The Evergrande crisis will have unavoidable knock-on effects as China accounts for a large portion of global growth but Beijing’s commitment to reducing high leverage in China’s corporate sector should not trigger wider financial instability.
Scope Ratings says the impact on European banks should be limited, though UK banks account for more than a quarter of foreign bank claims on Chinese residents.
“The expected default of the Evergrande Group is a reflection of China’s deliberate attempts to enhance financial-sector discipline,” says Eiko Sievert, Director at Scope Ratings. “While the possibility of an escalation into a widespread credit crisis cannot be excluded, we consider such a severe form of contagion unlikely at this stage. The international fallout should therefore be contained beyond the impact of less vibrant Chinese growth on the global economy.”
As China’s growth will account for nearly a third of global growth this year, the impact of Evergrande will filter through to activity in Europe and the US where trade links are the strongest, in addition to weighing down on global investor sentiment and heightening market volatility.
Weakness in the Chinese property sector has already curbed domestic economic activity this year. Scope revised down its growth expectation for China to 8.6% for 2021 from an earlier projection of 9.3%.
Beijing’s attempt to deflate domestic credit and asset bubbles is unlikely to be smooth. The approach toward Evergrande is consistent with efforts to force deleveraging in the sector and more defaults are likely to follow.
Chinese real-estate companies have tapped the public US dollar bond market for USD 274bn in the past five years, according to Bond Radar data. Of that, roughly USD 215bn remains outstanding from roughly 120 companies, predominantly sub-investment grade. Many of the issuers have developed a programmatic borrowing approach so have multiple lines outstanding. Some USD 10bn falls due between now and the end of the year and roughly USD 50bn in 2022.
Chinese banks, insurance companies and bond funds have provided significant funding in recent years and Chinese banks’ large exposure to the property sector is among the more significant risks facing the Chinese financial system. In response to the evolving crisis, some banks have started to increase loan loss provisions while others are prepared to roll-over existing loans.
The heavy bias towards Chinese banks and securities firms in underwriting groups suggests limited exposure by international investors in aggregate to Chinese US dollar-denominated real estate debt. Indeed, initial placement data where this was made available at the time of issuance mainly shows single-digit percentages of order books allocated to EMEA/US accounts; the majority being parked with Chinese financial institutions.
“The effect on European banks is likely to be limited as they appear to have only small exposures to Chinese property developers, certainly relative to aggregate assets,” says Dierk Brandenburg, head of financial institutions ratings.
“However, next to higher credit loss charges there will be further negative spillovers through the banks’ Asian capital markets operations, asset management and private banking, as well as from lending to property-related sectors, such as materials,” Brandeburg says. “These will impact the P&L of Europe’s globally active banks in the coming quarters as could the ensuing regulatory crackdown by Chinese authorities.” According to the BIS, UK banks are most exposed, accounting for 27% of the USD 917bn foreign bank claims on Chinese residents as of Q1 2021.
The prospect of bailouts from local governments or regulators has generally been factored into credit risk assessments. “The recent policy changes and a higher tolerance for corporate defaults by the authorities are now forcing investors and lenders to re-assess credit risk on their existing loan books,” says Sievert.
To tackle the moral hazard risk in the real estate sector, the authorities are likely to tolerate a market correction provided there are no clear signals of more widespread systemic risk. However, the large off-balance sheet exposures, often involving a range of non-bank financial institutions, increases uncertainty about how any shock will spread through the wider financial system. If liquidity shortages in developers lead to widespread fire-sale dynamics, the resulting financial distress becomes increasingly difficult to contain.
“Chinese authorities will have to tread carefully between reducing indebtedness among highly leveraged developers, which is likely to include further managed defaults, and avoiding the hard landing they are aiming to prevent,” says Sievert. “If managed successfully, China’s efforts to reduce excessive leverage and moral hazard can help to stabilise the financial system. Indeed, the transition of the Chinese financial system supported a revision of the sovereign credit Outlook of China to Stable, from Negative, in July.”