Moral hazard and the Evergrande collapse

Welcome to Finance and Fury. In this episode we will be looking at the Property market in China and focus on the Evergrande developments – in particular if there is actually a timebomb starting to surface – and look at the potential contagion risks to the rest of the world – such as the Aus and US

1. Many in the press are comparing what is happening to Evergrande as another Lehman’s moment – which was one of the defining collapses of a financial institution that lead to the flow of effects culminating in the GFC – it is understandable that the media takes this route – Lehman’s is a recognisable name and fear and doom scenarios generates more clicks and sells more adds – but is this worst-case scenario true? Is the collapse of Evergrande really going to lead to another global financial crisis?
2. A few weeks ago – we covered where the next financial collapse is likely to come from – between the USA and China – Two factors were the focus – leverage and contagion risks
   1. Looking at leverage – Credit growth is a major risk to almost every market – both from bonds from investors and lending from bank of financial institution borrowing – both of these are relevant to the private sector in China
      1. Credit growth is even a concern in Australia – APRA worried about banks and lending – they have increased their servicing cost by 0.5% – worried about credit growth vastly outpacing income growth
      2. But the major focus for any systemic issue is the contagion risks – if one company defaults, does this create a GFC, or just a collapse of an isolated entity – The loss potentials are substantially different between both scenarios – one is investors in a company losing money versus every investor globally losing funds due to collapsing markets world wide – the degree they collapse also is different
   2. If Evergrande fails – what does this matter? At this stage – The irony of the contagion risks is from the increased news coverage that this topic is being granted – if a topic is covered in the news everywhere – this creates uncertainty and fear – investors can panic – this creates real market declines, so the risk of market declines become a self-fulfilling prophecy – even me covering this topic can create some level of risk aversion, which may cause people to sell off investments – but is there more than just the normal fears in the markets from media coverage occurring?

To start with – What is happening in China – We need to look at their property market, or more specifically the debt that property developers hold – especially in relation to Evergrande and Chinese economy at large

1. Chinese economy – the rise and fall of Evergrande is tied into the economy of China quite heavily –
   1. Evergrande is China’s second largest property developer – but this ranks around 147^th in the world – but it is the most indebted property developer in the world – which should start to ring some alarm bells – it’s on balance sheet liabilities amount to around 2% of Chinas GDP – off balance sheet – this could be higher – and likely is
2. A company in isolation with debt isn’t much of an issue – but a company with too much debt can be a problem – In isolation this isn’t too much of an issue – if the company defaults but business in other sectors of the economy continues as normal then markets may go down a bit but then continue as normal –
   1. but what if this one company is a sign of greater systemic issues – where most of the companies in your country in this sector have the same problems – that of having too much debt that they are likely to default on? Especially in the property sector –
   2. The BIS released a paper showing that Chinese non-financial companies have 160% Debt to GDP, versus in the US where it is about 80% – so double in China compared to the US – Property also has an overweight on GDP compared to the US
   3. It is estimated that property development makes up around 25% of China’s GDP – this growth has been fuelled by Debt – this is a major issue for the CCP –

China property market – the history over the past 20 years

1. The increase in demand for property and the increase in pricing has been fuelled by massive amounts of urbanisation – rural workers/population moving to cities for work and a better income for their families
2. High demand for properties in desirable cites has massively inflated the property values in these urban environment – developers often sell every property in a development in advance of the construction even starting
   1. This has led to lower quality – contractors skimming on materials to lower costs – where constructions can actually collapse in a few years after completion
3. Prices to income ratios – results in a situation where you have generations of people living in one apartment trying to repay the loans
   1. We think that Australia is bad – and it is – but many major cities in China, such as Shenzhen see 43 times the average household income in property prices – compared to Sydney which was around 13 times at the peak of the market
4. Speculation – large increases in property prices saw massive speculation in developers – if you think that the property that you will construct today can lead to a 50% gain in the next year or two – then you will likely borrow large chunks of money to bank on this trend
   1. Lead to many apartments not being rented, and purchasers buying up more than one property – but the limit per family is capped
   2. The population is also limited in what they can invest in – so property is where most of the upper middle class and beyond put their life savings
5. Large property developers are politically connected – But this has created moral hazard – every loan given, or bond investments have been made based around how likely it is for the government to bail out these developers
   1. Rather than on their ability to meet the debt repayment cashflow
   2. Moral hazard is a large component of any investment or economic decision – as an example – say you have an expensive car – now in one situation you have comprehensive insurance and in another you have no cover – in which situation are you likely to drive a little more recklessly, or park this in a car park unattended overnight?
   3. Same goes for insurances – especially if you are forced to have insurances – you may as well use it for your premiums – such as health insurances – But what if we are talking about a government backing debt for bail outs – and that is the expectation of the markets – this creates a moral hazard –

But China realised they have a debt problem – as well as a moral hazard problem – so policy makers tried to reign this in – focusing on moral hazard first and foremost

1. Policy changes – the CCP put together that their economic growth is mostly paper/debt based – where the growth they are receiving in GDP is funded through borrowing from property expansion – which is not sustainable in real terms
   1. They want to transition their economy to more long-term sustainable growth – real estate is the most important sector in their economy at the moment – but this is debt reliant – they prefer real returns – which is why you see a push towards resources and other manufacturing sectors – but a real issue in China is the affordability of property ­
   2. Look at government policy across the world – they always say that they promise to tackle issues of property affordability – but then comes a situation where prices are starting to decline – what do governments do? Create policies to help prop prices up to avoid a decline which could have further reaching issues – governments don’t want bubbles, but they don’t want a collapse
2. China appears to be the first government in a long time to not follow this pattern – they are trying to change moral hazard – and expectations in the market -which can easily lead to collapses in the property sector
   1. Rather than bail out Evergrande – which would be easy for the CCP – it appears that at this stage they have decided to let this company deal with their own problems
   2. This is technically how it should be – but it is rare to see this response
3. I think this is mostly due to their Hard lines polices – trying to reduce the economy reliance on debts – They actually introduced three hard line policies on property developers in Aug 2020
   1. These are hard limits on property developers – relating to their liability to asset ratios, net debt to equity ratios, cash to short term debt ratios – all of these are important when it comes to developers who fund their projects using debt now for equity in the future
      1. Had an instant effect on property development firms – no longer could you raise capital through debt funding as most developers were above the allowable ratios
      2. What made this is worse, is they had to reduce their debt levels – to do so they were quickly forces to sell down assets and taking losses – this caused prices of property to fall, so the valuation on their assets started to go down
   2. This made it worse – These losses make their ratios look worse – making these companies need to deleverage further – this can lead into a downwards spiral
4. On top of this – because the prices of property started to slow as well last year – to make more pre-sales – Evergrande needed to offer some discounts on the pre-sales – this lead to less liquidity available – less liquidity meant they don’t have the money to fund debt repayments as they come due

Evergrande itself – In the property sector – the company acts like a conglomerate

1. Property development, property management, and Wealth management products –
2. They are looking to sell of property management – recoup $5bn
3. But wealth management products – WMPs may be a concern – this is around $6bn –
   1. Small number – but investor fury has made this more of a social issue
   2. But these investors were told they would get a guaranteed 12% return on their investment p.a.
   3. This money was used to help close funding caps that the parent company had in construction –
   4. This is fine, as long as the returns on the property sales in the year are more than 12% to repay investors –
      1. But for a time they weren’t – this meant that new investor flows had to be used to make repayments to existing investors – in the process there was less to help close the funding gap –
      2. But then add onto this the slump in sales – then you start to have a real issue – as more and more new investor flows need to be used to repay existing investors – which is the basis of a ponzi scheme – but moral hazard still existed – investors had the certainty in their own minds that this was a sure bet – as any defaults would be covered by the government
   5. The issue is based around the moral hazard – investors thought their returns were guaranteed with little risk – but where it can get bad is contagion risks

Fallout effects – will come from two areas – property domestically in China – which will spread out and have their own issues – as well as contagion risks throughout the economy and throughout the world

Property prices in China –

1. Can see a decline – if they liquidate and need to sell off the property development – could see a fire sale of assets and property prices decline
   1. The fact they are trying to sell quick is bad for property – fire sales see massive price reductions
2. Domestic fallout –
   1. People who have placed deposits on properties that may never be built – lose those funds People who have invested in the WMPs – will also lose money – you will start to see some social issues
      1. This will reduce the trust in property investment –
   2. Evergrande employs lots of people – around 4m – which would be huge for a country like Australia – but out of a population over around 1.4bn is about 0.29% of the population

Contagion risks – who owns the debt and are there any derivatives on this?

1. Look at the debt – $300bn of debt – bonds issued – estimated that only around $20bn of this is overseas debts – the rest is domestic – these foreign bonds are priced in at around 25-30c on the dollar – depending on their maturity
   1. China is a large economy – it can pretty easily soak up these losses – even though $300bn is a large amount of debt to cover
   2. This is owned across 128 banks and 121 non-bank institutions
      1. Investment managers – investing in risky emerging market debts – Ashmore group, BlackRock Inc, UBS and HSBC hold $450m, $400m, $300m, and $200m, respectively – which isn’t too much for these groups to absorb

Best case scenario – Evergrande will be allowed to collapse – the parts will be bought up by other developers in the nation at a fire sale rate – i.e. getting a good discount

1. The People Bank of China will also likely buy out some of the debt – Like JP Morgan Buying Bear Stern back in the GFC – with help and oversight from the FED – but this doesn’t solve all the problems
2. But the issue comes back to the moral hazard – the CCP wants to minimise speculative risks
3. Evergrande by itself defaulting isn’t a risk for markets – but it does spell some risks – of over leverage throughout the system – if many other developers start to see the same systemic issues of overleverage and issues in meeting their debt obligations, then you get into further trouble
   1. Fantasia – another property developer failed to make a bond payment – missed $315 million in payments to lenders – created further fears that financial strains in the country’s outsized property sector are spreading beyond the troubled Evergrande conglomerate. S&P and Moody’s slapped “default” credit ratings on Fantasia

Lessons to be learnt –

1. The moral hazard and the belief in a sure thing – the belief before the GFC is that debt on peoples homes was a sure thing – not many people would default all at once, so package up 1000s of mortgage holders debt and make bets on this
   1. But due to this belief, lax lending standards were employed – this then turned out that due to the belief that things couldn’t go bad, resulted in them going bad due to too much risk
   2. How this is different from the GFC – Derivative used in making bets on the property market
   3. Credit swaps, derivatives on CDO – this doesn’t seem to be occurring in China – and the banks’ ability to eat losses on the debt isn’t too great to not be able to recover
2. Lehman’s collapse was considered to be the plug of the dam being pulled in the GFC – property prices dropped, people defaulted on debt then Lehman went into default – but only due to their exposure to complex CDOs and derivative positions –
3. If these don’t exist on Evergrande – which it appears at this stage they don’t – then there is less contagion risk –
   1. But who knows – there is no way to tell until it is too late – however, there hasn’t been much in the way of transaction in credit default swaps in banks like HSBC which have greater exposure to the Chinese debt markets
   2. It took Lehman over a year to default and go bankrupt – so time will tell how this pays out

Where things could get worse – is if more developers start to default – showing greater systemic risks

1. My gut feel is that the China growth from property is coming to an end –
2. This will likely have larger effects on the commodity markets – such as iron ore – than it will on the global share market in the short term – but if their property market starts to decline due to defaults on developers and a lack of trust – this leaves their economy very susceptible
3. Your guess is as good as mine as how this will turn out – we will keep an eye on this

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