Market contagion tests China's resolve on Evergrande

How far will President Xi Jinping go with his crackdown on China’s real estate sector?

The question has suddenly become an urgent one for trading desks around the world. After months of treating the crisis at indebted developer China Evergrande Group as largely contained, investors on Monday rushed to price in the risk that Xi will miscalculate as he tries to curb China’s property market excesses without derailing the economy.

The resulting market turbulence may add pressure on Chinese leaders to tap the brakes on policy tightening, or at least take steps to limit the fallout.

Goldman Sachs Group Inc. analysts called for authorities to send a “clearer message” on how they plan to stop Evergrande from causing “significant spillovers” to the broader economy. Citigroup said officials may commit a “policy error of overtightening.” Economists at Societe Generale assign a 30% probability to a “hard landing.”

“Even though most people don’t expect Evergrande to collapse all of a sudden, the silence and a lack of major actions from policy makers is making everyone panic,” said Ding Shuang, chief economist for Greater China and North Asia at Standard Chartered in Hong Kong. “I expect China to at least offer some verbal support soon to stabilize sentiment.”

Hong Kong’s Hang Seng Index tumbled more than 3% Monday, led by real estate companies. Equity benchmarks in Germany, France and Italy lost more than 2%, S&P 500 futures slipped and the U.S. dollar rose. The average price of junk-rated dollar notes from Chinese borrowers slid the most in about a year. A 12% slump in iron ore futures made matters worse, as did holiday closures in many Asian markets.

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Chinese authorities, who recently hired advisers to look into Evergrande, have provided no public assurances that there’s a state-led plan to resolve the crisis. Official media commentary has largely avoided the subject, apart from a tabloid that said Evergrande was an “isolated case” and called out Western outlets for bashing the Chinese economy. There’s been no clear evidence of state funds stepping into the domestic stock market, as they did in March. 

The response so far has been largely limited to the People’s Bank of China, which injected a net 90 billion yuan into the banking system on Friday. It added another 100 billion yuan on Saturday.

Evergrande has around $300 billion worth of liabilities, more than any other property developer in the world. It’s a whale in China’s high-yield dollar bond market, accounting for about 16% of outstanding notes. Some $83.5 million of interest on a five-year dollar bond comes due Thursday, and failure to pay within 30 days may constitute a default. Evergrande also needs to pay a 232 million yuan ($36 million) coupon on an onshore bond the same day.

Evergrande’s shares lost as much as 19% on Monday, briefly taking its market value to the lowest on record. The stock closed 10% lower.

“With policy makers showing no signs of wavering on property market deleveraging, the latest headlines regarding Evergrande likely suggest that housing activity may deteriorate further in the absence of the government providing a clear path toward an eventual resolution,” Goldman economists led by Hui Shan wrote in a Sunday note.

With more than 200 offshore and almost 2,000 onshore subsidiaries, Evergrande has about 2 trillion yuan in assets -- equivalent to 2% of China’s gross domestic product -- according to Goldman Sachs calculations. A messy spillover into an already slowing housing market could be costly, with real estate accounting for 40% of household assets in China. Data last week showed home sales by value slumped 20% in August from a year earlier, the biggest drop since the onset of the coronavirus early last year.

Authorities appear determined to push ahead with their campaign to deleverage as well as cool the property market. Guo Shuqing, the chief banking regulator, last year identified banks’ excessive exposure to the property market as the biggest risk facing the financial system. The challenge for officials is how far to go before their tough measures threaten to create the kind of financial instability that they are trying to avoid. 

Regulators are increasing efforts to tame land and home prices that have fueled China’s property industry -- and much of its economic growth. China has in recent months tightened mortgage approvals and raised rates for first time buyers, introduced rental controls in cities and suspended some centralized land sales. Chinese banks are being told to lower their lending to home buyers and officials in May revived the idea of a national property tax. The government last year drafted what are known as “three red lines” — debt metrics that developers will have to meet if they want to borrow more.

“China will do what it takes to ease the impact,” said Peter Garnry, head of equity strategy at Saxo Bank. “For China it is about structuring the right communication and make the right plan for how real estate should look like under the new policy direction. When that is done they will move quickly and in great size.”

The central government has shown it can stomach heavy market losses -- whether at tech companies, online tutors or Macau casinos — as officials seek to achieve Xi’s goals of “Common Prosperity.” The plunge in Hong Kong property developers on Monday was fueled in part by speculation China will extend its real estate clampdown to the city, one of the priciest places in the world to buy a home.

“Insisting unchanged policies while the Evergrande overhang persists could trigger more weakness than the government is comfortable with,” Citi analysts led by Dirk Willer wrote. “We will watch market signals, like banks’ CDS, for example, and equity behavior of property and financial sector stocks, to monitor whether this crisis could become more systemic.”

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