Evergrande Update 1: Is The Contagion Spreading?
Over the past three weeks or so, Evergrande has, after missing initial deadlines, managed to meet interest payments on its debt within the 30 day grace period. As such, it has so far managed to avoid a formal default. However, as headlines over the past few days attest, the contagion, initially contained within the real estate sector, has begun to spread to other parts of the Chinese markets.
USD based bonds of Chinese property companies have borne the brunt of the selling, as illustrated below. Bear in mind that both the index and ETF performance shown are of large developers, including some who have been in the headlines over the past month (China Vanke, Country Garden, Sunac). The year-to-date (YTD) performance of almost -40% says it all.
The broader Chinese fixed income market has begun to suffer as well, as shown by the net asset value (NAV) of Blackrock’s China Bond Fund (hedged), which is down about 10% from its 2021 highs.
The largest holdings in this fund are mainly in the long term debt of Chinese banks, showing how the Evergrande contagion has begun to spread into the domestic banking system, which is the next, and most crucial stage. This is the point where if defaults, fear, and uncertainty continue to spread, the current real estate crisis can quickly metastasize into a domestic financial crisis, and from there spread to the rest of the Chinese economy.
However, short term rates for Chinese bank debt have yet to register any sign of contagion, as the NAV of another Blackrock fund (investing in 6 month to 3 year onshore debt of Chinese policy banks), has actually increased through the end of October and beginning of November.
Should we start to see prices of short duration Chinese bank debt start to plummet (yields rise), it would be a good indication that the Evergrande contagion has begun to morph into a domestic financial crisis – so watch Chinese short term rates very closely.
If they start to rise, or even spike, undercapitalized Chinese banks reliant on short term funding will begin to face the kind of liquidity pressures that can force them to go under, at which point Chinese banks, and not property developers will be dominating the headlines.
That being said, the Evergrande saga remains contained within China for now, as there has yet to be any firm indication of a global USD squeeze. While the Dollar has strengthened against most currencies this year, it hasn’t versus the CNY. As a matter of fact, USDCNY, at the time of writing, is trading around 6.40, which is much closer to its 2021 low (CNY strength) at 6.35, than its high (CNY weakness) at 6.58.
Keep an eye on how USDCNY trades as the Evergrande contagion continues to spread. Should it start to move higher, which can happen very quickly in a crisis, it would be a good indication that the contagion has begun to spread to international Dollar funding markets, and hence global economies.
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