China Evergrande: Subprime on steroids, the greatest threat to markets?

When China Guangfa Bank Co successfully applied to freeze $20 million in bank deposits and assets associated with China Evergrande, it was big news in the boardrooms, offices and around the water coolers at major financial institutions globally.

At face value this may seem strange – $20 million is just a drop in the ocean for one of the world’s biggest property developers. However, for months concern had been mounting about Evergrande’s spiralling debts.

That decision made by a court in China’s Jiangsu province was handed down in July 2021 and the matter (involving money owed by an Evergrande subsidiary) was resolved just days later. But since, Evergrande’s astronomical debt burden has continued to unravel and many fear the ripple effects could spread globally. Some have even suggested it could be the catalyst for another subprime-style crisis.

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Who is China Evergrande?

China Evergrande cranes dominate the skylines of many Chinese cities. The company develops and manages real estate across China, primarily focussing on residential apartment complexes. According to the company website, Evergrande Real Estate owns more than 1300 projects in over 280 Chinese cities.

It is the second-largest property developer in China and ranks amongst the top 150 companies in the world based on revenue. According to Fortune 500, the company has over 123,000 employees, and posted total revenues of $73.5 billion in 2020.

Alongside its enormous property development and management operations, Evergrande has also made investments into other sectors such as electric vehicles, internet and healthcare businesses.

The company was founded by billionaire businessman Xu Jiayin in 1996. He is ranked by Forbes as the third-richest person in China and the 31st richest man in the world.

Xu Jiayin, 62, announced his resignation as Chairman of Evergrande Real Estate Group on Tuesday, August 17 2021.

China Evergrande
Sinking ship? Xu Jiayin, the founder of China Evergrande, resigned from his role as Chairman of Evergrande’s Real Estate Group.

Evergrande is listed on the Hong Kong stock exchange (HKG: 3333). Since July 2020, its share price has plunged around 80%.

China Evergrande’s debt crisis

There’s speculation of more than $356 billion of global debt exposure to China Evergrande.

The company is the largest issuer of US dollar denominated Chinese junk bonds – bonds that very few investors now want to touch.

As Hilliard MacBeth, author of When the Bubble Bursts, puts it on the Richardson Wealth blog:

“Evergrande bonds which had been trading at par, and maturing in 2025, are now trading below 40 cents.

“This implies a return of more than 2.5 times in just 4 years, plus a 10.5 percent coupon, which means that the market believes there is little chance that Evergrande can pay this debt.”

Asia Markets notes the yield to maturity on Evergrande bonds maturing in 2023 is now hovering at around 35% – an huge yield, implying a risk level unacceptable by most investors.

China Evergrande
Credit: Richardson Wealth

Rapid debt-fuelled expansion is widely attributed as the main reason China Evergrande finds itself is a such a perilous position today.

“They did it (growth) in such crazy mass, with lots and lots of debt,” explained macro strategist Tyler Neville on the On The Margin podcast.

Since the China Guangfa Bank Co court proceedings were made public in July, there has been a series of further concerning developments.

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Just days later, an avalanche of law suits were initiated by Evergrande suppliers for alleged unpaid bills. Those include Huaibei Mining Holdings Co, which took court action over an alleged unpaid bill of $84 million, an unnamed investment company that won a court order to freeze Evergrande’s 20% stake in Shanghai-listed Langfang Development Co, and advertising company, Leo Group, which claimed it was owed around $61.5 million.

Further, Lanzhou City overnment officials have publicly revealed the city is owed money for land.

The extend of the debt problems has, not surprising, prompted ratings agencies to take action.

On Thursday, August 5, S&P downgraded the company’s credit rating from B- to CCC (two levels), while also lowering the long-term rating on U.S. dollar notes issued by Evergrande from CCC+ to CC-.

“Evergrande’s liquidity position is eroding more quickly and by more than we previously expected,” said S&P.

“The company’s non-payment risk is escalating, not only for the substantial public bond maturities in 2022, but also for its bank and trust loans and other debt liabilities over the next 12 months.”

Other major ratings agencies, including Moodys and Fitch, have also posted similar credit rating downgrades.

Survival

While investors have long debated the presence of a Chinese property bubble, bubble speculators may be vindicated should Evergrande completely collapse… And global market bears too.

While it’s in Beijing’s best interest to try mitigate a catastrophe, the administration has stopped well short of indicating a bail-out may be on the table – this a continuation of a more cautious policy approach to debt that’s been a trademark of the China Government in recent years.

On Thursday August 19, The People’s Bank of China and China Banking and Insurance Regulatory Commission took the unusual step of publicly urging Evergrande to take action to reduce its debt risk. It followed a meeting with company executives.

“Evergrande, as a top real estate company, must earnestly implement strategic arrangements made by the central government to ensure the stable and healthy development of the real estate market, and strive to keep operations stable,” the public statement read.

The statement went on to urge Evergrande to “actively diffuse debt risk and maintain real estate and financial markets stability.”

24 hours later, Evergrande management responded saying it would “fully implement” Beijing’s requirements, including reducing its debt risks and maintaining market stability.

There has been some progress on that front in recent days.

China Evergrande has confirmed reports that it’s in talks with smart phone manufacturer Xiaomi to sell a stake in its EV business, while negotiations with major creditors to extend loans have been successful. But the scale of the debt runs deep and much more will need to be done to avoid what many fear is the greatest threat to global markets.

China’s Lehman Brothers?

The collapse of world’s most indebted property developer could have an enormous impact on global investment markets.

David Llewellyn-Smith, co-author of The Great Crash of 2008 (currently a strategist at renowned Australian Investment Manager, Nucleus Wealth), is watching the devolvements closely and believes the significance of what’s occurring should not be lost on investors.

“Evergrande was once China’s greatest property developer. It is now an unbelievably over-leveraged tottering edifice with fewer and fewer friends and a near-impossible equity value below 10% of its debt load,” he wrote in Australian publication, Livewire.

Llewellyn-Smith also highlights something many industry insiders have long suspected – that the stable coin Tether is exposed to Evergrande’s commercial paper.

“This $300 billion debt monster is potentially China’s Lehmann Brothers, trading in subterranean junk debt to Chinese (and global) counterparties (which may include Bitcoin via Tether) at spreads that imply insolvency. There is no realistic scenario for restructuring Evergrande in which market dislocation is avoided. It is only about how much pain the Chinese government can bear.

“And there is a conga-line of Evergrandes queuing up in the property sector.”

Tyler Neville made a similar comparison noting: “If they’re borrowing money from the commercial paper market and doing all these funky things then this is sub-prime on steroids.”

“There’s probably a lot of other exposure… you could be looking upwards of a trillion or a couple trillion dollars.

Hilliard MacBeth further points out the baking sector “contagion” that could emerge.

“So far, Evergrande’s financial problems have not impacted other large developers or the Chinese banks. The largest Chinese developer, Country Gardens, is still trading near its all-time high,” he says.

“But aggressive price cuts on home pre-sales by Evergrande pushed home prices back to 2016 levels. Land costs have risen substantially, so profit margins are eroding. This could impact all developers, as buyers wait for price reductions before buying.

“The largest banks in the world are Chinese, with six of the top 11… The exposure of Chinese banks to Chinese real estate developers is enormous. About half of the assets (loans) held by the top ten banks are in China, about $15 trillion.”


China Evergrande

“This $300bn debt monster is potentially China’s Lehman Brothers, trading in subterranean junk debt to Chinese (and global) counterparties (which may include Bitcoin via Tether) at spreads that imply insolvency. There is no realistic scenario for restructuring Evergrande in which market dislocation is avoided.

David Llewellyn-Smith

Asia Markets Partner