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Oracle’s Global Equities Portfolio Manager, Nick Cummings discusses the impact of Evergrande on the global market and whether they could potentially cause the next Global Financial Crisis.

Evergrande is the 2nd largest property developer in China and has been recently struggling with a growing debt pile. Together with weaker than expected sales and industry wide regulatory pressure to reduce leverage in the Chinese Financial System.

Evergrande currently owes around $450 billion Australian Dollars to several parties, 1.4 million apartments and homes to buyers who have already paid for them. They also employ over 200,000 people directly and up to ten times this figure indirectly. Investors have become so concerned that some of their bonds are trading at 25 cents on the dollar.

Two of Evergrande’s bonds come due on the 23rd of September, hence why the recent commotion. Evergrande is attempting to raise cash by selling assets and property. As the media headlines have grown, more dire buyers have lost faith in purchasing new homes/apartments off the company. There is a risk that if Evergrande collapses the shockwaves will be felt in the Chinese property sector which represents 25% of Gross Domestic Product (GDP) resulting in a massive negative wealth effect and perhaps loan defaults.

Exacerbating the situation are other heavily leveraged property developers with the potential to amplify Evergrande’s pain into most corners of the Chinese Banking system. Finally, the pain in the Chinese banking system could spill over affecting the Global economy.

Is this the next Global Financial Crisis?

We acknowledge that the Evergrande situation may impact the Chinese economy, the Chinese property sector and sectors that supply this sector (certain commodities); we currently find it unlikely that this event will lead to Global Financial contagion like the Global Financial Crisis. Why?

Firstly, global banking leverage is much more conservative than in the run up to the Global Financial Crisis (GFC) and the banking system outside of China has little to no exposure to Evergrande or the Chinese property sector. These global banks just passed a perhaps, more extreme test than the GFC dealing with Covid-19.

Secondly, the Chinese banking system and investors that hold the bonds can afford in most cases to take the losses or at least partial losses. We must remember the majority of Evergrande’s bonds are secured by property and assets which will potentially mitigate losses.

Thirdly, debt in the Chinese property sector is mostly denominated in Yuan rather than dollars and this applies to Evergrande as well (only $19.5B denominated in US Dollars).

Fourthly, the Chinese government has many more tools than other governments to negotiate a Evergrande default event. They can bailout the bonds, get State Owned Enterprises to buy or seize assets off Evergrande and negotiate where the losses occur to cause the least amount of damage. Many investors are anticipating some sort of bailout. On top of these tools, they can use more conventional tools like lowering reserve requirements for banks to encourage lending, lower interest rates and encourage local government incentives to stabilise the property market.

Where to from here?

While we don’t profess to know the exact path the Evergrande financial situation will take we think it’s important to approach the situation with a broader political mindset. Next year is a big year for China, internally they have the 20th party congress, and globally they are hosting the Winter Olympics for the first time.

With these events taking place, we believe the Chinese leadership will want to show progress towards their stated ‘Common Prosperity’ goals (recent political/business moves suggests this is likely and currently taking place across the economy). Importantly this reinforces the leaderships’ goal of genuine growth rather than speculative debt fuelled growth which they have been trying to curb for several years. With this in mind, we think the government has let Evergrande go to the brink as a warning to others, particularly speculators in the property and financial system, that they are serious about speculation/debt reduction in the system, and to let the populace know that the wealthy/investor class in China will get no special favours.

While letting Evergrande completely fail would be hard, we do expect investors in the Evergrande capital structure will continue to be punished and may take on some losses. Although, on the other hand we think they will bailout in some form those who have paid for homes yet to be built by Evergrande if they must. Also, to stabilise the property sector to a degree considering the Chinese populations high household ownership (90%).

invest in china

How Oracle thinks about investing in China?

Investors in China can think about it in two frameworks: China is in the too hard basket, or they can confront the difficulties and differences to western markets and aim to manage risk through weighting and security selection. At Oracle, we think about it in the second framework while acknowledging there are plenty of gaps in our knowledge and that we will be operating with lesser conviction than Western markets in most cases.

Recently, the Chinese government has highlighted how much control and power they have in all aspects of the economy from technology to education and to property. This has resulted in large losses for investors in Chinese stocks over the last six months and forced many to revaluate their thinking and positioning towards the middle kingdom.

We think investors have been put on the back foot for two reasons: the change in rhetoric from the government and the speed of implementation of their proposed changes. In terms of the change in rhetoric, we have covered some of that above with reference to next year’s event calendar and pursing their ‘common prosperity’ goals. While the speed of implementation banning minors gaming, sharing of music rights, or opening technology platforms to third party applications can scare investors, who are more accustomed to protracted global legal battles over five to ten years (think Facebook and Google currently). This is simply a reality of the Chinese political system and investment landscape. Change can happen at a rapid pace from a regulatory perspective which isn’t always a negative (think about the rapid pace of economic growth and development within China over the last three decades aided by regulations, incentives and innovation).

Our final thoughts

Oracle currently believes China is rebalancing power after two decades of innovation and disproportionate wealth creation, however we don’t believe they are setting out to destroy Chinese capital markets or businesses permanently. As a result, we continue to allocate some capital to China (cognizant of the consumption growth tailwinds) and manage our exposure at a Portfolio level.
Written by Nick Cummings
Portfolio Manager
Oracle Global Equities Portfolio
Nick Cummings
Get in touch with us today for complimentary consultation to discuss your financial position and we can provide you advice tailored to your unique situation.
Important information – Oracle Advisory Group makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.
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