What’s going on with China Evergrande Group?
Authored by RSM US LLP
It’s been anything but smooth sailing this year for Chinese stocks. A series of regulatory overhauls that began in earnest last November tightened government control across a swath of industries. The moves stemmed from president Xi Jinping’s publicly stated goal of “common prosperity” — not-so code for communist wealth redistribution.
One key regulatory change directed at the real estate market, which was intended to mitigate systemic risk to the financial system (dubbed the “three red lines”) sets limits on the amount of leverage firms are permitted to employ. China Evergrande Group, one of the country’s largest real-estate development firms and the most heavily indebted publicly traded real-estate development or management company in the world1, breached all three. Consequently, it was restricted from tapping the financial markets for liquidity, its major source of funding.
Its cash crunch was no doubt accelerated by the COVID-19 pandemic, which hindered property sales for months and therefore choked off much-needed cash flows to service the company’s sizeable debt. Still, while headlines surrounding the Evergrande crisis have taken center stage in the lead-up to debt payments coming due this week and provided a ready excuse for global stocks to take breather from their record climb so far this year, its parlous financial condition was well-known. Its stock price began its decent more than a year ago (freefalling to near zero over the past couple months), while its bonds were quoted at around about one-quarter of their par value, clear indications that the market was aware of the gathering storm.
On Wednesday, China Evergrande’s main onshore unit said in a filing that an interest payment on a key yuan-denominated bond “has been resolved via negotiations off the clearing house.” Payments on offshore, dollar-denominated debt are also being prioritized by the firm in a bid to stave off bankruptcy. While the immediate default crisis appears to have ebbed, at least temporarily, there is still uncertainty. Though few, if any, credibly view the situation as comparable to Lehman Brothers collapse in 2008, the possible fallout has investors assessing the potential knock-on effects given not only the company’s footprint in China’s real estate market, but the various other industries into which it expanded in recent years, particularly wealth management products (another avenue by which it generated cash flow to support its primary business).
As shown in the chart, the ongoing ambiguity surrounding China’s regulatory environment, now compounded by fears of potential Evergrande-born contagion, has dragged on the performance of the broader MSCI Emerging Markets Index. We believe concerns about the broader impact of an Evergrande Group implosion — should it occur — are not misplaced, though they are perhaps overdone. What happens in China is likely to stay (mostly) in China. According to Fitch Ratings, a default by Evergrande could expose many other sectors to heightened credit risk, though it expects fallout in the banking sector to be manageable2. S&P Global Ratings said an Evergrande default “will neither lead to a tidal wave of defaults nor mere ripples from a pebble in a pond but something between the two3.”
Ultimately, the circumstances suggest China’s government might be inclined to let market forces come to bear on Evergrande and its subsidiaries. However, it has already taken steps to support the broader financial system and reassure market participants. Per Barron’s, “The People’s Bank of China also pumped a further 120 billion yuan ($18.6 billion) into the banking system, easing investors’ nerves. Add to that reports that Chinese authorities are preparing the groundwork for a potential restructuring and it seems Wall Street may be right that this isn’t another Lehman Brothers moment4.” The company is, after all, not a state-owned enterprise; and the situation was accelerated, if not brought on, by new government-imposed regulations. Either way, we expect officials to take any necessary steps to maintain investor confidence and the integrity of its financial system. As for long-term U.S. investors, we view this as a potential buying opportunity, though the situation is likely to drag out with volatility along the way. Accordingly, we recommend a dollar-cost-averaging approach.
1 S&P Global Market Intelligence
This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services. This document does not constitute audit, tax, consulting, business, financial, investment, insurance, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein. Information has been obtained from a variety of sources believed to be reliable though not independently verified. RSM US LLP, its affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person. Internal Revenue Service rules require us to inform you that this communication may be deemed a solicitation to provide tax services. This communication is being sent to individuals who have subscribed to receive it or who we believe would have an interest in the topics discussed. Past performance does not indicate future performance. The sole purpose of this document is to inform, and it is not intended to be an offer or solicitation to purchase or sell any security, or investment or service. Investments mentioned in this document may not be suitable for investors. Before making any investment, each investor should carefully consider the risks associated with the investment and make a determination based on the investor’s own particular circumstances, that the investment is consistent with the investor’s investment objectives.
Tax and accounting services are provided by RSM US LLP, a registered CPA firm. Investment advisory, aggregated reporting, financial planning, retirement plan advisory and other wealth management services are provided by RSM US Wealth Management LLC, an investment advisor registered with the U.S. Securities and Exchange Commission (SEC) and wholly owned subsidiary of RSM US LLP. Registration as an investment advisor does not imply any skillset of the wealth manager and/or its advisors.
RSM US LLP is a limited liability partnership and the U.S. member firm of RSM International, a global network of independent audit, tax and consulting firms. The member firms of RSM International collaborate to provide services to global clients, but are separate and distinct legal entities that cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International.RSM, the RSM logo and the power of being understood are registered trademarks of RSM International Association.
© 2021 RSM US LLP. All Rights Reserved.
Call us at (800) 627-0636 or fill out the form below and we'll contact you to discuss your specific situation.
This article was written by Derek Vasko, CFA and originally appeared on 2021-09-24.
2021 RSM US LLP. All rights reserved.
The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.
RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.
Lewis, Hooper & Dick, LLC is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.
Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise and technical resources.
For more information on how Lewis, Hooper & Dick, LLC can assist you, please call 1-800-627-0636.