Wake Me Up When September Ends

Sam Triantafillopoulos

At the start of 2021, China’s financial regulators in step with CCP policy introduced a new approach to the domestic real estate industry, with the foremost goals of the so called ‘Three Red Lines’ being: a stabilisation of the growth in house prices; a reduction in the structural overreliance of construction and infrastructure as an engine of gross national product; and a reduction in the exposure of the broader economy to real estate, especially regarding banks and corporate credit markets. The three red lines consisted of: a liability-to-asset ratio of no greater than 70%; gearing of no greater than 100%; and a cash to short term debt ratio of no less than 1x.[1] Of course, the model on which Chinese developers have profited was incongruous with this new policy, especially given the pace at which development, both public and private, was occurring of late; it is worth mentioning that in the years 2000-2015, China poured more concrete than the United States did in the entire 20th century. Yet even then Chinese policymakers noted a worrying tapering in the rate of urbanisation; incomes among rural citizens are woefully low and a growing inequality problem is manifesting geographically as well as educationally. This presented a two-pronged problem for China; a burgeoning real estate industry could hypothetically dampen house prices, yet if employment opportunities for unskilled workers remain sparse in major cities, there is little impetus to move. On the other hand, if policymakers sought not to fight slowing urbanisation and instead cater to it, the structural oversupply of dwellings poses the prospect of a cratering in house prices.

Chinese developers for the most part have relied on a housing bubble that seemingly defied odds; even with vacancies soaring and amenities going unused, prices continued to climb, allowing firms levered to the hilt to remain solvent. Ultimately this model relies on breathtaking scale at razor thin margins, owing in part to China’s hyper-competitive corporate culture; the catch of course is that lines of credit must be open, especially considering that the vast majority of issuers will naturally fall below investment grade, that being BB or below. Naturally, banks would be somewhat skittish about lending at such volumes should they be given a choice. Instead, government bodies until recently have persuaded major state-owned banks to issue far beyond what a free market would, with the Industrial and Commercial Bank of China and the Construction Bank of China comprising the bulk of state bank issuances. In placing their foot on the scales, the Chinese government created an issue which they attempted to remedy-perhaps to a draconian degree-thereafter; the overallocation of capital to construction, resulting in an underserving of more credit worthy sectors, namely technology, with its lesser capital requirements and more favourable margins. What resulted in 2019 was a bumper year for Chinese high yield debt, with Evergrande leading the pack.

In July, S&P downgraded Evergrande’s issuer rating from B- to CCC+, reflecting a belief that default risk is high. The company’s issue rating, that is its implied risk of default disregarding a bond’s position in the capital structure, had sat at CCC+ for some time.[2] Since then, the issue rating for the majority of the company’s instruments has fallen to C while the company as a whole has sunk to CC. It is worth mentioning that every single developer rated CCC or below is in breach of all three of the government’s ‘three red lines’, with only 6.3% of the broader market complying with all three. It is not hard to see why Evergrande is a pioneer in abysmal balance sheets; the company’s interest coverage ratio (ICR) currently sits at 0.83x. For reference, highly reputable Australian companies typically aim to maintain an ICR in excess of 10x. While many high-risk issuers can have a sub-1 or even negative ICR, this would come with significant covenants intended to protect creditors; in 2017, the mandated fixed charge ratio was reduced from 1.5x to 1.25x. This of course is well within an acceptable range, yet not so when accounting for Evergrande’s access to capital markets, which more closely resembles a far more responsible issuer. With liabilities of $313 billion, Evergrande comprises approximately 6.5% of the of the Chinese property sector.[3] When government directives to deleverage are factored into the equation, the fact that most of Evergrande’s securities are secured would give investors little solace. With some of its most sizeable issuances trading below 30 cents on the dollar, the market has identified that the most likely recovery rate of the company’s bonds is well below the average 38%.[4]

Evergrande will not be able to pay the coupons on its dollar-denominated instruments, yet even so it appears as if the damage to the broader market has already been done; the deafening silence from the CCP indicates that Evergrande may be left to fail, with regulators electing not to repeat the events of 2014-15. The risk of contagion may be so great that rectifying the trigger, that being Evergrande, will do nothing to stem the systemic failures across the real estate industry and beyond. The government has most likely identified this; that being the exposure of the world’s two largest bank by assets, the Industrial and Commercial Bank of China and the Construction Bank of China, not to mention China’s largest private bank, Minsheng.[5] The degree of concentration as a result of government directives is rather staggering; around 7% of the ICBC’s book comprises of Evergrande loans. These of course are senior to the corporate bonds denominated in US dollars, and as such the government is likely ready to see widespread defaults provided domestic banks remain stable. Leaving private investors out to dry while protecting state banks also services the government’s goal of portraying itself as tough on corruption and hardnosed in the face of the corporate elite, yet this will likely sow further distrust in the Chinese financial system. The most likely case is that the central bank (People’s Bank of China) is saving its dry powder for the effects of a deleveraging which policymakers intended; in such a sense this is less of an earthquake and more of a controlled demolition gone wrong.

[1] https://www.ubs.com/global/en/asset-management/insights/china/2021/china-three-red-lines.html

[2] https://www.bondsupermart.com/bsm/article-detail/china-evergrande-group-proposed-amendments-to-notes-RB_396

[3] https://www.barrons.com/articles/evergrande-has-debt-due-next-week-it-cant-pay-51631883256

[4] Fabozzi, F. and Mann, S., 2012. The handbook of fixed income securities. New York: McGraw-Hill.

[5] S&P Global Intelligence

Sam Triantafillopoulos is a the Vice President of Publications at UNIT (University of Melbourne), primarily focusing on fixed income, corporate credit, monetary and foreign policy.

Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.

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