Investors feel the burn from China Evergrande

Foreign  investors are becoming increasingly fretful that Beijing is preparing  to separate out Evergrande’s real estate arm, leaving them with major  losses.

Karen MaleyColumnist

Foreign  investors are stampeding towards the exits as anxiety mounts that  they’re likely to be left nursing hefty losses when Beijing finally  comes to the rescue of the giant Chinese debt-laden property developer, China Evergrande.

Astute  investors are becoming increasingly concerned Beijing could be  preparing to bail out Evergrande’s real estate arm in China, and leave  the holding company – which owes most of the debt – to either default,  or to reach a deal with its bondholders, which involves them taking a  large haircut.

They  argue that the recent move by the billionaire founder of Evergrande, Xu  Jiayin, to step down as chairman of the company’s main real estate arm,  Hengda Real Estate Group, suggests Beijing is already preparing to  separate out the corporate giant’s real estate division. Xu – who still  owns 71 per cent of the group – remains chairman of Evergrande.

Back in 2015, Xu was forced to sell his $39 million mansion in Sydney’s Point Piper,  after the Foreign Investment Review Board deemed it was purchased in  contravention of Australian laws that prohibit foreigners buying  property without government approval.

But investors are fearful  that such a separation could disadvantage bondholders – who have lent  the group nearly $US28 billion ($38 billion) – because they will have  little recourse to the group’s onshore real estate assets.

From  Beijing’s perspective, bailing out Evergrande’s massive real estate arm  – the group’s cranes dot China’s urban skyline – would limit the damage  that Evergrande’s financial difficulties are inflicting on the Chinese  economy.

Beijing could possibly offer financial assistance to help other property developers to take over some of Evergrande’s projects, ensuring that contractors and suppliers are paid in full.

Even  more important, Beijing would be able to ensure that apartments are  built and delivered to the more than 1.5 million homebuyers who have  paid large deposits on yet-to-be-completed properties.

Resuming construction

Last  week, Evergrande said that “with the coordination and support of the  government” it was actively negotiating with suppliers and construction  companies to try to get them to resume work on its property  developments.

But the growing fear that they could be left with  swingeing losses has unnerved Evergrande’s bondholders, causing them to  dump their bonds.

Trading in the debt issued by the embattled  property titan was temporarily halted on the Shenzhen stock exchange on  Friday morning after bond prices fell more than the daily limit of 20  per cent. On Shanghai’s stock exchange, trading in another Evergrande  bond was briefly halted because of “abnormal volatility”.

Doubts  over Evergrande’s survival were fuelled last week after China’s most  heavily indebted property developer warned it risks defaulting on its  debt if it is unable to raise cash.

Evergrande’s liquidity crisis is causing delays on some of its real estate projects because it has failed to pay suppliers and contractors on time.

In some cases, Evergrande is paying some of its suppliers and contractors with apartments instead of cash.

The  troubled developer is also trying to offload assets to reduce its debt,  selling stakes in an internet company and a bank, and various property  projects.

But investors are worried that Evergrande will not be  able to dispose of assets sales and will not be able to sell off assets  fast enough to stave off its liquidity crisis. There’s also a fear  investor confidence in the property developer will collapse further if  it starts selling assets for less than book value.

Exacerbating  the jitters around Evergrande’s finances, Bloomberg News reported on  Friday that at least two of the developer’s largest non-bank creditors  had demanded immediate repayment of some loans.

The two creditors  are trust companies, which pool money from wealthy individual investors  and are a major source of funding for Evergrande and other Chinese  property developers. At the end of 2019, roughly 40 per cent of  Evergrande’s borrowings were from trusts.

Bracing for default

As  fears swirl through the markets Evergrande will not be able to repay  the $US300 billion it owes to banks, shadow lenders, suppliers and  homebuyers, the property developers bonds have slumped to fresh lows of  less than 30 cents on the dollar, suggesting investors are bracing for a  default.

The problem for Beijing is that while it may be able to  limit the damage that an Evergrande default inflicts on the local  economy, it is powerless to limit the impact on the country’s $US12  trillion bond market.

Nervousness around Evergrande’s financial  plight has spread to other debt-laden property developers, making it  more difficult and expensive for them to raise debt by issuing bonds.

And  this is increasing the financial strains faced by China’s real estate  sector. Banks have whittled back their exposure to the property sector  after Beijing introduced new rules, called the “three red lines” that  limited how much property companies could borrow relative to their cash  reserves, their equity and their assets.

Meanwhile, the experience  of property groups such as Evergrande is making trust companies more  wary of lending to real estate developers, choking off another important  source of funding for the sector.

Some economists warn that  China’s economic growth could brake sharply given the struggles that  property groups now face when it comes to raising fresh funding.

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They  point out that the property market in the broadest sense – covering  construction of new apartments, furnishing and leasing – accounts for  some 30 per cent of China’s gross domestic product.

In a paper  written last year, Peak China Housing, Harvard Professor Kenneth Rogoff  and Yuanchen Yang from Beijing’s Tsinghua University warned that “we  find that a 20 per cent fall in real estate activity would lead to a 5  to 10 per cent fall in GDP, even without amplification from a banking  crisis, or accounting for the importance of real estate as collateral”.

A significant slowdown in the property sector would also weigh on demand for Australian iron ore, given that China’s construction industry accounts for more than half of the steel used in the country.

That  could spark a further steep fall in the price of Australia’s largest  source of export revenue. Since hitting a record high back in May, iron  ore prices have tumbled by close to 40 per cent.

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Sign up nowKaren Maley  writes on banking and finance, specialising in financial services,  private equity and investment banking. Karen is based in Sydney. Connect with Karen on Twitter. Email Karen at karen.maley@afr.com