The saga of China’s heavily indebted property market is not going away.
Evergrande – the one that’s most obviously in the firing line right now – failed to make a payment on a dollar bond that was due yesterday.
It now has a 30-day grace period before it’s actually deemed to have defaulted.
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So what happens now?
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Evergrande has missed a bond payment
Yesterday China Evergrande failed to make an $83.5m coupon payment on some of its outstanding dollar debt.
This isn’t really a huge surprise. The company’s bonds are trading at a massive discount to their face value – what does that mean in English? It means that no one believes that Evergrande’s IOUs – particularly IOUs to foreigners, rather than Chinese citizens – are worth very much.
What’s the point? The point is people knew this was very likely to happen. Evergrande needs to restructure its debt; it owes too much money to too many people and it has virtually no way of raising cash to pay them. So that’s a given at this point.
Also, Evergrande has been in trouble for a long time. So anyone – particularly outside China – who has money there, should have been aware of the risks. As Udith Sikand of Gavekal Research points out: “With Evergrande’s US dollar denominated bonds currently trading at around 30 cents on the dollar, offshore investors are clearly pricing in a brutal haircut for institutional creditors.”
In other words, Evergrande will be coming to a deal with the people it owes money to, which will involve them only getting some of it back (right now, markets are guessing not much more than 30%).
So a lot of this is “in the price” and chances are, if you’re reading this, you probably don’t own any Evergrande bonds. So what’s the worry?
We’re moving into a much more fragile market environment
As I noted last time I wrote about this, despite all the headlines, markets have been quite relaxed about all of this. It’s partly because there’s still a belief that the Chinese authorities are capable of stepping in to sort this out.
Well, what we’re all worried about here are the knock-on effects.
Most people reckon it’s not “Lehman Brothers”. And I think that’s a reasonable thing to say. It seems highly unlikely that the rug will be ripped out from under Evergrande. China’s authorities (and global regulators) are highly aware of 2008 and they don’t want sudden shocks. They’ll be looking to avoid systemic risk – already the Chinese central bank is pumping a bit more money into markets.
The thing is though, just because we’re not going to get a repeat of 2008, doesn’t mean that everything is fine. “At least it’s not a once-in-a-generation financial crisis” is quite a low bar to beat.
One problem is that Evergrande is not alone; it’s hogging the limelight, but the Chinese property sector overall has been hit hard by a general crackdown on the sector. This arguably isn’t yet reflected in prices.
So one risk, notes Sikand, is that the Chinese authorities make foreign bondholders take a bigger haircut than onshore ones. You could then get a scare which leads to a big sell-off in the bonds of other Chinese property developers, for example. This could lead to much tighter credit conditions for emerging markets more generally.
Does that matter for your portfolio? Again, it’s hard to judge until we see how it all starts to unfold.
A big dent to China’s economy would usually be bad news for commodity prices, but given that we’re all short of so much stuff at the moment, it’s possible that China isn’t currently the biggest driver of that market anyway.
So it’s messy, and it’s not easy to read, but all in all, I still think this is a slow-burn issue. But what I would point out is that this is all happening at a time when wider markets are bracing for developed-world central banks to embark on a monetary tightening cycle. It’s also happening at a time when wider markets are not exactly cheap.
So it does feel as though we have a relatively fragile market environment where the participants have been drugged by a decade of monetary policy support into thinking that there is no alternative but to “buy the dips” because someone will always step in to make any risks go away.
Yet at the same time, we are moving into a far less forgiving environment for both investors and for the authorities. Evergrande may not be the straw that breaks the camel’s back, but the poor old beast of burden is looking pretty weighed down right now.
We’ll be looking in more detail at these risks in future issues of MoneyWeek magazine. You can currently get the Kindle version of my book, The Sceptical Investor, free when you subscribe to MoneyWeek, and you get your first six issues free too – just sign up here.
