China plays down contagion fears as clock ticks on Evergrande

While Evergrande is the largest and most high-profile of the Chinese property developers in trouble, a lengthening string of other companies have been missing interest and principal payments and sales by the bigger property companies were down nearly 40 per cent in September compared to the same month last year.

Most of the biggest developers breach some or all of the “three red lines” – metrics limiting debt and debt-servicing ratios – that the authorities imposed on the sector last August in an effort to reduce the high levels of leverage in the sector.

Yi said the authorities were trying to protect consumers and home buyers and he believed they could prevent systemic risk, although the higher default risk for some companies because of “mismanagement and breakneck expansion” would slow the economy.

The threat posed to China’s financial system and economy isn’t confined to Evergrande, although it has provided the epicentre for a wider sectoral crisis. As other missed interest payments have demonstrated, there are other big over-leveraged players with similar business and funding models.

He also said the rights of Evergrande creditors and shareholders would be respected “in strict accordance with the law,” with the law clearly indicating the seniority of the liabilities.

The actions of bond holders, particularly foreign holders of Chinese developers’ offshore bonds, would suggest that they believe they will be at the very tail end of the queued of creditors. The value of offshore bonds has been smashed in trading to fractions of their face value and yields have soared into the high teens.

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The Evergrande crisis was never regarded as a direct threat to China’s banking system. It has bank debt of “only” about $US90 billion within its $US305 billion of liabilities and that debt is widely spread among individual banks.

Its other sources of funds have been the bond markets, where it owes an amount very similar to its bank loans, about 40 per cent of it falling due within a year, high-yield wealth management products issued within China’s shadow banking sector, pre-sales of its apartment developments and its trade creditors.

It’s the non-bank elements of its funding base – particularly the buyers of apartments yet to be developed and its contractors and suppliers – that Beijing will be most concerned about.

Xi Jinping’s mantra of property being for living not speculation, means that bond investors and those chasing yield through the wealth management products will attract little sympathy.

The threat posed to China’s financial system and economy isn’t confined to Evergrande, although it has provided the epicentre for a wider sectoral crisis. As other missed interest payments have demonstrated, there are other big over-leveraged players with similar business and funding models.

Being reliant on bond sales, shadow financing and pre-sales of apartments yet to be developed when there are about 30 million empty apartments already, property sales and prices are falling and access to the offshore bond market and funding from pre-sales is being closed off makes the entire sector acutely vulnerable to a liquidity crisis.

If the offshore bond market remains essentially closed to Chinese property developers – only the bravest of investors would subscribe to a new issue until the market settles – there will be a wave of defaults over the next 12 months that could envelop even the more conservatively managed companies.

The Chinese authorities will do what they can to blunt the fallout, particularly as it relates to individuals and the local government authorities reliant on property developments for large proportions of their income. Unfinished developments will be completed to avoid social stress and unrest ahead of next year’s Communist Party Congress, at which Xi will seek a third term.

They have, however, being trying for several years to deflate China’s debt-driven property bubble and the over-exposure of China’s economy to it. Property directly accounts for about 15 per cent of China’s GDP but more than twice that if property-related activity is included.

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The authorities would like to redirect the resources tied up in the sector towards more productive activity, or at least activity that meets the Party’s strategic goals. With a rapidly ageing population and that extraordinary inventory of empty properties the development sector has to be shrunk and more soundly based.

It will be reaching that end-point without destabilising its financial system and economy and without entrenching moral hazard by bailing out “too big to fail” developers or financial institutions that will be the tough and delicate task, given the scale and significance of the sector within the financial system and economy.

A formal default by Evergrande this week would signal the real start of that test of China’s authorities, and its system.

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