Concerns over the potential default of Evergrande, the second largest developer in China, further escalated over the past week as its share price fell by a further -30% last week, and its dollar bonds due 2022 closed off the week below 30 cents.
The negative impact on Chinese equities was further exacerbated by regulatory news relating to the gaming sector in Macau, and we saw the Hang Seng Index fall 4.9% in another week of fragile sentiments.
To recap, we had earlier in June this year downgraded our position in Asia ex. Japan equities to neutral in light of deteriorating near-to-medium term risk-reward in China, and in addition had in May 2020 highlighted Evergrande as our top ‘sell’ idea in our Chinese property sector report, and last reiterated our 'sell' rating on 1 Sep 2021. Since our 1 Sep report, Evergrande’s share price has declined another 39.8%
Evergrande’s bonds began its sell-off in May when news broke that regulators had launched an investigation on related-party transactions between it and its majority-owned subsidiary Shengjing Bank.
This set off a chain of credit events and ratings downgrade on Evergrande and its subsidiaries. Market confidence towards the company deteriorated and its financing conditions tightened significantly, impacting its operations.
Amidst a flurry of recent media reports of protests at its headquarters and inability to fulfill its interest payments to banks and customers of its wealth management products, Evergrande announced on Tuesday (14 September) that it faced “tremendous” cash flow and liquidity pressures amidst poor contracted sales in the month of September (-26% year-on-year), a key source of ongoing liquidity, as negative media reports had affected buyers’ confidence in Evergrande’s ability to complete their purchases.
As a result, the company had appointed restructuring experts Houlihan Lokey and Admiralty Harbour Capital as joint financial advisors to explore “all feasible solutions” to address its financial problems.
In addition, Bloomberg also reported on the same day that the regulators in Evergrande’s home province of Guangdong had dispatched accounting and legal experts to assess Evergrande’s situation, including a team from restructuring specialty law firm King & Wood Mallesons.
This was interpreted as a signal that the Chinese government could be laying the groundwork for a restructuring of Evergrande and its debt, which could be one of the largest to-date in the country.
Regulators have expressed that Evergrande, as the country’s second largest developer, poses potential systemic risks and its outstanding debt (RMB571 billion) is about half of Huarong’s RMB1.1 trillion.
It is the largest high yield dollar bond issuer in Asia, and a sizeable issuer in the onshore bond market although not as significant compared to the offshore market. For now, the contagion from Evergrande’s risks has not spread beyond the real estate sector in China’s high-yield bond markets.
While we would not be surprised by heightened volatility as the market grapples with uncertainty regarding the resolution of Evergrande’s situation, and as investors weigh the risks of government intervention coming in too late to contain widespread contagion effects, our base case is that the risk of an economic crisis in China due to Evergrande is limited at this time.
In assessing the second-order effects of a potential Evergrande default on China’s banking sector, we note that Evergrande’s direct borrowings from China’s banks is a small portion of the overall loan book of the banking sector as a whole.
Nonetheless, the impact is relatively uneven – selected banks have been reported to be vulnerable to Evergrande’s woes, including affiliated Shengjing bank and national Mingsheng Bank.
The domestic banking system is potentially exposed to Evergrande’s supply chain, including many suppliers and construction contractors for whom Evergrande was usually its largest customer. Of the company’s well over RMB1 trillion worth of liabilities, approximately half are supplier credit or trade payables.
In addition, the Chinese government would also need to manage potential overly adverse spillovers to real estate prices and engineer a soft landing.
In our latest sector report, we have broadly lowered our core earnings forecasts for the Chinese developers under our coverage, largely on weaker gross profit margin assumptions.
Chinese developers have continued to de-rate after the 1H21 earnings season given the margins compression trend, coupled with restrictive policy measures and growing concerns over Evergrande’s liquidity issues and contagion risks to the property sector and other related industries.
Notwithstanding the slowdown in China’s economy, the overall regulatory environment on the Chinese property sector is expected to remain tight as the government remains focused on capping developers’ leverage and preventing the housing market from overheating.
Chinese developers are now trading at trough valuations, with a forward price-to-earnings (P/E) and price-to-book (P/B) ratio of 4.0x and 0.61x, which is 2.4 and 2.2 standard deviations (s.d.) below their respective 10-year averages.
The forward dividend yield has increased to 9.6% (3.4 s.d. above 10-year average of 5.3%), according to Bloomberg consensus.
We do see selective buying opportunities in good quality developers with healthy balance sheets and an increasing ESG focus, but caution that it would be tough to bottom-fish amid an uncertain regulatory landscape.
While we remain constructive on the long-term outlook of China’s economy, we are cautious of a mixed set of risk-reward over the medium term and continue to hold a neutral weight position in China equity markets.
Our stance on Chinese high yield bonds is similarly cautious and we need to see solutions for Evergrande before overall sentiment improves for the Chinese HY property sector. Under the current market environment, our current calls remained skewed to higher-rated names (BBB and BB-rated papers) for better defense against price volatility. We advise clients with concentrated high yield bond positions in China to diversify into other regions, including CEMEA in which we currently have an overweight position.
Given the impact of mobility restrictions due to the delta variant of the Covid-19 virus and a mix of domestic and external constraints on growth, China’s economy is mired in a soft patch.
Retail sales growth for the month of August moderated significantly to just 2.5% year-on-year, from 8.5% in July. Sales of cars and catering spending were visibly hit, due to the zero-tolerance policy towards Covid amidst the outbreak of the Delta variant in several cities. Fixed asset investment also fell from 10.3% year-on-year in July to 8.9% in August.
Moreover, the carefully managed policy stance on credit and restrictions on lending for property and infrastructure investment have dampened overall investments. Lastly, the ongoing shortages in semiconductors have weighed on industrial production, which eased from 6.4% year-on-year last month to 5.3% in August.
That said, our GDP forecast for China remains fairly firm at 8.2% for 2021 and we believe China’s economic recovery is broadly intact despite near-term challenges.
Local governments are set to step up borrowing to finance new spending, and the PBoC is likely to follow up its July cut in commercial banks’ reserve requirement ratios (RRRs) with further moves to free up liquidity to support lending if needed. Finally, we note that foreign demand for China’s goods and services remains robust as August’s exports were stronger than expected, increasing by 25.6%YoY as the rest of the world continues to reopen.
We will continue to monitor near-term downside risks to China’s economic outlook for the rest of the year.Disclaimer applicable to recommendation
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