China has seen rapid urbanization; as of 2020, 61% of its population lived in urban areas.1 In 1960, that number was a mere 16%.2 Evergrande benefited from—and helped fuel—this change by borrowing funds to sell property to the Chinese public long before these projects were complete. The firm eventually expanded into owning theme parks, bottled water and a soccer team. However, the Chinese government, under its “common prosperity” campaign, has sought to deleverage the sector in order to avoid a potential bubble, enforcing its “three red lines” policy on property developers while steering investor capital toward the manufacturing sector. As a result, Evergrande has not been able to recently service its debts, missing bond payments in late September, sparking fears of contagion among investors.
First, is Evergrande truly contained, or could this be a Lehman moment?
We believe the Evergrande situation will be contained. Insiders have commented that the Chinese government will step in if necessary to provide the needed guarantees, but only after making various stakeholders sweat it out and letting equity holders bear the brunt of the pain for excessive risk-taking. We’ve already observed some initial steps from the government that support our view in the form of buying Evergrande’s stake in a bank. Time and time again, the Chinese government has successfully navigated similar situations given its powerful centralized structure. Of course, if there is fraud or accounting irregularities with Evergrande, which is a distinct possibility, this might change the facts—and our outlook—but we think even then, the government would have the tools to handle the situation.
It is a re-election next year for President Xi, which provides extra motivation to exert as much power as needed to make sure any Evergrande asset sales go smoothly.
There is a laundry list of reasons why (and how) the Chinese government may respond differently to a financial crisis than the United States. Unlike the United States, the Chinese government controls its banks, which are encouraged to prioritize the Chinese economy over their own profitability, and the government has access to their deposits. The Chinese government also controls the movement of funds across its borders, as well as the courts. Given the reach of the government, it can instruct state-owned real estate and construction companies to help complete Evergrande’s 800 unfinished property complexes. China’s “common prosperity” campaign has been recently touted by President Xi Jinping, and it would seemingly be a priority to protect homebuyers and certain investors from losses and preserve the integrity of the property sector considering its systemic importance to the economy. Lastly, the government can manage public perception and response, both in its control of the media and by curbing public demonstrations.3
Additionally, our view is that there are plenty of assets to cover Evergrande’s debt if asset sales are managed in a controlled fashion, based on conversations with various professionals with deep knowledge of China within Franklin Templeton and external restructuring experts. More importantly, it is a re-election next year for President Xi, which provides extra motivation to exert as much power as needed to make sure any Evergrande asset sales go smoothly.
Lastly, when looking back to the global financial crisis, we saw credit default swap spreads widen drastically and currency volatility spike, indicating that banks and investors were put on their heels in response to a potentially dramatic crisis. Here, we have not seen credit default swap spreads move too much for US or Chinese banks (see first chart below), nor has there been a lot of currency volatility in the renminbi (see second chart below), most likely indicating a very different set of circumstances and a commensurately different outcome.
Should this become more systemic, the government would also have traditional levers to inject liquidity, such as the additional reserve requirement ratio (RRR) cut that was initiated in July.
Second, what would a slowdown in the Chinese property market mean for global growth?
In part due to the reasons stated above, the ramifications related to Evergrande will likely have limited global impact. We believe China is likely to experience below-trend growth in 2022 when compared to other regions (see chart below).
As we think about the outlook for China and its impact on the global economy, the recent meaningful regulatory shift we’ve seen this year across a number of industries (for “common- prosperity”) deserves keen focus. There are specifics risks to watch out for as the government exerts more regulatory influence. One strong example is the recent elevation of de-carbonization initiatives, and the resulting intervention in industries that conflict with that stated goal by consuming too much power.
Regarding the property sector, could the government’s orchestrated slowdown get amplified in a way that escapes its control? Certainly, that is not out of the realm of possibility, in which case China would underperform growth expectations and may warrant further scrutiny. Then again, it’s possible that the markets more recently have been underestimating China’s ability to once again intervene and engineer a favorable outcome. Taking a broader perspective, foreign capital and investor confidence is also a wildcard. Will foreign investors withdraw as we continue to see more regulatory and sectoral shifts by the government? So far, the answer has been “no,” but we are in the early stages of a continued transformation of China which will extend for many years to come.
We have thought for a while that the dramatic widening in Asian high yield corporate spreads this year foreshadowed a number of forthcoming defaults. However, there are likely to still be a few surprises that catch investors off guard—such as the recent Fantasia default—that suggests some property developers may become increasingly grim about future growth prospects and throw in the towel. This sentiment amongst developers bears watching in terms of how widespread and infectious it becomes. We also need to ensure there aren’t widespread hidden liabilities among other property developers. Should these additional risks materialize across the entire sector, it would clearly destroy confidence and become a formidable challenge for the government to overcome.
Ultimately, we believe China will provide a form of bailout to Evergrande (creating moral hazard), in order to preserve broader financial stability and “common prosperity,” continuing to walk the tightrope between that prosperity and pressuring developers to de-leverage and avoid excessive risks. While Evergrande itself may not be too big to fail, despite its gargantuan size, we believe the Chinese property sector is certainly too big to fail given that it represents almost 30% of China’s GDP, and by some estimates 60% – 70% of the average household’s net worth. We are keenly monitoring this situation for its global, and multi-asset, implications.
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1. Source: United Nations Population Division. World Urbanization Prospects: 2018 Revision.
3. Source: K. Bradsher. “How China Plans to Avert an Evergrande Financial Crisis,” The New York Times, September 26, 2021.