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As the world’s largest emerging market, China is always on our radar. However, the recent news of property developer China Evergrande Group has prompted fear in the markets over contagion. Here’s what our Emerging Markets team is saying about the current situation.
Q: Have you seen contagion yet?
Very limited to date. Evergrande has sold off from 80 to 25c while other HY property names have moved roughly 80 to 60c, and high quality investment grade Chinese names have fallen roughly 2c. Outside of China signs of contagion have been even more difficult to see. (Exhibit 1).
Exhibit 1: China HY spreads have widened dramatically, but EMD assets have been minimally impacted.
Source: Bloomberg. As of September 30, 2021.
Q: Evergrande has been likened to China’s Lehman moment—some even speculating it is far worse. Do we expect the Evergrande situation to cause broad-based contagion?
Simply, no. We do not expect any broad exceptional risk events related to Evergrande. We do, however, expect Evergrande to restructure its debts. A recent People’s Bank of China (PBOC) stress test examined the impact of property development related loan losses (nonperforming loans (NPL) are up by 15 percentage points) across the entire banking system and found limited systemwide impact (capital adequacy ratio (CAR) moving from 12.3% to 14.4%). We believe the Chinese Central government has extensive resources and desire to ensure the stress to Evergrande and the creditors in its immediate sphere is contained.
Q: Are Evergrande problems symptoms of bigger issues?
The central government of China has designed this outcome by regulatory action and specifically through the imposition of the “three red lines” to force a deleveraging within the property development sector. We know that real estate, and fixed asset investment in general, became such an outsized portion of the Chinese economy and resulted in a broad misallocation of capital away from more desirable and productive enterprises. Additionally, several enterprises operating in this sector became highly leveraged. Leaving such fragility in an oversized economic segment was undesirable to economic planners.
The Chinese government seeks financial stability and the regulatory burden that helped cause Evergrande’s downfall now was designed to eliminate a true systemic crisis had the size of any future defaults proved larger than the government's resources.
What this likely means is that attempts to reverse GDP growth declines below the annual targeted rate will no longer direct credit toward the real estate sector as a means of fiscal stimulus. We expect China’s GDP growth to be modestly more volatile around a lower target rate.
Q: What can you tell us about other companies operating in the same industry as Evergrande? Has your outlook for the industry changed as a result of recent Evergrande developments?
We believe the property development industry will likely see moderate sales declines and lower profit margins in the near term as the regulatory burden will likely stay unchanged despite an Evergrande’s debt restructuring. While we will probably see some localized relaxation of mortgage approvals and land auctions, no broad and centralized policy changes are expected given the government’s priorities to reduce the high debt levels in the industry. We thus expect more debt restructurings in the industry as there are still many small and medium-sized developers with unsustainable debt levels. We also expect further industry consolidation led by large developers with adequate balance sheets and state-owned enterprises.
It is worth highlighting that the Chinese government is facing a difficult challenge in engineering an orderly deleveraging of the industry. Its policies are likely to have unintended consequences that could cause lasting damage to the real estate industry, particularly in small cities and suburban areas. China’s property development industry is largely driven by investment demand, as urbanization trends and population growth have slowed down. In fact, China’s home ownership rate is among the highest in the world and it is estimated at over 90% of households, according to Peking University. Any damage to homebuyers’ confidence, either through undelivered properties or through sustained home price declines could be difficult to reverse and put the property development industry in a challenging position.
Q: What are you watching to tell if today’s Evergrande-specific issues spill-over to broader markets?
The two primary signals of contagion and broadening of market stress beyond the Evergrande and the Chinese property sector are: 1) excessive deviations in credit spreads on high quality property developers, 2) excessive deviations in credit spreads of large systemic banks, and 3) signs of material currency intervention by the PBOC. To date, we have seen no noticeable signs of contagion.
This material is provided by Aegon Asset Management (Aegon AM) as general information and is intended exclusively for institutional and wholesale investors, as well as professional clients (as defined by local laws and regulation) and other Aegon AM stakeholders.
This document is for informational purposes only in connection with the marketing and advertising of products and services, and is not investment research, advice or a recommendation. It shall not constitute an offer to sell or the solicitation to buy any investment nor shall any offer of products or services be made to any person in any jurisdiction where unlawful or unauthorized. Any opinions, estimates, or forecasts expressed are the current views of the author(s) at the time of publication and are subject to change without notice. The research taken into account in this document may or may not have been used for or be consistent with all Aegon Asset Management investment strategies. References to securities, asset classes and financial markets are included for illustrative purposes only and should not be relied upon to assist or inform the making of any investment decisions. It has not been prepared in accordance with any legal requirements designed to promote the independence of investment research, and may have been acted upon by Aegon AM and Aegon AM staff for their own purposes.
The information contained in this material does not take into account any investor's investment objectives, particular needs, or financial situation. It should not be considered a comprehensive statement on any matter and should not be relied upon as such. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to any particular investor. Reliance upon information in this material is at the sole discretion of the recipient. Investors should consult their investment professional prior to making an investment decision. Aegon Asset Management is under no obligation, expressed or implied, to update the information contained herein. Neither Aegon Asset Management nor any of its affiliated entities are undertaking to provide impartial investment advice or give advice in a fiduciary capacity for purposes of any applicable US federal or state law or regulation. By receiving this communication, you agree with the intended purpose described above.
Past performance is not a guide to future performance. This document contains "forward-looking statements" which are based on Aegon AM's beliefs, as well as on a number of assumptions concerning future events, based on information currently available. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance, and actual outcomes and returns may differ materially from statements set forth herein.
The following Aegon affiliates are collectively referred to herein as Aegon Asset Management: Aegon USA Investment Management, LLC (Aegon AM US), Aegon USA Realty Advisors, LLC (Aegon RA), Aegon Asset Management UK plc (Aegon AM UK), and Aegon Investment Management B.V. (Aegon AM NL). Each of these Aegon Asset Management entities is a wholly owned subsidiary of Aegon N.V. In addition, the following wholly or partially owned affiliates may also conduct certain business activities under the Aegon Asset Management brand: Aegon Asset Management (Asia) Limited (Aegon AM Asia). Aegon Private Fund Management (Shanghai) Co., Ltd (Aegon AM Shanghai).
Aegon AM UK is authorised and regulated by the Financial Conduct Authority (FRN: 144267) and is additionally a registered investment adviser with the United States (US) Securities and Exchange Commission (SEC). Aegon AM US and Aegon RA are both US SEC registered investment advisers. Aegon AM US is also registered as a Commodity Trading Advisor (CTA) with the Commodity Figures Trading Commission (CFTC) and is a member of the National Futures Association (NFA). Aegon AM NL is registered with the Netherlands Authority for the Financial Markets as a licensed fund management company and on the basis of its fund management license is also authorized to provide individual portfolio management and advisory services in certain jurisdictions. Aegon AM NL has also entered into a participating affiliate arrangement with Aegon AM US. Aegon AM Shanghai is registered as a Private Fund Manager with the Asset Management Association of China to manage or distribute the private investment fund products to qualified investors in Mainland China.
Jeff Grills, CFAHead of US Cross Markets and Emerging Markets Debt
Jeff Grills, CFA, is head of US cross markets and emerging markets debt responsible for the oversight of the fixed income teams for emerging markets debt, US centralized trading and quantitative solutions.