Evergrande: why the crisis of China’s 2nd largest developer is causing so much risk aversion in the market

SAO PAULO – In addition to fears about the economic slowdown and regulation in various sectors, a specific factor caused the Chinese and Hong Kong stock exchanges to register a strong risk aversion movement in recent sessions.

The fear is of a possible default of the country’s second-largest real estate developer, Evergrande, leaving banks and investors with tens of billions of dollars outstanding, with the risk that could thus spread across world markets. Evergrande has large international companies among its investors, such as Allianz, Ashmore and BlackRock.

The world’s largest-debt developer, with liabilities of around $300 billion (though it won’t have to make bond payments in foreign currency before next year), said last week it may not be able to meet its financial obligations .

This led to a sharp drop in the prices of its bonds and trading in its shares on the Shenzhen and Shanghai stock exchanges was even suspended. In the year, the share decrease is around 80%. Just this Thursday, the company’s shares fell 6.4% in Hong Kong. The news of the industry giant’s plight also raised concerns about the high leverage of the country’s real estate sector, which accounts for more than 28% of China’s economy.

The 52-stock Lippo Select index, which is composed primarily of mainland China-based real estate companies, fell 23% year-to-date, closing at the lowest level in four years on Thursday.

Following this news, on Wednesday of last week, ratings agency Moody’s reduced Evergrande’s foreign currency credit rating from “CCC+” to “CC”, pointing out that “default” of some sort “seems likely ”. Moody’s, in turn, pointed out that creditors have “weak prospects for recovery” in the event of a “default”.

Fitch Ratings highlighted the potential for credit risk for various sectors if Evergrande fails to pay its debts, adding that smaller banks and vulnerable developers could face a “significant” increase in bad loans.

This week’s Wednesday, there was, to some extent, confirmation of expectations, with the announcement by Chinese officials that Evergrande’s major lenders should not expect interest payments on bank loans due next week.

Seeking to expand its growth, Evergrande made low-interest financing and leveraged it into other segments such as football and electric vehicles, but now it is running out of options to pay its creditors. The company has been looking to raise money by trying to sell several assets, but operations have not yet taken place.

Evergrande’s liquidity crisis raises investor concerns about the performance of China’s broader real estate sector. According to official data, the value of property sales fell 20% in August compared to the previous year.

Analysts at Morgan Stanley have cut earnings forecasts for the sector by 6% this year and 12% for 2022 after the segment’s results in the first half.

The investment bank expressed concern that an Evergrande default would affect suppliers, other developers and financial markets. Analysts are also concerned about the risk of a broader industry slowdown and any expansion of property tax measures.

Analysts at Goldman Sachs also cut annual earnings growth forecasts for Chinese property developers through 2023 by five percentage points. In addition, they cut target share prices by 18% on average, citing considerable pressure on the segment due to China’s deleveraging measures.

This could still “lead to a gradual decline in property prices and construction activity,” analysts such as Yi Wang wrote in a report on Tuesday.

Analysts noted, however, that China could take some steps to contain the damage in the sector.

Theresa Kong, director of fixed income at Matthews Asia, told CNBC that there is “a lot of leverage” in the system. “That’s why it’s really important to make sure there’s still liquidity and there’s confidence.”

“Last but not least is certainly to ensure that there is no more social unrest because Evergrande has such a deep reach.”

Evergrande has more than 1,300 real estate projects in more than 280 cities across China, according to the company’s website. In recent days, protests from buyers of failed projects and angry investors have gained traction in cities across China.

Analysts point out that the Chinese government must not allow a chaotic break. “An Evergrande bankruptcy could damage consumer confidence if it affects deposits paid by families for homes that have not yet been completed, but we assume the government will act to protect them,” Fitch said.

Chinese authorities, according to international agencies, are preparing for a debt restructuring, bringing together accounting and legal experts to examine the developer’s finances. But Beijing’s top officials won’t say whether or not they will allow Evergrande’s creditors to take heavy losses, so bondholders have ruled out the slim chance of a bailout.

It should be noted that the Chinese government is determined to reduce financing to the real estate sector, precisely to contain the sector’s indebtedness, at unprecedented levels. Thus, it tightened the conditions of access to credit for real estate developers in recent months.

Also, under the new rules, Evergrande cannot sell properties until construction is definitely complete. In the past, the group has abused this model to fund and keep its businesses running.

“Chinese authorities are very concerned about the rapidly rising housing debt for two main reasons. First, the excessively rapid accumulation of real estate debt by households and developers could trigger a systemic financial crisis if property prices suffer a sustained decline,” says Japanese investment bank Nomura.

The second point is that the rapid accumulation of debt is unsustainable and excludes financing that could be allocated to more sustainable and efficient uses, such as investment in the manufacture of high-end goods and domestic consumption, experts say.

The problem, however, is that “cutting” the financing of this sector means facing a “mountain” of debt.

Nomura warns that China’s real estate sector is heavily reliant on credit. “According to our estimate, debt totaled about 33.5 trillion yuan at the end of the second quarter of 2021. On the other hand, China’s mortgage loans totaled 36.6 trillion yuan at the end of the second quarter of 2021, 13% more than at the end of the second quarter of 2020. To put these numbers in perspective, China’s nominal GDP in 2020 was 101.6 trillion yuan,” they assess.

Investment bank Natixis expects more private and small real estate developers to stay in the way with tougher regulations and weaker revenues, especially those with high leverage. China is increasing its regulatory pressure in various sectors in an attempt to regain control of the economy.

“A key question is whether the fall of Evergrande will trigger a domino effect and present systemic risks. The answer is that systemic risks must be avoided before the 2022 Communist Party Congress, because of their historical significance. However, it cannot be ruled out that Evergrande’s debt crisis could snowball into the future, given that economic growth will not be as strong as in the past. The most likely scenario is that Evergrande will be forced to sell assets at deep discounts,” concludes Natixis.

This could have big impacts for China. The real estate sector is the biggest “contributor” to the country’s GDP. Based on 2020 data, Nomura estimates that the real estate sector contributes about a quarter of China’s GDP. The importance of the real estate sector for public revenues is even more significant.

Together, the slowdown in new home sales volumes and investment in real estate construction (in real terms) could directly affect real GDP growth in the second half of the year, economists reckon.

(with information from Bloomberg)

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