Market Update: 22 September 2021

Property developer China Evergrande Group is receiving considerable media attention due to its current financial woes. We think the Evergrande issue is unlikely to be systemic, due to its nature and the lack of desire for a disorderly unwind.

Rather than calling this a “GFC-style event” or “China’s Lehman”, we need to think about the type of company this is and the level of leverage in the banking system. China has been focused on reforming its financial sector in recent years, reducing the risk of a widespread domino effect.
 
Some individuals and corporates will be impacted, but that is the nature of corporate lending. The Chinese economic system is ultimately underwritten by the government and should not collapse as bears fear, even though Evergrande and other developers may be allowed to fail. It is also worth remembering that China has not experienced the rampant asset price boom we have seen in most parts of the world.
 
Evergrande does not represent trillions of dollars of inflated assets, where the interest could never be serviced. It is a property developer with developed and undeveloped land, hence it has collateral. It is relatively straightforward to assess, value and/or liquidate. It may cause anxiety, a slowdown in property market activity (which may spill into the real economy), and a market reaction in the short term.
 
Bad debts (offset by the collateral) will be created; some suppliers and creditors will be burned. Undeveloped land and unsold properties will most likely change hands, resulting in better-capitalised owners. As we have previously written, there remains long-term demand as Chinese housing stock modernises. We have been investing in the better-quality players in the sector for this overlooked potential. The regulators may assist with liquidity (“confidence”) in worst-case scenarios.
 
The important context for all of this, is that this is a policy consequence, and not a sudden event. The stock prices of Chinese financials have been suffering for some time. In 2020, the regulations tightened on debt levels among developers - what is now commonly referred to as the “Three Red Lines” policy. Along with changes to land auction policies and apartment price caps, as well as restrictions on second homes, this is all part of an attempt to manage property affordability - part of a broader goal of so-called “Common Prosperity”.

The outcome is that for some time, we have expected this to favour higher-quality, better-managed developers and for the lower-quality operators to be forced out. A year ago, there was already concern that Evergrande could be a victim of this. As companies near bankruptcy, an increasingly vicious cycle emerges. The overriding impact is for the sector to be avoided entirely by investors. We have positions in the strongest players, believing that they do have a future, post the industry shake-out, and are priced too cheaply for that eventuality.

Most of the other companies that we have migrated towards in China, partly due to recent fear around regulation, are unlikely to be affected in the medium term.

We are close observers of China’s long-term reform path and economic dynamism. We have also repeatedly highlighted the speculative elements of global markets, which should be avoided. Chinese property is at the opposite end of the spectrum in terms of sentiment, and we are not advocating owning the risky players.

Our view has always been that when there is fear in the market around a transient issue, this is a time to acquire good businesses at great prices. We do this by taking a longer-term view, and are devoting analytical resources to this.

For more on China, please see:

In Focus: China (Video, 6 August 2021)
China: Time to Run or Time to be Bold? (Article, 29 July 2021)
China’s Societal Change (Article, 29 June 2021)

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