China Evergrande: Macro Perspective

In this note, we analyze what we think authorities are likely to do in order to contain the threat of contagion arising from Evergrande and the chances of systemic risk spilling over to the banking sector.

Overall, we think that policymakers are likely to provide more clarity over the problem and enact more forceful measures in the coming days and weeks to stave off systemic risks. This should provide a backstop for Chinese markets and signal that authorities will not permit a property and financial system collapse in order to make an example out of a property developer.

Policymakers have already started to act

Despite Chinese policymakers being reticent over the Evergrande issue lately, they have already started to act. We think there are a few policies that regulators could implement shortly. Yesterday’s net injection of RMB 90bn into the interbank market through reverse repos follows two large injections over last weekend. These short-term liquidity injections have aided the interbank markets to remain relatively calm and resist the uncertainties erupting from Evergrande.

Additionally, we think that authorities may implement measures to protect retail customers of Evergrande’s pre-sold residential units and wealth management products to head off social disturbances. It’s possible to see policymakers strongly encourage or necessitate that other developers step-in to take on unfinished projects.

Finally, it’s possible that banks are instructed to delay and rollover interest payments for the time being so that the troubled developer can restructure in a measured way.

Systemic risk to Chinese banks analysis

In our assessment, the risk of a systemic financial crisis in China is lower than in many other economies, contrary to the conventional wisdom. Most financial crises start with pressure on the funding of banks or other financial firms, rather than asset quality problems.

In China, the bulk of the banking system is state-owned, state-backed or tightly regulated. Furthermore, regulation of the financial system has been enhanced in recent years, rather than loosened – in contrast to the run up to the Global Financial Crisis of 2008 or Eurozone Financial Crisis of 2009-12. State backing and regulation has certainly reduced the risks of a run on Chinese banks.

Many observers see growth and financial stability as challenges in China’s overall debt ratios and debt growth. It’s true that China has high debt levels compared to many other major economies, both developed and emerging. But people rarely, if ever talk about China’s extraordinarily high savings rates, which remain among the highest in the world, over 46% of GDP in recent years, which is over three times as high as in the US. Simply put, China’s high savings provide the financial system with deep pockets to service its high debt and absorb losses if needed.

From a macro perspective, China’s tightened financial regulations and its deep pockets reduce the risk of a systemic problem and should ,in our view, provide comfort that the authorities can manage the financial pressures ad contain the issues to individual firms while protecting the system as a whole.

Furthermore, there have been many episodes of financial distress that were managed without a systemic crisis, even though there were often periods of significant and extended market turbulence. Chinese banks were recapitalized without severe deposit withdrawals in the 1990s and 2000s, for example.

Financial stability remains a top priority

We also believe that Chinese authorities are prepared to do whatever it takes to maintain financial stability, whether regulatory tightening, managed debt workouts or targeted liquidity provision. Such tools were used during the 2015 pressures on the exchange rate, when there were stresses on shadow banks and significant capital outflows in expectation of a currency devaluation. This time, at least so far, there is little if any evidence of such pressures.

When the dust settles, we will want to watch how the authorities reform the property sector and the housing finance system to make for a less speculative construction and property investment environment. This may translate into lower returns but with the benefit of more stability and less financial volatility – not unlike what the US and Euro Zone experienced after their own housing credit crises in 2008-2012, but likely with more of a focus on individual workouts rather than a systemic bailout.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Debt instruments are exposed to credit risk which is the ability of the borrower to repay the interest and capital on the redemption date.

Changes in interest rates will result in fluctuations in the value of the investment.

When investing in less developed countries, you should be prepared to accept significantly large fluctuations in the value of the investment.

When investing in certain securities listed in China there can be significant regulatory constraints that may affect the liquidity and/or the performance of the investment.

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