In recent weeks, China Evergrande Group, a major international debt issuer and one of the largest Chinese real estate companies, has been on the brink of collapse, causing market shockwaves. Now that the initial public shock has subsided and some of the smoke has cleared, experts are beginning to make sense of the situation given the recent developments.

Described by Fortune as the “great-granddaddy of China’s property bubble”, China Evergrande is a property development behemoth. According to Evergrande’s own website, the company has built more than 1,300 projects in more than 280 cities within China. But such high ambitions can be costly, and The Wall Street Journal’s Peter Santilli noted, “As of the end of 2020, the property developer had more than 700 projects under construction, covering 132 million square meters of total floor area. For comparison, the total floor area of the Empire State Building is about 257,000 square meters.”

These ambitions have helped Evergrande become positioned as a particularly leveraged company, owing a massive $300 billion, including $19 billion in USD denominated bonds, to a consortium of creditors including banks, contractors, foreign bondholders, local investors (including many employees), and homebuyers who paid in advance for new properties that the company is struggling to complete. To illustrate the breakdown noted above, the Wall Street Journal provided this graphic outlining the overall liabilities:

An important part of this debt load exacerbating the market concern: This $88.5 billion includes $7.4 billion in bond payments due in 2022 alone!

So what happened? While many investors only first heard of the company’s default risks in recent weeks, others have noted that this has all been going on since 2020, when Evergrande first began struggling to cover its debts. Evergrande bonds have been on a rapid decline since May, with a nosedive occurring in July. Per Fortune, on September 20th, Jim Reid, Head of Global Fundamental Credit Strategy at Deutsche Bank, wrote in a morning markets note, “It’s a confus[ing] world when equity markets are generally within a couple percent or so of their record highs whilst we’re seeing the biggest dollar-Asian-high-yield company, Evergrande, with $300 billion of liabilities, on the brink, with no-one really aware of how the work-out will be managed and whether [there will] be contagion.”

Investor confidence in the company’s stock is almost completely lost, with the price dropping 85% over the past 12 months.

On August 6th, Reuters reported that S&P Global had downgraded Evergrande’s ratings for the second time in less than two weeks, citing concerns regarding the ability to pay on upcoming debt payments. Moody’s and Fitch took similar actions within the same time frame. Then, in September, after China’s largest credit rating firm downgraded the firm amid more default concerns, Chinese regulators told major lenders to Evergrande not to expect interest payments due on some of their bank loans. On September 18th, these concerns became reality as interest payments to some of the company’s largest bank creditors were missed. (This miss was not immediately factored as a true default, as Evergrande has a 30-day grace period on those payments.)

After the downgrades and subsequent collapses in the bonds, many investors began to fear a larger, widespread issue with the Chinese conglomerate’s debts and began to panic. Many pundits have begun to question if this issue could become “China’s Lehman Brothers,” although analysts believe this perception is overblown. According to Rob Carnell, Regional Head of Research for Asia-Pacific at ING, this is not nearly as bad since Evergrande is not “a hedge fund with massive leveraged positions or a bank whose financial asset prices are hurtling towards zero.” The crash of Lehman Brothers was caused by a crash in financial instruments such as CDOs (Collateralized Debt Obligations), ultimately leading to a crisis of confidence in the health of the global banking industry. Evergrande owns the land, and therefore at least has salvageable assets that creditors will look to get their hands on in the event of default. Another aspect of difference is in the strong governmental control; where the U.S. government allowed Lehman Brothers to fail, many believe the Chinese government’s involvement in the real estate industry will disallow such a widespread crisis.

“We must not forget that housing is for living in, not for speculation,” President Xi Jinping proclaimed in November 2017. China has already been on a mission to tamp down on overleveraged private companies, implemented by a “three red lines” system. The three red lines include: (i) liability-to-asset ratio (excluding advance receipts) of less than 70%, (ii) net gearing ratio of less than 100%, and (iii) cash-to-short-term debt ratio of more than 1x.

Beijing has sent clear signals on its wishes to reign in debt and reduce the amount of property speculation. Since learning of the firm’s inability to pay, the Chinese government has mostly signaled that market forces will come into effect, meaning that banks and investors who lent to corporations with weak balance sheets, such as China Evergrande, should be prepared to face losses.

According to Fortune’s Eswar Prasad, the “looming default shows that Beijing is sticking to its plan of letting market discipline work, sorting out risky borrowers from sound ones, even if that causes some short-term financial pain. Rather than preventing a default, the government seems eager to limit its intervention to contain the fallout, especially on homeowners.” If this holds true, it will be a rough time for many investors, including Chinese citizens who speculated on property rather than trust their country’s banking system.

On Monday, October 4th, Evergrande officially defaulted on a $260 million interest payment, causing the HKEX (Hong Kong Exchange) to halt trading in Evergrande’s core property development unit and the group’s property management subsidiary.

Of course, investors will look for opportunity in debt-crisis situations such as this. As it is known, one person’s trash is another person’s treasure, and many debt investors will seek to mitigate the risks of failures such as Evergande’s and take advantage of the fallout.

As expected, many investors have been navigating this concern for months, and there has already been massive interest and investments made into the struggling Evergrande, as highlighted by the actions of a consortium of credit hedge funds. These funds have reportedly amassed positions in the offshore bonds ahead of the defaults, as prices had fallen to about 25% of face value. While a positive outcome is not guaranteed, these investors believe they have the ability and expertise to navigate these types of debt-driven situations.

While it remains to be seen how the complete aftermath of the China Evergrande situation will look, financial advisors can seek to mitigate their own market risks by investing with skilled market participants who have navigated significant crises and multiple market cycles in the past.

Sources:
Evergrande
China Daily, November 2017. “Full text of Xi Jinping's report at 19th CPC National Congress.”
Bloomberg, October 2020. “What China’s Three Red Lines Mean for Property Firms.”
Reuters, August 2021. “S&P downgrades China Evergrande again to 'CCC'.”
Bloomberg, September 2021. “Clock Ticks for Evergrande as $7.4 Billion of Bonds Due 2022.”
Forbes, September 2021. “What Would A Restructuring Of Evergrande Look Like?”
Reuters, September 2021. “China tells banks Evergrande won't be able to pay interest due Sept 20 - Bloomberg News.”
Bloomberg, September 2021. “Saba, Redwood Are Among Credit Funds Buying Evergrande Bonds.”
Bloomberg, September 2021. “Evergrande Misses Loan Payments to Banks as Bond Deadlines Loom.”
Bloomberg, September 2021. “Evergrande Debt Crisis Is Financial Stress Test No One Wanted.”
CNBC, September 2021. “Here’s why the Evergrande crisis is not China’s ‘Lehman moment’.”
The Wall Street Journal, October 2021. “China’s Evergrande Debt Crisis: Sizing Up a Big Mess.”
Fortune, October 2021. “How will Beijing handle an Evergrande default? A troubled airline group may hold clues.”
Fortune, October 2021. “With Evergrande’s managed collapse, Beijing is sending mixed messages to the markets.”