Regulatory changes were the catalyst that caused a well-publicised liquidity squeeze on China Evergrande Group. These changes have had significant implications for the Chinese property development sector; GAM Investments’ Andrew Dewar assesses what lessons can be learned and gives his outlook for bond investors in this space.
China Evergrande Group is one of China’s largest property development companies. Its landbank comprises a gross floor area of 214 million square meters (nearly four times the land area of Manhattan) and its property management arm manages 400 million square meters of real estate. It employs over 160,000 people directly and it is estimated that it creates around 3.8 million jobs in the economy through its supply chain.1 The company also has subsidiaries in industries such as electric vehicle production, aged care, theme parks, food and beverage, digital media and more. This scale of growth has been built thanks to leverage; according to Statistica, the company is the sixth-most indebted firm in the world with total liabilities of USD 304.6 billion, as denoted in the company’s financials, against a current market capitalisation of USD 6.2 billion2. Despite its massive scale, following the recent regulatory pressure a default or restructure is looking increasingly likely.
The excessive use of leverage in Evergrande – and the Chinese property development sector as a whole – has been a concern for regulators for years. Not only is it increasing the risk in financial markets, but it is also helping to further increase property prices in the country. In order to reduce the use of leverage, the regulator introduced the ‘three red lines’ policy in August 2020. This policy sets limits on three leverage ratios and categorises property development companies according to how many of the limits they breach, with each category encompassing a limit as to the amount of debt growth allowed in a year.
Table 1: The three red lines policy
The policy has indeed worked, and we are seeing most developers actively reducing their leverage to meet these ‘red lines’. However, as can be expected with new policies, there have been some unfortunate side effects. For example, some firms are increasing their use of minority interests and joint ventures, allowing them to increase leverage through a subsidiary and net the equity value in their balance sheet. This ultimately reduces the transparency of the financial statements and does not reduce leverage as intended. On top of this, with companies being limited to the amount of debt they can raise (while at the same time trying to reduce leverage to meet the red lines) their freely available cash levels and overall liquidity sources are decreasing. This could weaken a company’s ability to weather any short-term crisis.
Evergrande has some of the highest leverage ratios in the sector and at year-end 2020 it was one of only two companies still in the red category. As seen in Table 2, it was actively deleveraging and in its latest results, it did meet one of the three red line ratios. However, its minority interests were growing while its cash / short-term debt was declining. This meant it had less capacity to weather a short-term cash crunch and total debt exposures were becoming less visible.
Table 2: Latest Evergrande deleveraging results
In May, this year, a news article regarding regulators examining Evergrande’s related-party transactions with Shengjing Bank was published. Following this, news was leaked that the Chinese regulator had asked banks to stress test their Evergrande exposure. This resulted in further concerns from stakeholders that the firm may default – increasing the risk of a self-fulfilling prophecy – as creditors stopped lending, assets were frozen, litigation was undertaken and projects were halted.
Because of its sheer size, Evergrande is likely considered by many as a systemically important company and as such, too big to fail. However, to date, the government has done little to shore up sentiment and in fact its regulatory actions in the education and technology sectors in July caused investors to panic further. The result was a large sell-off in the Chinese real estate sector. Not only did it impact the secondary bond market, but new issuance all but dried up and a sector that relies heavily on short-dated bonds is facing serious refinancing issues for the next six to 12 months with those companies that have high levels of bonds maturing in the short term being hit the hardest.
So that is where we are now and what is next?
Developers released H1 results in August and actually, in aggregate, they were positive. Many firms continue to reduce leverage, but they are also actively preparing for the next year by building cash reserves, slowing CapEx (capital expenditure) and landbank buying to ensure they can self-fund upcoming debt maturities. This resulted in a recovery in bond prices from the July lows as well as the primary market opening up for some of the higher-quality names. However, September has seen some weakening with more Evergrande news being released. This sort of volatility is to be expected over the short term as the Evergrande story unfolds.
Looking at the scenario that the company does default, the default rate for Chinese high yield (HY) bonds could rise from 4% to 20%. Its default could also push the Chinese banks’ non-performing loans ratio up by 1.2% to 2.96%, sending a ripple effect across the Chinese economy with many of their counterparties suffering distress as a result.3 While it is unlikely that the government will not provide some support for an orderly unwinding of Evergrande, the bond market seems to have already priced in a worst-case scenario, with the company’s bonds trading at as low as USD 24 and record proportions of bonds priced under USD 50 in the Chinese HY property sector. This is providing some attractive opportunities but navigating these conditions will require caution and active management will be paramount, in our view.
The ‘three red lines’ policy was a catalyst for the Evergrande situation. Overall, we believe the policy was necessary to initiate the deleveraging of a very exposed sector and is helping to slow down an overheated property market. It appears likely that the regulator will ensure greater visibility on joint ventures and minority interests. In our view, this will result in a more stable sector with a reduced amount of outstanding bonds. With this in mind, we are currently focusing on liquidity levels, access to capital, debt-maturity profiles and joint-venture exposures to ensure companies can sustain the short-term volatility. This is as well as landbank quality, stable and healthy margin levels, and strong cash conversion rates to ensure holdings can not only survive the near-term risks but thrive in the longer term. While we expect volatility to continue in the short term, we remain constructive on the sector in the medium to long term. Companies are continuing to deleverage and fundamentals are improving; with Evergrande freezing the capital markets, we are now in the middle of a liquidity squeeze, however once past this we believe the sector will recover well in aggregate, but with differentiation between weak and strong credits remaining key.
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