This week speculation about the possible default of Chinese property company Evergrande contributed to a notable if brief sell-off and much florrid commentary about whether this was a ‘Lehman moment’. China-linked assets (especially Iron ore and AUD) sold off as did most risk assets, but the move was quickly reversed at a global level. These trends were amplified (in rhetorical terms) by the recent arbitrary application of technology regulation by Chinese authorities, even though those policies had actually reduced foreign investors exposure to onshore and some offshore Chinese markets.
By week-end, Evergrande had made its domestic debt payment, missed its external debt payment, and had yet to provide much guidance on how it would treat its sizable liabilities to suppliers or purchasers of prepaid agreements. However, Chinese officials had given some indication that they would manage the impacts on the local buyers and suppliers if not all of the risk asset purchasers. Global markets walked away feeling that contagion risk was low. This piece lists some of the key questions ahead for Chinese and global growth and asset markets. The slowing of the Chinese property market, issues dealing with the sizable debt burden and efforts to shift the drivers of growth and wealth, will continue to be a major theme in the weeks, months and years to come.
Overall, the end result is likely to be continued slowdown of Chinese growth, less supportive monetary/credit impulse to the global economy from China, more government involvement in the economy, all of which may reinforce some of the geo-economic tensions between the US and China as both look to reduce their supply chain exposure. This doesn’t mean a global financial crisis or a Chinese one, or a recession but more likely rolling financial pressures, reduced Chinese borrowing abroad, greater government role in transactions and greater caution from foreign investors.
Several policy choices will determine the impact on macro and market terms takes place.
- What sort of default- and if so on which creditors are made whole (local debt, external debt, what about other stakeholders? What about WMP holders ?) Will there be a Bailout (probably not).
- Restructuring: how is Evergrande restructured and how are projects/assets divided up? Does government prioritize appt buyers (probably ie continuing with projects)? Is it taken over explicitly by government actors or just receive implicit support? Are they local authorities or national? Are workers kept on?
- Broader market/regulatory response. Are there Liquidity injections at a national level Are there new rules and regulations on a) WMPs (to avoid future losses) b) more restrictive or supportive property policies especially for first time buyers to support affordability c) are there more consumer oriented measures? Does government need to recapitalize banks/Asset managers/local governments.
- How will China balance priorities/guiding principles? Top priorities include stability (financial and social) but also reducing moral hazard. This means avoiding broad market distress (both of banking system but broader real estate sector, arguing against a major structural change). This implies government has an interest in avoiding broad discounting of units, thus avoiding race to the bottom on property prices which would hurt financial and social stability. However, the government is likely to be less concerned about losses for speculative actors especially those issuing abroad foreign ones and perhaps greater restrictions on external finance (in hard currency). Note that China recently rolled out some planned new regulations for banks to lend money for foreign projects, facilitating some new external lending in yuan.
- In terms of global implications, a managed default and continuation with most but not all projects would reduce global contagion (indeed global markets already downplaying it), but impact will depend on policy response especially restructuring terms and any new regulations will set the trajectory for real estate market, which will struggle to grow. Bigger global issue is probably growth link not financial market link.
- The development likely reinforces inward policies from China and market jitters were reinforced by the arbitrary imposition of policies (tutoring. Consumer finance vehicles, gaming etc) have already reduced some global investors and market structure issues led SEC to place Chinese IPOs on hold. These trends could add to select financial decoupling risks and bifurcation of investment plans from foreign investors.
Structurally, real estate will continue its downdraft and policy induced slowdown that has been underway for the last half decade. This suggests continued sluggishness of Chinese growth which has experienced weak credit demand and supply of late and moderating domestic demand due to little stimulus (vs DM peers like the US). It might increase reliance on exports which are again positive contributor to growth and add to trade tensions with US. At a global level Global imbalances slowly growing (especially bilateral, but also because many EM, not just China but also Europe are having improving current account balances due to weak domestic growth that caps imports. Fiscal austerity, monetary tightening and adjustment from EM in Latam for example is cutting imports in ways that improve financing. From the US, these measures might increase pressure to limit stimulus benefit to foreign countries and boost select protectionist pressure. Watch the supply chain review and new transparency regulations. Overall, this is set to be a recurring story and drag on growth and returns. The impact will depend on Chinese government choices and whether their communication improves. The risk is that it will add to volatility of the business cycle. - In China, like Europe, rising power costs are likely to lead to shut-ins of less important production as it is more cost-prohibitive this winter. Overall, this will likely mean a soft end to the year and start to 2022.
Ziemba Insights 