Evergrande Crisis Intensifies

The liquidity crisis at Chinese property developer Evergrande shook global markets this morning with stocks falling in Asia, Europe and New York.

The S&P 500 fell 2.1 per cent in afternoon trading, while the Nasdaq Composite slipped 2.6 per cent. The Vix, which measures expected volatility on the S&P, hit 26.5 — around its highest level since May.

Monday’s sell-off came after shares in Evergrande, the world’s most indebted property developer, closed 10 per cent lower in Hong Kong to hit their weakest level since May 2010.

Concerns about the broader health of China’s real estate sector triggered a wider sell-off, sending the Hang Seng Property index, which tracks a dozen listed developers, down almost 7 per cent to its lowest point since 2016. At 24,099 points, Hong Kong’s broader Hang Seng index closed at its lowest level since last October.


Patrick's Books:
Statistics For The Trading Floor:  https://amzn.to/3eerLA0
Derivatives For The Trading Floor:  https://amzn.to/3cjsyPF
Corporate Finance:  https://amzn.to/3fn3rvC

Patreon Page: https://www.patreon.com/PatrickBoyleOnFinance

Visit our website: www.onfinance.org
Follow Patrick on Twitter Here: https://twitter.com/PatrickEBoyle

Patrick Boyle On YouTube

Transcript

Welcome back everyone. Just a short follow up video on Evergrande.  I uploaded my original video on Thursday of last week and since then the story has exploded.

If you didn’t watch the last video, Evergrande is Chinas second largest property developer, and it is also the worlds most indebted property developer with approximately $310 billion dollars in liabilities.  The stock has been in freefall recently and it looks like company is insolvent. Back in 2018, Chinas central bank put together a list of companies that might pose systemic risks to the nation's financial system and Evergrande was near the top of that list.

The Chinese government are signaling that there will not be a bail out.  The company owes significant amounts of money to more than 128 banks and over 121 non-banking institutions.  As I’m sure you recall, Lehman brothers went under in 2008 due to their exposure to a collapsing US property market, and Evergrandes default could not only hurt the financial sector, but its property liquidation could significantly hit property prices in a country where property is unusually expensive as a multiple of incomes – there is a lot of leverage in the Chinese property market.  Evergrande has been trying to sell their property portfolio at markdowns of as much as 25% in order to service their debts and this has not been working. They have a huge portfolio of property that might be unsellable – there balance sheet includes almost half a million parking spaces…  The fact that they are trying to quickly sell is not good for the Chinese property market and there are many other property developers with similar levels of leverage (and hard to sell assets) that will be feeling the squeeze. The financial press are putting this forth as possibly being Chinas Lehman moment – this could be an exaggeration, as of course drama drives clicks for the press.  We should note that China has the advantage of having seen how the Lehman bankruptcy went wrong and having seen how the hastily put together AIG bailout – which bailed out all of the American (and really global) investment banks was deeply unfair to the taxpayer.  So it is unlikely that we will see the same events unfold twice.

The Chinese middle class have a lot of individual exposure to Evergrande, which makes it quite different to Lehman.  Evergrande has a wealth management unit, which allows Chinese investors to deposit their savings and earn interest.  They are trying to offer these clients parcels of real estate in exchange for this debt, and these investors are not really interested, as the real estate may be worth very little.  You put your money in a bank account, you don’t really want to be offered a parking garage in a ghost city in exchange for that. There are investors who have placed deposits (which may be their life savings) on 1.5 million properties, which may never be built. On top of this Evegrande is a huge employer – 4 million people could lose their jobs and owes lots of money to suppliers.  This is why you are seeing all of these protests and demonstrations on television.

Last week when I made my first video, I was a bit surprised the extent to which the market was ignoring this story.  Today people are starting to pay attention, the S&P is down about 1.5% as we speak and it seems to be the top news story.

The commodities market was a bit quite a bit ahead on this story, iron ore has halved since July. It is quite difficult to get your head around the scale of the Chinese construction sector, and its importance to natural resources exporters. A statistic that highlights this scale is the fact that over a three-year period more concrete has been poured in China than was poured in the United States during the entire 20th century. It is no surprise that commodities reacted ahead of stock markets to a dramatic slowdown in the Chinese construction sector.

China’s share of global commodities consumption is estimated as being between 40-70%, but of course not all of that goes into real estate.  The real estate sector in China is estimated to consume up to 20% of the global commodity supply.

Evergrande which I mentioned in Thursdays video was down 80% over the last year has fallen an additional 8% today (as of recording this video). The Hang Seng Property index, which tracks a dozen listed developers, down is around 7 per cent, to its lowest point since 2016. Hong Kong’s broader Hang Seng index closed at its lowest level in a year. 

Evergrande has obligations of around $310bn to creditors and other businesses, and a crucial interest payment deadline on its offshore bonds comes this Thursday.  They are frankly more likely to miss a payment to offshore investors than to the Chinese banks which are largely controlled by the government.

So, who has exposure to these obligations? According to Bloomberg Ashmore Group, a London-based money manager that specializes in emerging-market debt, has more than $400 million worth of Evergrande bonds, based on end of June filings – this figure may have changed between then and now. 

BlackRock, UBS and HSBC were also large owners as you can see from the chart on screen, many of the bonds are held by vehicles that focus on riskier emerging market or Asian credits. Bloomberg reports that the law firm Kirkland & Ellis and the investment bank Moelis & Co. have been hired as advisers by some of these bondholders.

So what are we seeing right now?
 Metal prices fell today as concerns grew a pullback in the Chinese property market. Copper prices are down 3 per cent today on the LME, and Iron ore fell below $100 per tonne for the first time in over a year.

The financial times quotes a Hong Kong based Stockbroker Louis Tse as saying that “Evergrande is just the tip of the iceberg,” “Chinese developers were under substantial repayment pressure on dollar-denominated bonds, while markets had become nervous that Beijing would push listed real estate groups to cut the costs of housing in mainland China and Hong Kong. That affects the banks as well — if you have lower property prices what happens to their mortgages?”  “It could be a chain reaction.” Lets hope it is not as bad as it sounds.

President Xi Jinping’s crackdown on private enterprise has been a significant drag on the Chinese economy of late – I’m sure everyone has seen the news about his crackdown on the tech and education sectors, but Chinas most vulnerable sector is residential real estate. 

Foreign investors who put their money in China struggle to recognize many of the risks, because they’ve seen China confront significant difficulties in the past and always come shining through. But Xi’s China is not necessarily the China that they are familiar with, as many Chinese people on the ground will tell you. Xi is putting in place a modernized version of Mao’s communist party, he regards all Chinese companies as instruments of a one-party state. You can see this quite clearly in the way he has taken stakes in and placed board members on the board of directors of the country’s most important firms. Chinese financial authorities have gone out of their way to reassure foreign investors, but, Xi’s moves towards Mao’s vision of China, should not really provide a lot of reassurance to investors. I’d try to give you some data on how markets performed under Mao, but of course there was no Stock market in China under Mao.

If you want a more detailed explanation of what has been going on at Evergrande, and how they found themselves in this situation, you should definitely watch my last video at this link.

Have a great week and talk to you soon! Bye