China property risks small relative to global capacity to absorb

September 20, 2021

2 mins

Steven Wieting

Chief Investment Strategist & Chief Economist

SUMMARY

Global markets saw a highly correlated selloff on Monday, with the debt pile and financial troubles of Evergrande - one of China’s largest property developers – being the catalyst. But we believe both the Chinese and global financial systems have room to absorb the shock if it materializes.

On Monday, news emerged that Evergrande might be unable to make loan payments. It is also due to make interest payments of $84 million on its bonds this week. The larger setting of “absent volatility” and heightened macro policy uncertainty seems critical background for market action this week.

Evergrande’s bonds have fallen precipitously since May, to about 30% of their par value. Shares have fallen all year long. However, suspense over a Federal Reserve meeting Wednesday, the US fiscal drama, and moderating economic growth have culminated in a round of risk aversion and profit-taking for shorter-term traders.

Evergrande has $14 billion in external bonds, $9 billion in onshore bonds and $66 billion in bank loans, with the majority of this borrowing from domestic Chinese banks. The scope of direct financial losses from an Evergrande default could be easily absorbed by available risk capital and central government resources.

However, Evergrande’s woes can be linked directly to Chinese macro policy, including strong restrictions on housing developers. This weakness can now be seen in a severe erosion of financial conditions for most of the nation’s property developers, pointing to an economic slump in the sector.

If Chinese authorities tolerate this level of financial woe for the housing sector without compensating macro-level easing, it will signal deteriorating overall growth prospects for China, with spillovers to the world economy. Markets will watch actions from Chinese authorities closely in coming days.

As examples of assets with negative exposure, iron ore futures fell 4% today with China’s trading partners such as Germany, Australia and Brazil seeing negative spillover in equities markets and/or foreign exchange.

Asian markets (including China) were closed for a holiday Monday, exacerbating liquidity issues for investors scrambling to address Evergrande. In the US, implied volatility has spiked, with the cost of downside protection particularly high versus upside exposure in derivatives.

The probability seems high that investors will overstate Evergrande risk after strong market gains in 2021. This is partly because of building US policy uncertainties. However, if China acts to contain macroeconomic fallout and the Fed doesn’t surprise markets with a hawkish policy turn this week, we believe a sharp rebound in markets could follow a near-term sharp decline.

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