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China's Evergrande risk: “Too big to fail?”

01:56 PM Sep 22, 2021 | Abheek Barua

Market sentiments have been rattled by the potential contagion from a liquidity crisis at Evergrande, the largest property company in China. The DXY, along with other safe haven assets, have gained while equities, metal prices and the Yuan have all come under pressure.

After a two-day holiday, Chinese shares fell by less than expected this morning amid plans for an upcoming interest payment by Evergrande (negotiated a coupon payment with bond holders) and injection of short term cash by the central bank (PBoC).

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The company has $83.5 million interest payment for its March 2022 bond due on September 23 and $47.5 million interest payment for its March 2024 bond due on September 29. However, this could be a short-term breather for the market and we remain cautious over this turning into a broader risk-off scenario which could mean increased pressure on EM currencies, including the INR, while dollar remains bid.

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While in the baseline, the Chinese government could step-in and bailout Evergrande – as expected by a wide section of the market – the risk of a more hands-off approach adopted by the Chinese authorities continues to loom (worst case scenario) which could lead to a significant increase in risk aversion in the system. In the latter case, the USD/INR pair is vulnerable to sharp volatile movements and a possible move towards 75.0 levels could be seen.

For now, the uncertainty around the Evergrande situation could keep the market on its toes (positive for dollar) which along with the US Fed policy decision later today could mean the USD/INR pair remains under pressure. We expect the pair to trade in the range of 73.65-74.0 today.

Changes in major asset classes since last week

The Evergrande Risk

Evergrande is the largest property company in China, with $300 billion in liabilities (2 percent of China’s GDP) and more than 1,300 projects in 280 cities. Besides housing, Evergrande has investments in electric vehicles, sports, theme parks, etc. and owns food and beverages business.

In 2020, the company had a liquidity scare which was later averted after investors waived their right to force a $13 billion repayment. The company’s ongoing crisis has to be seen in the backdrop of the Chinese government’s steps to tighten leverage restrictions in the housing market. In addition, the increase in construction costs, supply shortages and global inflation have added pressure to profit margins of Chinese property developers over the last year.

Evergrande's Financial Woes

Uncertainty around the policy response

The uncertainty around the policy response Investors are closely watching the response of both the central bank (PBoC) as well as the Chinese government to this evolving crisis. While in the baseline, the expectation of a broad section of the market is for the government to step in and offer a bailout/restructure the Evergrande group, investors are worried whether China will move away from the “too big to fail” narrative as its tries to rein in monopoly behavior, much like the stance it has taken in the tech sector. The latter is part of President Xi Jinping's "common prosperity" plan to address inequality.

The recent regulations and clamp down by Chinese authorities in a number of sectors including tech and education (box 2), creates uncertainty around the governments’ response to Evergrande. In the worst-case scenario, where Evergrande is allowed to default, the market could see a massive sell-off with significant contagion risks for global financial markets.

So far, the regulators have approved an Evergrande proposal to renegotiate payment deadlines with banks and other creditors. Moreover, China’s central bank injected 120 billion Yuan ($18.6 billion) into the banking system through reverse repurchase agreements today.

The Broader Risk

1. The Property Stress in China: Even as investors fixate on Evergrande, the developer infact only accounts for 4 percent of total annual sales in the market, and there are cracks emerging in the wider property market in China.

The risk is if there is trouble at other property companies (Other players like Country Garden - that also has liabilities of $300 billion), property values might suffer leading to a turmoil in the broader housing market. A hit on the housing market could hurt consumption.

That could also feed into other regional and global markets. Chinese buyers have led investments in US housing sector over the past decade. More recently, Chinese firms have been aggressively buying US farmland as well according to media reports. Therefore, a hit to the Chinese consumers/housing market could have ripple effects for other markets as well.

Pressure on property prices in China: Liquidation at Evergrande could ripple through China’s property sector. According to media reports, 60-65 million house units are vacant, accounting for more than 21 percent of all homes in urban China. If a default by Evergrande starts a selling frenzy in the housing market, it could weigh on the housing prices.

2. China slowdown: Real estate contributes 29 percent of China’s economic output. China’s economy is already showing signs of slowdown as gauged by high frequency indicators of exports, retail sales, vehicle sales, PMI manufacturing etc that slowed during June - August. The potential for Evergrande to default raises the risk of a slowdown in Chinese economy in 2022. 3.

3. Metal prices could lose steam: A downturn in China is likely to have significant implications for commodities demand as China is the world’s largest consumer of minerals and metals. To recall, Iron ore prices have declined by 60% to below $100 a tonne since May-21 due to a slowdown in the Chinese property and construction sectors. If Evergrande collapses, the sector’s difficulties are likely to exacerbate which is likely to further weigh on metal prices.

4. Impact on other Asian EM countries: A slowdown in China’s growth is likely to have an impact on the countries dependent on China. Impact on the market so far: Market sentiment took a hit on concerns about the potential contagion from Evergrande. As such, safe haven assets like the Dollar Index gained while the riskier assets felt the heat.

Impact on the market so far

Market sentiment took a hit on concerns about the potential contagion from Evergrande. As such, safe haven assets like the Dollar Index gained while the riskier assets felt the heat.

Stocks: Concerns about the broader health of China’s real estate sector triggered a wider sell-off in Asia stocks, with NIKKEI trading weaker by 0.60 percent today. In the US, S&P declined by 1.7 percent on econresearch@hdfcbank.com Monday and by 0.09 percent on Tuesday while Dow Jones declined 1.7 percent on Monday and by 0.14 percent on Tuesday.

Commodities: Metal prices came under pressure on concerns about the impact on commodity demand of a pullback in the Chinese property market. Iron ore prices declined by 4.8 percent on Monday

Yuan: Chinese yuan depreciated to 6.465 on Friday, hitting a one-month low and is currently trading at 6.47 (China was closed on Monday and Tuesday). Going forward, a stronger dollar and risk-off in the market could further weigh on the USD/CNY pair. We expect the USD/CNY to trade in the range of 6.45-6.55 by September-end.

BOX 1:

Evergrande’s Exposures According to the media reports, Evergrande has liabilities with over 128 banks and 121 non-banking institutions. HSBC holds $ 206.9 million of Evergrande’s bonds while UBS and Blackrock hold $275.7 million and $375 million, respectively. In addition, Ashmore Group, Fidelity, PIMCO, Goldman Sachs Asset Management are the few large bondholders of Evergrande.

As per Reuters, Agriculture bank of China has made some loan loss provisions for Evergrande-related exposure. Separately, China Minsheng Banking Corp and China CITIC Bank Corp are prepared to roll over some of Evergrande’s near-term debt obligations. In addition, Chinese Authorise have told major creditors to extend interest payments or rollover loans.

BOX 2

China’s Regulatory Crackdown: Tech firms in focus

The Chinese Government has announced a slew of regulatory measures since last year with an aim to promote “Common Prosperity” or “Moderate Wealth for all”. The Government has mainly targeted the “platform economy” i.e. internet companies that use platforms to provide services, so far. Besides protecting consumers’ interests, these measures aim at bolstering data security and privacy laws.

1. Alibaba: The Chinese Government interrupted Ant Group’s IPO in Nov-20 and levied a fine of $2.8 billion in April 2021 for violating Anti-Monopoly Rules. After Alibaba, a fine of 300K Yuan was imposed on the rival firm JD.com for promoting false information about its food products.

2. Didi (Ride Hailing Service): After its US listing, China’s biggest ride hailing app, Didi, was forced to stop new users’ registrations. There is an ongoing data security investigation against the company amidst which the authorities have banned 25 apps developed by the group.

3. Education: As per new regulations, all tuitions providing institutions are required to register as NonProfit entities. These institutions can neither go public nor accept investment from corporates. In addition, foreign investment is not allowed in these institutions. Following the announcement, while share price of TAL Education tumbled by 70.8 percent, new oriental education and technology’ share price declined by 54 percent.

4. Online Gaming: To control gaming addiction, the Chinese authorities have limited the time that can be spent on online gaming to three hours per week for children below 18 years. Besides this, the Government also banned celebrity fan clubs in China.

5. Others: Gambling, Online Insurance Companies also came under the radar in China.

The 5 Year Plan

The Chinese government has recently unveiled a five-year plan outlining tighter regulations for its economy.

As per the plan, new rules will be introduced in certain areas including national security, technology and monopolies. Furthermore, laws will be strengthened for "important fields" such as science and technological innovation, culture and education.

Regulations relating to China's digital economy, including internet finance, artificial intelligence, big data, cloud computing etc. will also be reviewed.

(Abheek Barua is Chief Economist, HDFC Bank. Treasury Economics Research Team also contributed towards the article)

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