Sep 20, 2021 Asia & Pacific

A different sort of China shock?

What to make of Monday's market turmoil

  • The looming debt restructuring of China’s second biggest real-estate developer is not surprising.
  • Some of the market reactions are a little startling and there could be some knock-on effects in coming days and weeks.
  • Still, we do not expect a systemic financial crisis, since this still seems like an idiosyncratic event. It serves as a reminder, though, if any was needed, to be watchful of risk events originating in China.
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The looming debt restructuring of China's second biggest real-estate developer is not surprising, but some of the reactions are.

Over the last 20 odd years, China has loomed as an increasingly important factor and a driving force of the global economy. The term "China shock" initially described the impact of rising Chinese exports to North America and Europe after its accession to the World Trade Organization in 2001. Increasingly, it has also been used as an explanatory variable for all sorts of other changes, from regional patterns in U.S. economic development to voting behavior. In financial terms, though, periods of turmoil originating in China have been relatively rare and comparatively contained. Following events of recent months and most recently over the weekend, fears of wider contagion are spreading. On Monday Hong Kong's Hang Seng index declined by 3.3% and the Euro Stoxx 50 Index was down by almost 3% in the early afternoon[1].

At least for now, that seems a bit out of proportion with the actual situation. The latest sell-off was triggered by the impending debt restructuring of Evergrande China's highly indebted and second biggest real-estate developer, (approx. 300 billion U.S. dollars in obligations). Those problems are neither new nor surprising. Between 2014 and 2018 there was a rapid increase in real-estate developers' debt. At Evergrande, this was also caused by an expansion into other business areas (from a soccer team and academy, to mineral-water and electric-vehicles).

The recent crisis began when the Chinese government started to implement restrictive measures to decrease / limit debt load in the real-estate sector. That too has been going on for quite a while. Since the summer, weak real-estate prices and subdued real-estate purchases as a result of the government restrictions have exacerbated the situation, leading Evergrande to cancel its interest-rate payment on September 20. Both the equities and bonds of other highly indebted Chinese property developers have also been hammered in recent months – again highlighting that the potential of a credit event originating in the segment can hardly count as a major surprise among most market participants.

Much of the immediate negative news may already have been priced in now. Still, the situation remains fluid and there are likely to be some knock-on effects in coming days and weeks.

What then, explains the relatively severe market reactions? Part of the reason may be technical. Most Asian markets were closed on Monday, except for Hong Kong. It remains to be seen how the broader Chinese markets will react on Tuesday. And while we think that most probable scenario remains a fairly orderly debt restructuring, instead of payment defaults or delays, worries about a looming bond payment on Thursday could further fray nerves.

In any case, we expect that the main priority of Chinese authorities is likely to be to limit the potential for social unrest, not stock market jitters. The two are not mutually exclusive, but if there are trade-offs in terms of timing, the former is likely to prevail. Chinese property developers typically charge homebuyers large upfront payments, often a year or two before a project is finished and representing much of those homebuyers accumulated savings. Those are the creditors likely to be at the top of the mind of Chinese decision makers. We would expect authorities to step in at the regional or municipal level to take over such projects and finishing them in due course. Organizing and orchestrating such responses, though, is unlikely to happen overnight.

We expect that the main priority of Chinese authorities is likely to be to limit the potential for social unrest, not stock market jitters.

For most Chinese banks their Evergrande exposure would be manageable in itself, but not if it drags down others.

Still, the Chinese government (especially at the central level) has strong incentives to avoid the negative scenario of large scale liquidations triggering potential domino effects and the damage to the financial situation of Chinese households more broadly. After all, prosperity and social security are in focus for Chinese politics at the moment, especially ahead of the 20th National Party Congress of the Chinese Communist Party (CCP) next year.

Also worth keeping in mind is that the direct exposure of foreign bond holders to Evergrande appears relatively modest. Even among domestic banks, exposure looks fairly widely scattered and the high indebtedness should have already led to high write-offs, perhaps limiting further pain. Individual smaller banks could be harder hit, i.e. their non-performing loans (NPLs) could rise significantly. That said, Chinese banks and financial institutions also have high exposure to the suppliers of Evergrande.

That highlights the potential for knock-on effects. For most Chinese banks their Evergrande exposure would be manageable in itself, but not if it drags down others. Deteriorating growth forecasts would further hurt sentiment, and not just among Chinese home buyers. Moreover, and speaking globally, the latest news out of China hits a market that is already facing difficulties from other sides, such as ongoing problems in global supply chains, or a sharply rising natural gas price. As a result, a slowdown in economic momentum can now be observed, which has already led to the first downward revisions of forecasts.

Asset-class implications

Fixed Income & Currencies: We have been extremely wary of debt issued Chinese property developers for quite a while, especially at the riskier, high-yield end of the spectrum. Obviously, we see no reason to change that stance in the light of recent developments. As for broader, investment-grade Asian credit, we will be monitoring events and market movements carefully in coming days and weeks. Certainly, there could be attractive entry points ahead of any recovery, but that remains a topic for the medium term. Nor are we changing our calls for major currencies. 

Equities: The travails of its property developers again follow on the heels of China’s crackdown on its technology champions and online tutoring providers in recent months, just as Chinese equities had shown some signs of stabilization. For now, we think it is too early to call the bottom just yet. In any case, recent events serve as a reminder, if any was needed, that careful selection at both the sector and the issuer level is crucial when investment in China, and that this needs to take into account broader political considerations as well.

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1. Bloomberg Finance L.P. as of 9/20/21

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