Investors are confronting the growing possibility that Chinese property developer Evergrande will default, a debacle that could cascade across global markets and has exposed the perilous state of China's vast property sector.
The world's most indebted property developer said last week it could fail to make good on its financial obligations, exacerbating a panic among investors, dealing a severe blow to its bonds and triggering trading suspensions in Shenzhen and Shanghai.
Fitch on Wednesday became the latest group to issue a warning, slashing Evergrande's foreign currency credit rating from triple C plus to double C and saying that a default of some kind "appears probable". This week, Moody's downgraded the company for the third time in as many months, saying creditors had "weak recovery prospects" in the event of a default.
The liquidity crisis has left some of Evergrande's bonds trading at less than 30 US cents on the dollar – a highly distressed level – and highlighted fears over the heavily leveraged real estate sector, which makes up more than 28 per cent of China's economy.
Why could Evergrande default?
Evergrande develops real estate projects and then sells the flats to customers who typically pay in advance before completion. It has 778 projects under way in 223 cities.
Evergrande payments to suppliers often rely on the issuing of commercial bills, a type of short-term IOU.
Last week, the company said its liquidity issues, including delayed payments to suppliers and construction fees, meant projects were being suspended. It is rushing to sell assets to generate cash but some companies have refused to accept Evergrande’s commercial paper. S&P has suggested that the developer might be paying suppliers through transfers of its properties instead of cash.
Evergrande is exposed to a vicious cycle in which it does not have enough cash to complete its projects and generate further proceeds from sales, which fell 26 per cent in August from the same time a year earlier despite heavy discounts.
The company needs that cash not only to service, but also reduce, its vast debts. New rules imposed by Beijing about a year ago that forced big Chinese developers to reduce their borrowing are one of the main reasons pressure has mounted on Evergrande in the past year.
"We do expect a default scenario for Evergrande, unless there is an unexpected positive development for the company such as asset sales," said Matthew Chow at S&P.
Which debts are at risk of default?
At the end of June, Evergrande had debts of 572 billion renminbi (€75.1 billion) including loans from banks and borrowings from bond markets within and beyond China. This was down 20 per cent from Rmb717 billion at the end of 2020, following a push to reduce borrowing.
But the company’s various other obligations mean its total liabilities are significantly higher at Rmb1.97 trillion (€258.6 billion), and have risen since December.
When it downgraded Evergrande in August, S&P estimated the company faced Rmb 240 billion of commercial bills and trade payables in the next 12 months, and Rmb 100 billion this year. As of the end of June, the developer had Rmb87 billion of cash.
Of its total of about $14 billion (€11.86 billion) in dollar-denominated bonds, none is coming due in 2021. However, Evergrande has $129 million of interest payments on those bonds due this month, and $850 million due this year, according to Fitch.
On Wednesday, Redd Intelligence, a credit intelligence service, reported that Evergrande may suspend payments on a wealth management product it had issued. Separately, Redd reported that Evergrande had told banks it would suspend interest payments to the lenders on September 21st.
Evergrande did not respond to a request for comment.
What would a default mean for bond markets?
Evergrande counts big international companies among its investors, including Allianz, Ashmore and BlackRock. A default is likely to have spillover effects on global markets, where many investors have historically anticipated Chinese government support at times of distress.
Evergrande is trying to resolve its woes by selling assets. But Iris Chen, an analyst at Japanese investment bank Nomura, argued in late August that such disposals would "actually hurt" offshore bondholders because "the proceeds will likely be used to repay onshore maturities" such as construction costs and trust loans.
Another prospect is a broader impact on other developers, which also rely heavily on debt markets and are subject to Beijing’s deleveraging campaign.
Guangzhou R&F was downgraded by Moody’s on Friday over concerns it would have a tougher time issuing debt to settle old obligations, a process known as refinancing. Guangzhou R&F has upcoming debt payments that exceed its cash, according to Moody’s so, if it cannot refinance, it risks defaulting. The group’s bonds have sold off this week.
Borrowing costs are rising, with yields on Chinese speculative-rated bonds soaring to about 13 per cent late last month, compared with less than 10 per cent in June, according to an Ice Data Services index.
Analysts at Citi last week noted that August sales were 19 per cent lower year on year across 31 listed companies in the property sector. The bank added: “Concern on contagion impact from Evergrande led to some difficulty in bond issuance onshore (due to demand) and offshore (due to cost).”
What would it mean within China?
Even if the central government opts to let Evergrande default rather than bail it out directly – a move which would align with perceptions of a shift towards a more market-orientated approach – authorities are likely to be involved in co-ordinating the continuation of projects at a group that employs 163,000 people.
Property developers in China typically also have large borrowings from the country’s biggest state-run banks.
The default in February of China Fortune Land Development, a company specialising in industrial parks, led to the establishment of a creditor committee. A Redd report in August said the Guangdong government was gathering feedback from banks over a potential creditor committee for Evergrande, while the group said in its interim results last week that it was talking to the government regarding suspended projects.
Beyond markets, the most important issue for Beijing would be any impact on the broader property sector, which has been a central engine of China’s booming economy for decades – but which has come under strain from tightened credit conditions. – Copyright The Financial Times Limited 2021
