The next Lehman? Unlikely. However…
This week, Evergrande, the second largest property developer in China (by sales), indicated that it may not be able to meet its debt re-payments. The company is a large debtor in the Chinese economy: with at least ¥1,522bn (AUD$324bn) in outstanding liabilities.
This had the market asking: what could the potential knock-on effects of such a large debtor defaulting be?
Many opined that this could be China’s ‘Lehman moment’ in the making.
However, we think these fears should be tempered by an understanding of ‘capitalism with Chinese characteristics’.
While Evergrande is unlikely to be the next Lehman, it does give insight into some fundamental changes in the Chinese economy and the authorities’ willingness to intervene in markets.
The impact of this is an important consideration when positioning portfolios.
‘Capitalism with Chinese characteristics’
So, why the sell off?
Fundamentally, we think that when a market is extended, it will always find a reason.
However, the Evergrande saga was commonly sighted as the cause.
The debt laden developer has been on the PBOC (People’s Bank of China) and the market’s radar for some time.
Evergrande is one of a cadre of property developers that have fuelled rising land prices and property speculation in China, enabled by a rapid accumulation of debt.
Recognising this, the PBOC instituted its Three Red Line policy in August of 2020. Broadly, this policy looked to limit the amount of debt property developers can take on and force the deleveraging of the sector.
Evergrande began this process, however a slowdown in sales and decline in house prices stopped it in its tracks.
Evergrande stakeholders wait nervously for an outcome
The key point is, the deleveraging of the property market is an outcome the Peoples Bank of China (PBOC) was driving towards. They were likely aware of the risks and prepared to mitigate the fall out.
It is easy to think of China operates in a capitalist system. However, in reality it is a system of ‘capitalism with Chinese characteristics’ that still exhibits elements of a control economy.
Characterising this as the ‘next Lehman moment’ may be putting the cart before the horse.
Therefore, we were less worried than the media pundits and doomsayers.
By the end of the week Evergrande had announced it has scraped together enough money to meet its next interest payment, quelling fears.
Panic was fleeting…
Source: Bloomberg Opinion, Google Trends
Why the Evergrande story matters
In the short term, putting a cap on leverage may moderate the property boom that has fuelled a significant part of China’s growth over the past decade.
Of course, this has global significance because any shift in the Chinese economy has impacts far beyond its borders.
The most immediate impact in the Australian market has been on the price of iron ore.
Clients are aware that we have been wary of extrapolating the recent heady prices we have seen in the market. They have remained underweight in their exposure to producers of iron ore.
We saw the price of Iron ore continue its fall this week, dragging the market down with it.
Source: IRESS, First Samuel
Longer term, the Evergrande story re-enforces the Chinese authorities’ willingness and ability to intervene in private markets.
The Chinese Communist Party has recently rebirthed a party commitment towards the goal of ‘common prosperity’, that is, a more egalitarian China.
Soaring house prices and the enrichment of a number of companies at the expense of upward social mobility fundamentally doesn't appear to align with this goal. Perhaps Evergrande and other heavily indebted developers are now heeding the consequences.
An economy where intervention is rife means Evergrande isn't likely to be China’s Lehman Brothers. However, this is a double-edged sword.
Recently, intervention has meant Didi, a billion-dollar Chinese ride sharing app, was banned in China shortly after it listed on the New York Stock exchange (resulting a significant loss of value for shareholders).
It has meant the initial public offering of Chinese internet finance giant Ant Group was pulled at the last minute, after founder Jack Ma made some less than flattering comments about regulation of China’s financial sector.
It has also meant a ban on Australian coal imports, tariffs on goods including wine, lobster and timber.
Increasing intervention is a very real risk for shareholders of Chinese companies and companies with strong links to China.
Evergrande reminds of this: a key consideration we have in constructing client portfolios.