Contagion

Price has become impulsive today in Hong Kong and in other assets levered to activity in Chinese real estate such as the Australian miners. The good news is that the rapid and emotional price action suggests that a significant capitulation in beliefs is underway. The market is pricing the spill overs and second order effects from the property tightening and the Evergrande debacle.

Of course, as we have noted for some time, the contagion and potential risk has been evident for several months if not years. There are two parts to this. First, China has been attempting to reduce leverage in the real estate sector for some time. If left unchecked, the increase in private sector leverage, especially in the real estate sector, would likely have contributed to a systemic crisis at some point. Indeed, some analysts would argue that it is already too late. As we noted last week, China’s private sector credit has surpassed 220% of GDP which is comparable to other historical episodes in other countries. A critical point is that a significant proportion of private sector leverage is related to real estate (directly or indirectly) where there is also material upstream and downstream linkages. Real estate provides a material contribution to GDP and employment. The good news is that most of the debt is held domestically and there has not been spill over into the currency (so far).

Second, the cyclical pressure has emanated from a slow down in the rate of credit growth. This pressure has been evident since November last year and is similar to other slowdown phases over the past decade or more (e.g. 2012, 2015 and 2018) and coincided with other “growth scares” in China. The good news is that process is well advanced as the credit impulse is already near trough levels (chart 1). As an aside, these cyclical episodes also tended to coincide with expectations of Fed tapering, rate hikes or tightening in US dollar liquidity. The good news on that front is that we ought to have some clarity after the September FOMC this week. It is also important to note that the current slowdown in China has been exacerbated by other regulatory pressure in China. On the positive side, that is also well appreciated with around three quarters of Hong Kong listed China already affected in some way.

Returning to the issue of leverage in the property sector and the linkages, the structural challenge is that a large proportion of the sector is highly levered. Around 60% of the China High Yield market is in real estate and 40% of the broader Asian high yield market. The sector was able to sustain that leverage while asset prices were rising. A common practice of these construction companies was to bid land prices significantly higher than the underlying fundamental value. That didn’t impact them in a rising market because the risk was transferred to the apartment buyers and the banks (or wealth management products) that financed the purchase. Evergrande excelled at this practice. The process also worked for local governments, households and banks while the asset prices were rising. Local governments benefited from increase in GDP or activity. However, this contributed to a self-reinforcing cycle of dependence on construction, leverage and a misallocation of capital in unproductive assets. It is also no longer compatible with the CCP’s goals of rebalancing the economy. That is also partly linked to the regulatory crackdown.

The risk stemming from this episode is rapidly being priced in the directly affected assets and spill over into assets leveraged to China real estate. Asian and China high yield is already trading at distressed levels and commodities like iron ore and the miners are down by around 50% from the recent peak (chart 2). The panic and impulsive today suggests that a capitulation in correlated beliefs is well underway. While we would not argue that the episode is entirely priced, the process is well underway.

A big picture concern might be that in contrast to the episode in 2015, actual default by Evergrande and other developers could lead to a more sustained and deeper slowdown in China activity, particularly related to construction, but also retail sales and employment. Put another way, the episode might have moved beyond the ability of policy makers to resolve by simply injecting more liquidity. For equities, we also fear that while there has been a considerable valuation de-rating in EM and Asia, the multiple is still elevated relative to the growth scare in 2012, 2015 and 2018. That is especially true in the United States where the market also has to contemplate Fed liquidity withdrawal as well.