Amid financial turmoil at Chinese property group Evergrande, GAM Investments’ Rob Mumford examines the key concerns and routes available to resolve the firm’s major issues. He also discusses the ongoing market uncertainty and risks if the situation is mishandled by either the company or regulators.
Improving the financial health of the real estate sector has been a key part of China’s policy normalisation in 2021. The government’s ‘three red lines’ policy is intended to guide real estate balance sheets to a prudent footing, with lending limits and caps on mortgage quotas among recent measures to be added. Evergrande met just one of the three red lines in its interim results earlier this year and has been a known trouble spot for some time. The property developer’s bonds are rated sub investment grade by overseas rating agencies due to the Evergrande’s high leverage and exposure to short-term funding.
A reluctance by the company to take more dramatic action sooner, despite clear directives to reduce debt, has concerned the market and led to fears of bigger systemic issues and dramatic headlines comparing Evergrande to Lehman Brothers or Long-Term Capital Management (LTCM). Despite this, accounts (PwC is the auditor) state that the company has considerable landbank / property under development, completed investment property and significant stakes in listed affiliates. In other words, Evergrande has tangible assets with plausible access to liquidity. For this reason, credit analysts are suggesting that while the company is in dire liquidity straits, the solvency situation is more encouraging, and it is unlikely to be a Lehman Brothers / LTCM scenario.
To our minds, the crucial issue is the current asset versus liability gap. Some rough adjustments to current assets (realisable in under one year) reveal a funding gap estimated at anywhere from RMB 200 billion (USD 30 billion) to RMB 500 billion (USD 90 billion) which in previous years would have been refinanced either domestically or offshore through financing cash inflow. But current policy focus includes specific gearing targets, which has made this route more difficult. Meanwhile, the broader slowdown impact from policy normalisation plus property-specific measures have also put pressure on Evergrande’s operating cashflow; operating cashflow cannot fill the gaps with 2020 operating cashflow of just RMB 110 billion (USD 16.9 billion) and H1 2021 sales down 16% year on year.
For the markets it is not just the multi-billion dollars’ worth of current borrowings or the long-term borrowings which are the broader issue, but also the almost RMB 1 trillion (USD 153 billion) of current trade payables that have been built up and which account for half the company’s total liabilities reported in the press. In other words, contagion is not limited to only financial liabilities of credit exposure at banks and insurance companies but also the knock-on effect of a default and / or slow / disorderly restructuring as these payables are spread over circa 7,000 parties. There is also the risk of negative impacts to the broader consumer market if disorderly property price moves start to occur due to forced liquidations of completed properties or failure to complete existing projects.
We believe the key to progress lies in Evergrande’s ability to raise cash in an orderly manner from liquid areas of current and non-current assets. The company’s most recent set of interim accounts valued Evergrande’s total assets at circa RMB 2.4 trillion (USD 369 billion) and analysts have identified circa RMB 195 billion (USD 30 billion) that could be raised near term from investment properties and non-core listed and non-listed assets (investment properties and property services business). Warnings from China’s housing authority of potential near-term missed interest payments illustrates the challenge, both in terms of the time frame and further out the scale of funding required if the more negative scenario funding gap becomes the base case.
The market has been surprised that the situation at Evergrande is still so uncertain at this stage given the obvious problems and clear directives and policy guidance from regulators since last year and has sold off in response given the negative impact of a possible credit event and potential disorderly liquidation affecting both enterprise and consumer sentiment. This is a test of nerves for the regulators who have been increasingly trying to move away from ‘too big to fail’ situations and would prefer market-driven solutions (though the Guangdong government is co-ordinating this situation and has had accountants and lawyers on site for weeks now).
The bankruptcy of Baoshang Bank in 2020 and the corresponding haircuts to interbank investors and in other instances allowing defaults at state-related companies have all been moves in this direction. The goal is that Evergrande independently moves to drastically alter its balance sheet / structure rather than request quick evergreen fixes (and asset trims at the margin) or realises that bankruptcy proceedings are a risk. However, there is awareness of the potential sensitivity of the situation and the ongoing restructuring at Huarong Asset Management indicates in certain cases specific state guided restructuring is warranted.
Given the imminent coupon payments due (and threat of headline grabbing defaults), public demonstrations and now a global focus on this situation, one would expect either more significant asset sales to provide for near-term liquidity or a stronger role from regulators to manage the situation very soon. Headlines regarding coupon payments are encouraging but significant challenges lie ahead. Despite reluctance from Evergrande to be a forced seller of assets in a weakening economy, there seems to be no other option and assuming there is not a black hole in the company’s landbank / uncompleted property line coupled with more tangible assets, a restructuring proposal could proceed smoothly and in either event likely reassure markets.
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