Source: Bloomberg
The good news for Australia is that prices are coming off very healthy levels and are still well above the US$70 price considered to be the likely long-term price. Miners are still making strong cash flows at these levels and activity should continue in the mining sector. Iron ore prices will likely also lift when steel production restrictions are lifted following the Winter Olympics.
Medium and long-term the picture is cloudier. The shift of infrastructure investment away from road and rail to less steel intensive technology-based infrastructure is also a headwind. Combined with a possible peak in new home construction, we may see iron ore demand disappoint in the future.
The most directly impacted investments of ours have been the iron ore miners. We had reduced our positions in these businesses in June and reduced further early this month before last week’s sell off.
The impact on the rest of the world
A slowing Chinese property market will have some impact on the rest of the world but should not drive a global recession by itself.
Some luxury goods companies have significant sales to Chinese consumers and may be impacted in the short-term. European equipment manufacturers have large sales to China but also have significant backorder books at the moment which will help sales continue in the short-term.
Global growth may slow but not collapse as long as China prevents contagion.
Conclusion
Markets sold off early last week partly because of the Evergrande contagion fears, and partly because markets were over extended, and this was a good reason for the market to grab onto to justify a sell-off. Markets then recovered as rumours circulated about Evergrande being able to make its Thursday interest payment which was then eventually not made.
While we believe contagion is likely to be prevented, China is an opaque economy to analyse compared to Western economies. We recognise that reality and will watch the situation very closely and prepare for anything.
On Friday China banned the use of all crypto currencies. It is likely this was partly motivated to stop cryptocurrencies as a mechanism for money to leave China. China wants to prevent money outflows from its economy as this removes liquidity from China and pressures its USD currency peg.
There will be plenty more news to come from the Evergrande saga and we will follow developments with interest.