China Credit: Reputational Risk from Evergrande

CreditSights Research

EXECUTIVE SUMMARY
  • Investors typically assess a borrower’s credit character by making a judgement on its ability to pay and its willingness to pay. In Evergrande’s case, the willingness to repay does not rest with the company alone. China’s government has intervened in past corporate restructurings and some investors had believed Evergrande was ‘too big to fail’.
  • As a privately-owned real estate firm, Evergrande is not the most obvious candidate for a state rescue. Recent policy measures have shown a concerted clampdown on excessive leverage and speculation in the property sector; a state-led rescue of an over-leveraged property developer could seem contradictory. Given the uptick in China’s defaults and the authorities’ increasingly tough stance on corporate failures, should investors rethink their assessment of credit risk in China?
  • A full state-led bailout for Evergrande may not be palatable, but nor is a chaotic collapse of the company, which could spiral into other areas of the Chinese economy. We expect any government intervention will be targeted at limiting the threat to financial, economic or social stability. Offshore investors are likely to be low down in the pecking order for protection from the Chinese government and would be both structurally and contractually subordinated in the event of default.
  • That said, we believe China will be keen to protect its reputation among international investors: Evergrande’s restructuring process cannot be seen to be arbitrarily unfair to offshore bondholders. $ bonds remain an important funding source for many Chinese companies. There are various channels for foreigners to access China’s onshore bond market, but many international investors are still more comfortable investing in Chinese credit via the offshore markets, given their more developed structures and trading liquidity.
  • If the offshore recovery rates for Evergrande turn out to be minimal, it could take some time to restore international investors’ confidence in the Chinese $ bond market. But we also believe they are unlikely to shun Chinese $ bonds forever. A low recovery value would probably reflect more on the credit character of the borrower than on China’s credit system. For now, investors with Asia investment mandates seem to be switching to higher quality or government-linked credits, but are not avoiding Chinese $ bonds altogether. The market is too big now.
RELATIVE VALUE

Can’t Pay or Won’t Pay?

Investors typically assess a borrower’s credit character by making a judgement on its ability to pay and its willingness to pay. In Evergrande’s case, the sheer amount of debt the property behemoth has taken on makes its ability to service, let alone repay its debt questionable. The company’s debt burden totalled RMB 590 bn at 30 June 2021, of which RMB 240 bn comprised short-term debt. The unrestricted cash balance was just RMB 87 bn.

Most market observers have little sympathy for Evergrande’s inability to pay. The company’s predicament stems not from an exogenous shock to its business but from an aggressive growth model aimed at upholding its “ever grand” status. The company’s debt has ballooned over the years to fund a sprawling network of property developments, as well as forays into new businesses such as electric vehicles, a football club, wealth management and bottled water, to name but a few. Total cash/short-term debt has consistently remained below 1x since FY17.

ASIA-PACIFIC
China Credit: Reputational Risk from Evergrande

CreditSights Asia Research Team

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