The plight of Evergrande, one of China’s biggest property developers, remains front of mind for investors globally.
With the equivalent of $US300 billion in liabilities and an opaque financing structure, it is an immensely uncertain situation that will surely see some market participants incur significant losses. Fears that smaller developers are running into their own troubles has only increased the drama.
However, for China’s ‘real’ economy, even a breakup of Evergrande will prove an insignificant, temporary negative – minimising the risk of a flow-on hit to Australia’s economic prospects.
The principal reason is that the structure of Evergrande allows for the parent’s construction subsidiaries to be individually sold or allocated to other developers for completion without the burden of the parent’s liabilities.
It is also worth keeping in mind that, at the best of times, Evergrande only made up 5 per cent of national new home sales, so its production should be easily absorbed by the rest of the industry.
However, the financial outcomes achieved by its stakeholders will differ wildly, with the Chinese Communist Party’s reform priorities key.
In terms of individuals, given each subsidiary’s project finance and workforce is independent, households who have purchased off the plan – and the workers and suppliers involved in construction – can be made whole, likely with limited delays.
But in keeping with authorities’ “common prosperity” ambition and to insulate China’s economy, payments to Evergrande’s investors are likely to be made according to their sophistication (from least to most), as well as their position in the capital structure.
Foreign currency bondholders and equity investors will be last in line.
Importantly for China’s outlook, we do not believe there will be a sustained effect on investor appetite for the economy or the property sector, as investing in debt in the space is known as a high-risk pursuit. Note as well that the catalyst for Evergrande’s current situation is sectoral reform – to reduce debt and improve profitability.
And as we’ve seen time and time again, the ability of Chinese authorities to ease stress in markets is second to none.
It may surprise, but the power outages seen in recent weeks are arguably a greater risk for GDP than Evergrande’s plight.
An already stretched supply chain trying to heal from the pandemic is now facing the threat of intermittent, multi-day outages because the economy has run down existing stockpiles of coal during the recovery and the abnormally high spot price is now making power generation uneconomic. China’s position on Australian coal and their long-term ambition to transition away from high-emission power and industry has amplified the issue.
If disruptions are only seen a few times, production will easily catch up. But, if the outages persist, production and GDP could suffer a material hit.
Signalling this situation is a real threat, China’s official Purchasing Manager's Index – a widely used metric for activity – fell to a contractionary reading of 49.6 in September.
Clearly, though, we can’t just consider the negatives.
Chief among the potential offsets is China’s services sector, where there is significant pent-up demand following a period of restrictions to stamp out the threat posed by the delta variant of COVID-19.
Importantly, in September, the services PMI jumped almost 6 points to an expansionary read of 53.2.
These data outcomes suggest to us it is best to have faith in China’s economic development and the capacity of their authorities to resolve concerns quickly.
It seems foreign exchange markets hold a similar view, with the peak for USD/CNY in the past month only 2 per cent higher than its 52-week low. Even without a clear path forward for Evergrande, more than half that loss has already been re-couped by the Renminbi in the past fortnight as investors waded back in.
We therefore see good cause to hold onto our China GDP forecasts for 2021 and 2022 of 8.5 per cent and 5.7 per cent, respectively. Yesterday’s data showing GDP in the third quarter of 0.2 per cent, slowing annual growth from 7.9 per cent to 4.9 per cent, was consistent with our expectations.
The above forecast, if realised, holds considerable promise for Australia in 2022 and 2023.
Continued robust growth in residential and business investment in China will support demand for Australian iron ore over the period, albeit at a price level a little lower than today if we are right in anticipating an increase in ore supply.
But tight global supply of energy commodities, such as thermal coal and gas, will provide additional support for our national income and the Australian dollar. As Australia’s interstate, then international, re-opening also proves successful, our dollar is expected to carry on through US75 cents at year end to US77c by mid-2022 and US80c by mid-2023.
As always, risks abound.
The most significant is trade and political tensions with China, which are currently limiting Australia’s upside from coal exports and, in time, could also materially affect the recovery in tourism and education.
Secondly, it will be important to continue to monitor the evolution of COVID-19, with additional large-scale outbreaks and disruptions a risk in areas of the world where vaccination rates remain low.
However, when the Evergrande story ultimately ends, it’s more likely to be a volatile, isolated event than China’s “Lehman Brothers” moment as some feared.
But the far-reaching implications of the underlying structural reform for the sector and the economy overall give cause to remain attentive to developments.
The information in this article is general information only, it does not constitute any recommendation or advice; it has been prepared without taking into account your personal objectives, financial situation or needs and you should consider its appropriateness with regard to these factors before acting on it. Any taxation position described is a general statement and should only be used as a guide. It does not constitute tax advice and is based on current tax laws and our interpretation. Your individual situation may differ and you should seek independent professional tax advice. You should also consider obtaining personalised advice from a professional financial adviser before making any financial decisions in relation to the matters discussed.