Evergrande Update 2: Is The Contagion Spreading?
Evergrande is back in the headlines after a few weeks out of the media spotlight, with scrutiny being shifted to fellow developer Kaisa instead. Unfortunately, the period of calm seems to have ended, with Evergrande reported to have finally failed to make coupon payments at the end of a 30 day grace period. How are markets currently pricing the potential for widespread contagion?
In addition to Evergrande seemingly crossing the rubicon into formal default and some kind of debt restructuring, the People’s Bank of China (PBoC) has also cut the required reserve ratio for most banks by 50 basis points. This loosening of monetary policy reflects two realities, that the Chinese government is becoming more concerned about the spillover effects from the country’s ailing property sector; and that policymakers have now begun to take more strident measures in an effort to mitigate broader economic contagion. (Prior to this, government intervention was focused on getting banks to keep extending housing related credit)
USD bonds of Chinese developers have certainly been affected by the latest turn in events, with prices now falling after a short lived bounce in November.
This move lower is mirrored in the broader Chinese fixed income market, which also bounced in November, but is back to moving down. Note that this fund’s largest holdings are long dated debt of Chinese banks, which makes it somewhat of a proxy for how the Evergrande contagion is affecting the domestic banking sector.
However, short term rates for Chinese bank debt are still holding steady, demonstrating that the Evergrande contagion has yet to hit the banking sector in vital short term funding markets. If it does, and short term borrowing rates for banks spike, it would be a clear warning sign of the contagion beginning to spark a domestic financial crisis, which of course would herald a whole new set of problems for the Chinese and global economy.
The CNY also continues to trade firmly against the Dollar, even though the Dollar has been rallying broadly. This indicates that the Evergrande saga remains within China for now, although the incongruence between the CNY and other currencies’ performance vs the USD is concerning, and does hint at CNY weakness ahead. Should this weakness materialize, it will be a warning that the contagion has begun to go global via Dollar funding markets.
As such, the situation remains pretty much the same as it was when we wrote our first update, with the contagion broadly limited to the real estate sector and long term debt of Chinese banks. Also, short term bank funding markets have yet to be impacted in a major way, and the CNY refuses to weaken against the USD.
It is important to note however, that global economic conditions are starting to deteriorate quite rapidly, and China, with its outsized importance to global production and growth, is not only part of the cause, but also susceptible to its effects. Given this, it would be prudent to not call an end to the Evergrande saga yet; the more strident action of the Chinese government certainly reflects this reality.
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