Beyond Evergrande & Global Contagion

All eyes will be on Wall Street tonight as it reopens after a weekend of digesting the implications of the fallout of an imminent default of Evergrande’s $315b unserviceable debt pile.  We gave the background to this on Friday here.  Since that article the warning signs have only worsened.

Much of Evergrande’s debt is via bond issuance, and needless to say high yielding or so called ‘junk’ bonds at that.  On Friday the yield on those bonds, the direct measure of risk or inversely how cheap they need to be priced to entice buyers surpassed even the COVID spike last year to the highest since China’s repo crisis in 2011.  If you have the appetite you can earn a whopping 14.3% holding these babies…

Whilst that might seem a disproportionate response for the WHOLE high yield (HY) bond market to be so distorted that view would be underestimating the amount of property companies in a similar situation to Evergrande and that Evergrande alone accounts for 16% of all outstanding HY dollar bonds in China, singularly the largest issuer. Those are dollar denominated and the Yuan situation on the mainland is even scarier at around 15 times the size or around $12 trillion.  Regardless of China’s size, disfunction in a $12 trillion bond market would be catastrophic. 

To reinforce the breadth of this, the chart below shows the price of 10 of China’s largest property developers.  Whilst Evergrande in yellow is the 2^nd worst, the carnage is across the board.

Financial analyst Gordon Johnson tweeted last week:

“While the collective world thinks Evergrande is the only Chinese developer at risk, they are wrong - i.e., Evergrande is not unique nor is it the first. That is, looking at the 10 Chinese developers below [chart above], interestingly, combined, the names (each in default or significant stress) represent over half a trillion dollars of total liabilities. Liabilities are not just debt, but payments to suppliers, employees, remaining construction costs, etc. The whole ecosystem is on the brink. Evergrande is trading down -4.45% in today's session, yet the collective investment world is simply ignoring this. In short, this moment seems eerily similar to where we were in Feb. 2020 when folks were dropping dead in the middle of the street in China and no one cared.”

UBS don’t hold high hopes:

“while the Chinese authorities have tried to intervene and ask banks to allow for payment extensions... the ability of Evergrande to generate sufficient liquidity in the near term through contracted sales and asset disposals has deteriorated considerably and in turn increased the likelihood of credit event occurring sooner rather than later."

And so whilst you can get a nice 14% yield on your bond, the chances of default will mean only but the bravest would go there and hence the chances of default ever increasing. 

The implications for the world, and arguably particularly Australia, are clear.  Whilst the housing market accounts for around 39% of Australian’s household wealth and 25% for Americans, in China it has been around 75%!.  In other words, the government instigated cooling of the property market is a massive threat to the majority of the population’s wealth.  The likes of Australia and Canada have had large investment from the Chinese in our property market, both in completed homes but also in developments.  On Friday we pointed out the risk of a huge pull back in ore and copper consumption on a Chinese property slump.  However looking at the numbers above you can also clearly see the risk around forced sales by Chinese of their Aussie property assets.

All eyes now are on whether the CCP relent and bail the sector out when it is their very actions of curbing the property bubble that lead us to this situation.  It would be a huge loss of face by a regime that holds such face saving as a cornerstone of its culture and dealings.