The media is having a field day with Evergrande's 300-billion dollar debt overhang. Bull markets and easy access to debt will inevitably lead to the unproductive extension of credit and this has been China’s cocktail for quite some time. Market participants have been discussing China's debt problems for years as their GDP has slowed while their debt levels have rapidly risen- not the best combination. These facts assisted with troubling anecdotes of overbuilding, property bubbles and ghost towns have led the media to purport that the day of reckoning is near and that Evergrande could be the next Lehman Brothers. There are many reasons to believe that China will have to contend with a wave of bad debts and strain on their financial system but to compare this to the level of contagion triggered by Lehman really misses the mark. It is our belief that disruptions in Chinese credit markets will create volatility but will not lead to contagion. Market participants will likely benefit from buying the dip and staying invested.
Lack of Global Interconnectivity
Yes, Evergrande’s debt levels are eye wateringly large. “Too big to fail” comes to mind but it’s important to realize that this widely reporting saying can be misleading. Ben Bernanke claimed that it wasn’t size that is the determining factor when it comes to the risk of contagion, but financial interconnectedness. Bear Sterns and Lehman Brothers were not too big to fail, “they were too interconnected to fail” to quote Bernanke. The US financial markets are the deepest and most globally interconnected in the world. Large financial institutions have direct and indirect linkages with the global financial network through a host of credit exposures, trading links, contractual obligations and other dependencies. Using an analogy that is not at all meant to be disparaging to China but purely instructive, comparing the level of global integration of US banks versus the level of global integration of Chines banks is like comparing modern-day artillery to a musket. China has restricted its economy and financial markets to global investment and competition. Its financial markets are one-dimensional and underdeveloped. Furthermore, Evergrande is hardly a financial institution- it is a property development firm. Yes, a default will put a strain on Chinese financial counterparties but this strain will not spread through linkages of the global financial system. Unlike Lehman, the risk of contagion in the global financial system is greatly mitigated by China’s lack of a globally integrated and fully developed financial system.
Who are Evergrande’s Creditors?
The majority of Evergrande’s creditors are Chinese SOEs banks or banks with strong ties to SOEs and the debt is denominated in Yuan. These banks effectively act as agents of the Chinese Communist Party (CCP) and will do whatever Beijing tells them to do. US investors have to separate what “default” means if Evergrande was a US company versus what “default” means for Evergrande as a Chinese company. Fortunately for Evergrande, “default” when SOEs are your creditor is not a terrible scenario- no fire sales of assets or knee-jerk layoffs needed. Given the size of Evergrande, we suspect more loan extensions and restructurings are right around the corner.
Will Beijing come to the rescue if needed?
We believe the CCP will always do what is in the best interest of the Party and we believe they seek economic stability. Without economic stability, the likelihood of social unrest is high - the CCP would like to retain their power and avoid unnecessary economic malaise at all costs. In short, if there are fiscal or monetary counteractions available, we believe the CCP will use them. China has deep pockets and leaders that can act decisively. Ones that are not burdened by a system of checks and balances and the arduous passing of legislation. This lack of restraint enables very quick action if a flashpoint were to arise. This ability is another factor that limits contagion risk. China's number one goal is economic stability, and its leaders are learned students of American Crises. They have the ability and willingness to step in quickly to resolve issues where needed. We believe that the CCP will do whatever is in its power to ensure that troubles in its financial system do not metastasize to the broader Chinese economy.
Evergrande’s debt being denominated in Yuan, the CCP standing ready to defend its economy, and the lack of interconnectedness of Chinese financial institutions leads us to believe that the risk of contagion is low. Yes, there could be forced selling by some investors that causes price volatility in other assets but a fundamental linkage is not something that we have observed. At some level peeling back the layers of counterparties can feel like a never ending Matryoshka doll. Because of the limits of our analysis, we will monitor the situation closely as it develops and more importantly keep an eye on the health of non-Chinese financial companies. For example, if a bank in Iceland goes under because of its linkage to China we will have to strongly re-evaluate our thesis. Until then, we will be buying on the dip.