Troubled Chinese property group Evergrande is battling to avoid a hard default, which would risk a spill-over that could severely impact China’s property sector, and beyond. Tough choices will need to be made regarding the distribution of the proceeds and any restructuring is likely to be complex. Lyxor’s Senior Cross-Asset Strategist looks at the causes of Evergrande’s default, and outlines the possible scenarios that could play out.
Why did Evergrande default?
Evergrande was the second largest real-estate developer in China, with nearly 800 projects in more than 200 cities. Evergrande’s cash flow depends on projects that will take 2 to 4 years to complete. A large pipeline of new projects were started in 2017 maximizing the need for cash in 2020 and 2021 in order to service their debt. The pandemic came at a bad timing, both cutting housing demand and slowing construction works. As a result, Evergrande’s sales weakened, drying operating cash flows, and leading the company to delay payments to suppliers. In turn, suppliers put a number of projects on hold, which compounded the drop in sales while further drying cash flows. The crackdown of authorities on real-estate developers also contributed to Evergrande’s liquidity crisis, forcing the company to find even more cash in order to reduce its debt with fewer options to tap markets. It started a vicious cycle that led the firm to sell its projects at a discount to find cash. With $300bn of liabilities and less than $15bn in cash, the company ended up facing rating downgrades an a pending default on loan payment.
Ways the situations could spillover?
Evergrande bonds trade at around 25 cents, consistent with a severe but still orderly restructuring. If the recovery rate from Evergrande’s assets proved substantially lower than implied by market expectations, equity and bond holders’ losses and a negative signal for Chinese real-estate prices could lead investors to dump property assets and other financial assets more broadly, potentially leading to a credit crunch in interbank markets. Besides, if offshore holders of Evergrande’s bonds, which theoretically benefit from implicit state backing, ended up with a severe relative haircut, a repricing of risk in other offshore Chinese bonds could prompt a selloff, while threatening Chinese companies’ access to international markets. In the longer run, other small and/or private developers, caught up by elevated debt, delayed cash flows, tighter credit access, plunging property prices, could also start defaulting.
What is the more likely scenario?
The story is moving by the day, though contagion remains contained on hopes authorities will strive to avoid a hard default. Tough choices will need to be made regarding the distribution of the proceeds and any restructuring is likely to be complex. A painful but orderly process remains our base case for now. How authorities plan to respond is not clear yet, aside from central bank liquidity injections. Yet, we do not expect them to let the situation turn systemic, ahead of next year’s Party Congress and Xi Jinping’s
selection for a third mandate. Besides, a disorderly liquidation would likely take a toll on the whole property sector, adding further strain on a decelerating economy, through both lower consumption and construction manufacturing.
Assuming we avoid a worst-case scenario, Chinese real-estate’s weakest links are set to feel the heat in the coming months. A toll on China’s economy also looks inevitable, leading authorities to add stimulus.