Chinese homebuilder's debt crisis must be on North American investors' radar
In recent weeks, China has shown an increasing willingness to crack down on select companies and industries that it feels are getting in the way of its longterm vision for economic growth: ride-sharing company Didi Chuxing Technology Co., tech companies Tencent Holdings Ltd. and Alibaba Group Holding Ltd., and the online education, video-game and gambling sectors all come to mind.
Now, Evergrande Group, one of China's largest homebuilders, has increasingly come under financial pressure, struggling to pay its US$300 billion in obligations outstanding, resulting in a downgrade in its credit rating by Fitch to CC with a “default of some kind appearing probable.”
Perhaps regulators will let Evergrande be the poster child of deleveraging/reforming the real estate sector.
Regardless, this is a fine line to walk, as anything that involves getting debt under control is always a painful process.
As one economist in the media has been quoted as saying, “this is China's Volcker moment,” in a nod to the former United States Federal Reserve chairman's willingness to plunge the economy into recession in order to break the back of inflation.
Remember, it is estimated that the direct and indirect share of the real estate sector is 25 per cent of China's GDP, so if regulators are too aggressive in their approach in resolving the situation at Evergrande, it could have significantly disruptive effects on the economy, which is already in a slowdown of its own to begin with.
This is why, despite some similarities to the Lehman Brothers Holdings Inc. outcome in 2008, we do not feel that this will turn into China's “Lehman moment.”
The scale and complexity of the counterparties involved were unprecedented and, for now, the current situation appears to be limited in size in terms of companies involved.
However, it does resemble the bursting of other credit bubbles, when one domino falls and triggers knock-on effects (the bankruptcy of New Century Financial Corp. or the savings and loans crisis come to mind).
In other words, this is a classic case of the “cockroach theory.”
There is no doubt that Beijing will do its best to limit the damage and attempt to arrange some sort of debt restructuring deal, but the fact remains that the massive amounts of leverage are an industry-wide issue, not just some idiosyncratic event.
So far, the effects have primarily been limited to just a China story (more specifically in the high-yield bond market).
But, with the company itself even acknowledging the widespread impact that defaults on its loans can have on other companies and industries, the size and scope of the problem may be wider than what is currently perceived — and spilling over into international markets if that is truly the case.
The fact that Canadian and U.S. investors' primary focus right now is on the Fed taper, signs of improvement on the COVID -19 front in the U.S., the infrastructure plan, labour and material shortages, wage pressure among lower-skilled workers, surging transportation costs as well as the relentless inflation debate means that they may be missing out on an important story — it has been relegated to the back part of the morning papers for the most part.
Indeed, we are reminded of the Thai baht devaluation story from 1997, which exposed the property and debt bubble across Asia at the time, and a plunge in asset prices across the continent.
Despite being primarily an Asian-oriented crisis, it eventually spread to the U.S. with the Long Term Capital Management LP meltdown, the Russian debt default and a near-20-per-cent correction in U.S. stocks.
It also ended up derailing the Fed's plan to embark on a tightening cycle, eventually turning into a series of rate cuts in 1998.
In similar fashion to what is going on with Evergrande, the situation in Thailand received very little attention from North American investors at the time.
Being aware of history goes a long way and, while no one is calling for the next global financial crisis here, when one of the largest property developers in a country with massive real estate debt exposure can no longer pay its bills — forcing what could be the largest debt-restructuring deal in China's history — it is worth paying attention to.
When one of the largest property developers ... can no longer pay its bills it is worth paying attention to.