The consensus that Evergrande’s default will not create a Lehman-style systemic disaster is now well established.
Evergrande’s debts of just over $300 billion are less than half the $619 billion that Lehman owed when it filed for bankruptcy in September 2008, and the Chinese property firm is not an important trading counterpart for systemically important financial institutions.
That should give Chinese authorities time to undertake the laborious task of winding down Evergrande.
A steady drip of liquidity from the People’s Bank of China in the approach to a national holiday at the beginning of October indicated that the central bank was determined to hold down interbank rates and calm fears of contagion to the banking system.
China is pushing state-backed firms to buy Evergrande assets and encouraging banks to support the housing market, which also eased concerns.
A belief that Chinese policymakers will do whatever it takes to prevent a disorderly unwind of Evergrande exposure has led many to feel that a better comparison would be with the failure of US hedge fund LTCM in 1998.
LTCM’s bailout was handled smoothly, but may have given false confidence to market participants about the ability of US supervisors to handle crises.
A sense of relief that the fallout may be contained should not be used as an excuse to neglect the work that still needs to be done
The Federal Reserve coordinated an unwinding of the positions held by LTCM, which owed around $125 billion on equity of less than $5 billion, for a leverage ratio of over 25 to one.
This was effectively a rescue mission for LTCM’s Wall Street trading counterparties, many of which had placed similar bets on interest-rate convergence via derivatives trades.
LTCM had notional interest-rate derivatives exposure of over $1 trillion when it failed, and it had also moved into equity derivatives trading, as well as merger arbitrage.
The unwind was complex but proceeded with no big problems. Losses were around $4.6 billion, which wiped out the firm’s capital; and ancillary costs to dealers were mostly shared between the big banks.
UBS was an outlier from this shared pain with a SFr950 million ($1.02 billion) loss from a structured investment in LTCM that prompted the resignation of chairman Mathis Cabiallavetta.
UBS seems likely to feature again in the roll call of casualties from the most recent market upset, as it is a holder of Evergrande bonds.
Morningstar said in a report on September 24 that UBS had around $283 million of exposure to Evergrande debt, based on filing data from the end of August.
Even if all this debt was retained and an Evergrande workout involved a recovery rate of around the 25 cents in the dollar where some bonds were trading in late September, UBS would still only face a loss of around $200 million.
And it could be expected to work alongside other Evergrande debt holders such as Ashmore, BlackRock, BlueBay and Fidelity to ensure that a recovery is as high as possible.
So, the direct hit for non-Chinese holders of Evergrande debt seems likely to be manageable, even if the firm’s $20 billion of offshore debt is at the end of the queue for repayment.
Temporary pullback
A temporary pullback from foreign investment in Chinese companies seems inevitable as investors digest the Evergrande failure and the implications of more aggressive regulation – especially for the technology sector that has been the engine of growth in recent years.
But the sheer size of the Chinese economy and appetite for higher returns by global investors is likely to ensure that this pull back does not last long.
A poll by Invesco of 200 global asset managers that was released at the end of September showed limited concern about future risks in China.
The survey found that 86% of respondents said their investments in China had either grown or stayed the same over the last 12 months, with 64% expecting further increases in the next year and only 12% expecting a reduction.
That marked less of a consensus on greater investment in China than the result of a similar study from 2019, but it certainly didn’t show much concern about the “rude awakening” that George Soros has warned is awaiting foreign investors in the country.
Asset managers can make their own decisions on which Chinese investments offer a degree of security from regulatory change.
Cathie Wood, the founder of the Ark Invest, has recommended shares in companies that seem to be making an effort to ingratiate themselves with Chinese authorities, for example.
That sounds like a worthy aim, but it is extremely difficult for outsiders to gauge the standing of any single chief executive with political leaders in Beijing, as the underwriters of the abandoned Ant Group $35 billion IPO can testify.
Exposure challenges
Investors and bankers should also be aware of the challenges in hedging exposure to China.
Derivatives growth in the country has been hampered by the lack of legally enforceable close-out netting of contracts. Foreign investors trying to understand Evergrande’s exposure via various subsidiaries and loans might be grateful that it does not seem to have an extra layer of derivatives liabilities to confuse matters even further.
LTCM’s derivatives book of over $1 trillion was unwound relatively smoothly, but Lehman had more than a million derivatives contracts outstanding with a notional value of around $39 trillion when it failed in 2008, which led to a decade of legal disputes with counterparts.
Evergrande’s creditors may have dodged a derivatives bullet, but investors who would like to hedge their exposure to Chinese companies cannot currently use the full financial toolkit.
In April, China published a draft futures law for consultation that appeared to recognise the enforceability of netting for over-the-counter derivatives.
There has been no progress since, however, which is extending the wait for legal certainty.
China has the second largest onshore bond market in the world – after the US – at roughly $15 trillion of debt, with corporate credit accounting for roughly $5.8 trillion of this total, according to a report issued by the International Capital Market Association (Icma) at the start of this year.
Both corporate and sovereign Chinese bonds offer substantially higher yields than US debt – and returns that are normally at least 3% above low-yielding European and Japanese bonds.
Liquidity remains constrained by a lack of hedging options, however, among other factors. There is no credit derivatives market to hedge single-name corporate risk, for example, which may have limited the appetite from hedge funds to take positions in Evergrande debt as it slumped over the last month.
Liquidity is better in the offshore markets for Chinese debt, but the early days of the Evergrande unwind are providing a reminder that these bonds are not a priority for authorities in Beijing when problems with a borrower arise.
The Evergrande crisis is bringing renewed attention to the opaque nature of many aspects of the Chinese economy, along with some confidence that supervisors will ensure systemic stability.
A sense of relief that the fallout from Evergrande’s failure may be contained should not be used by foreign investors and bankers as an excuse to neglect the work that still needs to be done to improve the hedging of Chinese exposure.
