Chinese authorities have asked local governments to be prepared for the possible collapse of stricken property developer China Evergrande Group. A step towards default appears to have taken place. Wealth managers ponder the fallout.

Crisis-hit Chinese property developer, Evergrande, has reportedly (Wall Street Journal, 24 September) failed to pay bond-holders, which takes it close to the point where it is in default. The saga around the firm shines a harsh light on fault-lines in the world’s second-biggest economy. 

With so much focus on China’s economy because of its crackdowns on sectors such as tech and after-hours/for-profit education, this story is unfolding at a sensitive time for Beijing. The Chinese Communist Party is tightening its grip on a country that has seen a particular form of capitalism flourish since the death of Mao and early reforms in the 1970s. 

What to make of the Evergrande situation? According to Amundi, the European asset management house, it does not think the group poses a “systemic risk” but it is a “wake-up call in an over-indebted world.”

“Over the past days, financial markets have been shaken by the Evergrande saga - China’s second-largest property developer - which is facing difficulties in servicing its huge debt pile. The scale of such a potentially large restructuring event is weighing on Asian credit markets, with bonds of other companies in the property sector (an important part of the high yield segment) trading down,” the group said in a note. “Putting this event into the broader context, the contagion effect on global markets has been limited so far, with some volatility in equities (the VIX index hit an intraday high of 28.8 on 20 September 2021) and a modest retracement from historical highs (the S&P 500 is down 2 per cent).”

“Down the road, we are likely to see cracks in relation to leverage issues coming to the surface, which will require additional focus on credit selection across the board….The housing slowdown is one of the negative drivers behind the downgrade of our China GDP forecast. Activity in the sector is cooling fast and liquidity pressure will remain high with no policy changes,” it continued.

Seema Shah, chief strategist at Principal Global Investors, said: “The risk posed by the Evergrande crisis is an acid test for the resilience of the post-COVID market recovery. After the sharp dip earlier this week, global indices regained ground before dropping again today [Friday 24 September]…. However, the current declines following the Evergrande bondholders’ tumbleweed experience are not the precipitous falls of a week ago nor have they sparked the same degree of anxiety over systemic financial decay.

“At the moment, the indications are that investors have confidence that while the economy is likely to slow further as sentiment sours and the property market cools, this episode will not lead to full-blown, systemic `contagion’. Our belief is that the Chinese government is sensitive to the need to avoid wider financial risks, and would not allow the Evergrande situation to develop into a Lehman-like scenario. The regulators already have considerable experience in containing risks posed by troubled institutions and will move to break the self-reinforcing feedback loops within the channels of financial risk. Short-term volatility is to be expected, at least until the Chinese Golden Week holiday in October, but this will not derail a strong longer term recovery in Asia and globally.

“Nonetheless, until there is a clear resolution, international investors may sit on the side-lines and adopt more of a risk-off approach to China and the wider Asian economy, waiting for an attractive re-entry point. If bondholders are forced to the table to discuss a restructuring, all eyes will be on the way in which the discussions are conducted as they will serve as a window into the extent of China’s efficiency as an international capital market,” Shah added. 

Atul Bhatia, writing for RBC Wealth Management, said: “We see concerns around the policy response and associated risks prompting some near-term profit-taking, which may lead to moderate pullbacks in equity and corporate bond markets.

“The size of a potential Evergrande default and its impact on the massive Chinese property development industry may create a longer-term headwind for global growth. But the broader macroeconomic conditions and Chinese policy flexibility mean that concerns over a repeat of the global financial crisis of 2008 - or even the Asian financial crisis of the late 1990s - are likely significantly overstated, in our view.

“We see concerns around the policy response and associated risks prompting some near-term profit-taking, which may lead to moderate pullbacks in equity and corporate bond markets."