Strategy team: Victor Balfour
China continues to grab headlines for all of the wrong reasons: growth is slowing; regulatory skirmishes persist; and now corporate debt-induced jitters are resurfacing in the real estate sector. Are these tactical troubles or structural headwinds?
Property developer Evergrande has the dubious honour of being China's most indebted company, with over $300bn in liabilities. The company is at risk of default, with an estimated $600m of interest payments due before the end of the year. Its outstanding bonds have collapsed to one quarter of their face value, while investors in the Hong Kong-listed stock are nursing sizable losses, with the share price down 85% since the start of the year.
Ahead, bondholders, other creditors, and share owners likely face debt restructuring and distressed asset sales. Sentiment has been hit across the broader real estate sector too – other highly-leveraged property companies also face investor scrutiny and financial pressure.
We doubt this heralds a Lehman-style financial collapse, domestically or internationally. Beijing's recent cash injections into the financial system – through central bank reverse repurchase agreements – and the relatively limited exposure of foreign banks to China, suggests systemic risks are likely containable. So far, at least, the wider ripple effects are small: global credit spreads – a measure of corporate stress – are muted, and the recent setback in global stock markets (-3% in September) is unremarkable, especially after such a strong run.
Evergrande and the property sector have come under such pressure as restrictive policy has sought to constrain what Beijing views as speculative activity in a housing market that is increasingly unaffordable to Chinese workers. Increasing scrutiny of developers, higher mortgage rates, and a government subsidised rental market have all served to cool the property market in recent years, diminishing profits.
There are similarities with China's recent attempts to restrain perceived anti-social activities, speculative froth and corporate hubris elsewhere – for example, in the education, gaming and technology sectors.
Fearful of promulgating another credit surge, the People's Bank of China (PBOC) has steered away from cutting its main policy rate, but in supporting the market as it slumps has so far focused instead on the degree to which banks can extend credit to the economy by tweaking the reserve requirement ratio (the most recent cut was back in July).
The days of property investment leading China's growth may be over. But the risk of a so-called "Minsky moment" – that Lehman-like event – looks small to us. China's corporate debt is high, but its consumer and (especially) government debt is low. Its still-massive foreign exchange reserves give it substantial "hard currency" assets with which to shore up the banking system should it ever need to do so (which is unlikely, in our view).
As noted, tighter controls on the property sector chime with Beijing's recent policy activism and intervention elsewhere. These developments clearly further complicate the near-term case for Chinese stocks – particularly as economic momentum has faded in recent months. However, we continue to doubt that the longer-term strategic case has been materially damaged.
Arguably, a reorientation of development priorities away from simple growth targets, and towards financial stability and social equality, is part of a healthy evolution in China's progression from an investment and export-led economy to one centred around domestic consumption and social objectives. Viewed through a long-term lens, the internationally investable indices may be pricing-in too much bad news (as yet, the Evergrande hit has not yet taken the internationally-investable indices to new 2021 lows, but has reversed a tentative rebound from the recent education/technology crackdown).
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