China’s Evergrande Group’s likely default on liabilities including interest payments and debt obligations has fuelled the fear of a contagion spreading across global financial markets.
China’s Evergrande Group’s likely default on liabilities including interest payments and debt obligations has fuelled fear of a contagion spreading across global financial markets. The second-largest real estate developer in China, Evergrande is a Fortune 500 company with over $300 billion in liabilities due for payment starting this week. Failure to pay the said liabilities could spark a series of events that may result in either the Chinese government bailing Evergrande out or a liquidation of the company’s assets that is likely to create spillover in various financial assets or have a domino effect on banks and non-banks with exposure to Evergrande, various market watchers have noted.
What is happening at Evergrande?
Evergrande is a real estate behemoth based out of China with 1.5 million already sold but not yet completed residential units, according to a note by Invesco. The company’s presence, however, is not limited to real estate. Evergrande has an auto unit, online media platform, health food vertical, and even healthcare projects. With its sprawling business, the conglomerate has a ballooning debt problem.
On a more immediate basis, Evergrande has over $300 billion due for repayment to investors, lenders, and suppliers. “Evergrande Group’s total liability size is ~$313 billion, which is ~6.5% of the total liability of the Chinese property sector. In terms of total offshore bonds outstanding, Evergrande Group has ~$19 billion, which is equivalent to roughly 9% of the total offshore bond market and 12% of the total HY offshore bond market,” analysts at UBS wrote in a note last week. This was around the same time when China’s Ministry of Housing and Urban-Rural Development told banks that Evergrande would not be able to meet its debt obligations that started yesterday.
Are Indian markets in trouble?
Sensex and Nifty did take a beating on Monday but seem fairly balanced so far on Tuesday. “The recovery in Dow which was down 972 points at the lows to close with a loss of 614 points is an indication of the market’s confidence that contagion is unlikely. However, investors have to be cautious since markets are richly valued and, therefore, vulnerable to corrections. The ultimate impact of the Evergrande crisis is yet to be seen and known,” said V K Vijayakumar, Chief Investment Strategist at Geojit Financial Services. “There is another view that the Chinese crisis- the regulatory crackdown earlier and the Evergrande crisis now- bode well for India, facilitating increasing capital flows to India. This may play out in the medium to long-term,” he added.
Global markets tumble
The fear of the Evergrande group’s default on repayments spreading across the globe has forced a sell-off in global markets, including India. On Wall Street, the Dow Jones tanked 1.78% on Monday while the S&P 500 fell 1.7%. While Chinese stock markets are closed for a holiday today, Hang Seng is down 3.5% since the end of last week. Similarly, Japanese equity indices Topix and Nikkei 225 are down more than 1.5% each. Evergrande, listed in Hong Kong, has dived 16.4% this week already. The stock is down 84.5% year to date.
The spill-over has also caused Dalal Street to tumble, falling nearly 1% yesterday with domestic steel stocks taking the heat. Today as well, Sensex and Nifty were under pressure, trading in the red.
Could Evergrande cause a deep global sell-off?
“While our base case is now that a credit event for Evergrande seems unavoidable, the extent to which we get spill over into other markets will be contingent on whether Evergrande restructures or fully liquidates,” the UBS report said. They added that restructuring of the liabilities is much more plausible.
Liquidation and its aftermath
In the event of a liquidation of Evergrande, if investors get extremely low recovery values, it would lead to a material loss of investor confidence in the broader property sector/Asia HY offshore market and create spill over into the broader Chinese financial assets. “We think this could also lead to a repricing of risk premium across global credit markets, with EM underperforming DM and HY-IG decompression in both USD/EUR markets,” UBS said.
Further, in case of liquidation, UBS expects a domino of credit events given that both banks and non-banks with large exposures to Evergrande could potentially go under or be forced into restructuring. UBS added that Evergrande’s liabilities could involve more than 130 banks and over 120 non-banking institutions. “The total debt exposure for Evergrande in the 1H was RMB 834 billion — made up of RMB 633 billion in loans and RMB 200 billion in offshore bonds and other debt. This means that Evergrande’s debt is roughly 2-3% of Chinese bank’s core tier 1 capital, which was around 18.5 trillion as of the end of Q2,” analysts at Invesco said in a note.
If the Chinese government does not step in to help Evergrande, UBS expects that rating agencies would change their methodology and remove multiple rating uplifts and assumptions of state support across non-property sectors both within the offshore USD market as well as the
onshore market. “This could lead to added selling pressure and drive large liquidity distortions across both Chinese offshore and onshore bond markets, with potential for spillover into EM credit, given that several EM credit accounts do tend to hold Chinese offshore bonds as a part of their Asia HY exposure,” they added.