Oct 11, 2021
Welcome to Finance and Fury. In this episode we will be looking
at the Property market in China and focus on the Evergrande
developments – in particular if there is actually a timebomb
starting to surface – and look at the potential contagion risks to
the rest of the world – such as the Aus and US
- Many in the press are comparing what is happening to Evergrande
as another Lehman’s moment – which was one of the defining
collapses of a financial institution that lead to the flow of
effects culminating in the GFC – it is understandable that the
media takes this route – Lehman’s is a recognisable name and fear
and doom scenarios generates more clicks and sells more adds – but
is this worst-case scenario true? Is the collapse of Evergrande
really going to lead to another global financial crisis?
- A few weeks ago – we covered where the next financial collapse
is likely to come from – between the USA and China - Two factors
were the focus – leverage and contagion risks
- Looking at leverage - Credit growth is a major risk to almost
every market – both from bonds from investors and lending from bank
of financial institution borrowing – both of these are relevant to
the private sector in China
- Credit growth is even a concern in Australia – APRA worried
about banks and lending – they have increased their servicing cost
by 0.5% - worried about credit growth vastly outpacing income
growth
- But the major focus for any systemic issue is the contagion
risks – if one company defaults, does this create a GFC, or just a
collapse of an isolated entity – The loss potentials are
substantially different between both scenarios – one is investors
in a company losing money versus every investor globally losing
funds due to collapsing markets world wide – the degree they
collapse also is different
- If Evergrande fails – what does this matter? At this stage -
The irony of the contagion risks is from the increased news
coverage that this topic is being granted – if a topic is covered
in the news everywhere – this creates uncertainty and fear –
investors can panic – this creates real market declines, so the
risk of market declines become a self-fulfilling prophecy – even me
covering this topic can create some level of risk aversion, which
may cause people to sell off investments – but is there more than
just the normal fears in the markets from media coverage
occurring?
To start with - What is happening in China – We need to look at
their property market, or more specifically the debt that property
developers hold – especially in relation to Evergrande and Chinese
economy at large
- Chinese economy - the rise and fall of Evergrande is tied into
the economy of China quite heavily –
- Evergrande is China’s second largest property developer – but
this ranks around 147th in the world – but it is the most indebted
property developer in the world – which should start to ring some
alarm bells – it’s on balance sheet liabilities amount to around 2%
of Chinas GDP – off balance sheet – this could be higher – and
likely is
- A company in isolation with debt isn’t much of an issue – but a
company with too much debt can be a problem – In isolation this
isn’t too much of an issue – if the company defaults but business
in other sectors of the economy continues as normal then markets
may go down a bit but then continue as normal –
- but what if this one company is a sign of greater systemic
issues - where most of the companies in your country in this sector
have the same problems – that of having too much debt that they are
likely to default on? Especially in the property sector –
- The BIS released a paper showing that Chinese non-financial
companies have 160% Debt to GDP, versus in the US where it is about
80% - so double in China compared to the US – Property also has an
overweight on GDP compared to the US
- It is estimated that property development makes up around 25%
of China’s GDP – this growth has been fuelled by Debt – this is a
major issue for the CCP -
China property market – the history over the past 20 years
- The increase in demand for property and the increase in pricing
has been fuelled by massive amounts of urbanisation – rural
workers/population moving to cities for work and a better income
for their families
- High demand for properties in desirable cites has massively
inflated the property values in these urban environment –
developers often sell every property in a development in advance of
the construction even starting
- This has led to lower quality – contractors skimming on
materials to lower costs – where constructions can actually
collapse in a few years after completion
- Prices to income ratios – results in a situation where you have
generations of people living in one apartment trying to repay the
loans
- We think that Australia is bad – and it is – but many major
cities in China, such as Shenzhen see 43 times the average
household income in property prices – compared to Sydney which was
around 13 times at the peak of the market
- Speculation – large increases in property prices saw massive
speculation in developers – if you think that the property that you
will construct today can lead to a 50% gain in the next year or two
– then you will likely borrow large chunks of money to bank on this
trend
- Lead to many apartments not being rented, and purchasers buying
up more than one property – but the limit per family is capped
- The population is also limited in what they can invest in – so
property is where most of the upper middle class and beyond put
their life savings
- Large property developers are politically connected – But this
has created moral hazard – every loan given, or bond investments
have been made based around how likely it is for the government to
bail out these developers
- Rather than on their ability to meet the debt repayment
cashflow
- Moral hazard is a large component of any investment or economic
decision – as an example – say you have an expensive car – now in
one situation you have comprehensive insurance and in another you
have no cover – in which situation are you likely to drive a little
more recklessly, or park this in a car park unattended
overnight?
- Same goes for insurances – especially if you are forced to have
insurances – you may as well use it for your premiums – such as
health insurances – But what if we are talking about a government
backing debt for bail outs – and that is the expectation of the
markets – this creates a moral hazard -
But China realised they have a debt problem – as well as a moral
hazard problem - so policy makers tried to reign this in – focusing
on moral hazard first and foremost
- Policy changes – the CCP put together that their economic
growth is mostly paper/debt based – where the growth they are
receiving in GDP is funded through borrowing from property
expansion – which is not sustainable in real terms
- They want to transition their economy to more long-term
sustainable growth – real estate is the most important sector in
their economy at the moment – but this is debt reliant – they
prefer real returns – which is why you see a push towards resources
and other manufacturing sectors – but a real issue in China is the
affordability of property
- Look at government policy across the world – they always say
that they promise to tackle issues of property affordability – but
then comes a situation where prices are starting to decline – what
do governments do? Create policies to help prop prices up to avoid
a decline which could have further reaching issues – governments
don’t want bubbles, but they don’t want a collapse
- China appears to be the first government in a long time to not
follow this pattern – they are trying to change moral hazard – and
expectations in the market -which can easily lead to collapses in
the property sector
- Rather than bail out Evergrande – which would be easy for the
CCP – it appears that at this stage they have decided to let this
company deal with their own problems
- This is technically how it should be – but it is rare to see
this response
- I think this is mostly due to their Hard lines polices – trying
to reduce the economy reliance on debts – They actually introduced
three hard line policies on property developers in Aug 2020
- These are hard limits on property developers – relating to
their liability to asset ratios, net debt to equity ratios, cash to
short term debt ratios – all of these are important when it comes
to developers who fund their projects using debt now for equity in
the future
- Had an instant effect on property development firms – no longer
could you raise capital through debt funding as most developers
were above the allowable ratios
- What made this is worse, is they had to reduce their debt
levels – to do so they were quickly forces to sell down assets and
taking losses – this caused prices of property to fall, so the
valuation on their assets started to go down
- This made it worse - These losses make their ratios look worse
– making these companies need to deleverage further – this can lead
into a downwards spiral
- On top of this – because the prices of property started to slow
as well last year – to make more pre-sales – Evergrande needed to
offer some discounts on the pre-sales – this lead to less liquidity
available – less liquidity meant they don’t have the money to fund
debt repayments as they come due
Evergrande itself – In the property sector – the company acts
like a conglomerate
- Property development, property management, and Wealth
management products –
- They are looking to sell of property management – recoup
$5bn
- But wealth management products – WMPs may be a concern – this
is around $6bn –
- Small number – but investor fury has made this more of a social
issue
- But these investors were told they would get a guaranteed 12%
return on their investment p.a.
- This money was used to help close funding caps that the parent
company had in construction –
- This is fine, as long as the returns on the property sales in
the year are more than 12% to repay investors -
- But for a time they weren’t – this meant that new investor
flows had to be used to make repayments to existing investors – in
the process there was less to help close the funding gap –
- But then add onto this the slump in sales – then you start to
have a real issue – as more and more new investor flows need to be
used to repay existing investors – which is the basis of a ponzi
scheme – but moral hazard still existed – investors had the
certainty in their own minds that this was a sure bet – as any
defaults would be covered by the government
- The issue is based around the moral hazard – investors thought
their returns were guaranteed with little risk - but where it can
get bad is contagion risks
Fallout effects – will come from two areas – property
domestically in China – which will spread out and have their own
issues – as well as contagion risks throughout the economy and
throughout the world
Property prices in China –
- Can see a decline – if they liquidate and need to sell off the
property development – could see a fire sale of assets and property
prices decline
- The fact they are trying to sell quick is bad for property –
fire sales see massive price reductions
- Domestic fallout –
- People who have placed deposits on properties that may never be
built – lose those funds People who have invested in the WMPs –
will also lose money – you will start to see some social issues
- This will reduce the trust in property investment –
- Evergrande employs lots of people – around 4m – which would be
huge for a country like Australia – but out of a population over
around 1.4bn is about 0.29% of the population
Contagion risks – who owns the debt and are there any
derivatives on this?
- Look at the debt - $300bn of debt – bonds issued – estimated
that only around $20bn of this is overseas debts – the rest is
domestic – these foreign bonds are priced in at around 25-30c on
the dollar – depending on their maturity
- China is a large economy – it can pretty easily soak up these
losses – even though $300bn is a large amount of debt to cover
- This is owned across 128 banks and 121 non-bank institutions
- Investment managers – investing in risky emerging market debts
- Ashmore group, BlackRock Inc, UBS and HSBC hold $450m, $400m,
$300m, and $200m, respectively – which isn’t too much for these
groups to absorb
Best case scenario – Evergrande will be allowed to collapse –
the parts will be bought up by other developers in the nation at a
fire sale rate – i.e. getting a good discount
- The People Bank of China will also likely buy out some of the
debt - Like JP Morgan Buying Bear Stern back in the GFC – with help
and oversight from the FED – but this doesn’t solve all the
problems
- But the issue comes back to the moral hazard – the CCP wants to
minimise speculative risks
- Evergrande by itself defaulting isn’t a risk for markets – but
it does spell some risks – of over leverage throughout the system –
if many other developers start to see the same systemic issues of
overleverage and issues in meeting their debt obligations, then you
get into further trouble
- Fantasia – another property developer failed to make a bond
payment - missed $315 million in payments to lenders – created
further fears that financial strains in the country's outsized
property sector are spreading beyond the troubled Evergrande
conglomerate. S&P and Moody's slapped "default" credit ratings
on Fantasia
Lessons to be learnt –
- The moral hazard and the belief in a sure thing – the belief
before the GFC is that debt on peoples homes was a sure thing – not
many people would default all at once, so package up 1000s of
mortgage holders debt and make bets on this
- But due to this belief, lax lending standards were employed –
this then turned out that due to the belief that things couldn’t go
bad, resulted in them going bad due to too much risk
- How this is different from the GFC – Derivative used in making
bets on the property market
- Credit swaps, derivatives on CDO – this doesn’t seem to be
occurring in China – and the banks’ ability to eat losses on the
debt isn’t too great to not be able to recover
- Lehman’s collapse was considered to be the plug of the dam
being pulled in the GFC – property prices dropped, people defaulted
on debt then Lehman went into default – but only due to their
exposure to complex CDOs and derivative positions –
- If these don’t exist on Evergrande – which it appears at this
stage they don’t – then there is less contagion risk –
- But who knows – there is no way to tell until it is too late –
however, there hasn’t been much in the way of transaction in credit
default swaps in banks like HSBC which have greater exposure to the
Chinese debt markets
- It took Lehman over a year to default and go bankrupt – so time
will tell how this pays out
Where things could get worse – is if more developers start to
default – showing greater systemic risks
- My gut feel is that the China growth from property is coming to
an end –
- This will likely have larger effects on the commodity markets –
such as iron ore – than it will on the global share market in the
short term – but if their property market starts to decline due to
defaults on developers and a lack of trust – this leaves their
economy very susceptible
- Your guess is as good as mine as how this will turn out – we
will keep an eye on this
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