Investor Alert

Market Extra

Sept. 25, 2021, 1:21 p.m. EDT

Why investors shouldn’t be too quick to shrug off Evergrande

By William Watts

U.S. stock-market investors appear to have largely put worries over China Evergrande, the Chinese property giant teetering on the brink of default, behind them. But analysts argue that the stakes will remain high as the situation plays out in coming weeks and months.

“The risk posed by the Evergrande crisis is an acid test for the resilience of the post-COVID market recovery,” said Seema Shah, chief strategist at Principal Global Investors, in a Friday note.

Fears of a disorderly default by Evergrande that could threaten the Chinese and global financial system were on display Monday as global equities and other assets perceived as risky tanked, sending the Dow Jones Industrial Average (DOW:DJIA) down more than 600 points, or 1.8%, while the S&P 500 (S&P:SPX) slumped 1.7%. Investors piled into haven assets, including U.S. Treasurys (XTUP:BX:TMUBMUSD10Y) , driving yields sharply lower.

Financial markets soon found their footing, with equities roaring back Wednesday and Thursday, turning major U.S. indexes positive for the week. Worries about Evergrande appeared to ebb as the People’s Bank of China pumped significant liquidity into the financial system.

At the same time, The Wall Street Journal reported earlier this week that the Chinese government had told local authorities to prepare for potential economic repercussions and social unrest that could result from Evergrande’s collapse.

Taken together, those measures have given, market watchers the impression that while Beijing is reluctant to bail out Evergrande, it’s also prepared to take steps to ensure the debt-strapped property behemoth’s woes wouldn’t gum up China’s credit system.

Extra Credit: ‘A different kind of moral hazard’: The history and politics behind the Evergrande debt crisis

That perceived reluctance for a bailout of what’s been described as the world’s most indebed property developer stems from the fact that Beijing in recent years has attempted to rein in excesses in the country’s highly leveraged property sector, including the August 2020 imposition of “three red lines” — limits on leverage by individual property companies. analysts said.

“Given Evergrande’s gobsmacking leverage, the clock has been ticking ever since unless it was believed that China’s regulators would do a pragmatic U-turn at the eleventh hour,” said Christopher Wood, global head of equity strategy at Jefferies, in a note.

Even before those developments, Wood and other Wall Street analysts and economists were quick to dismiss notions that the threat posed by Evergrande could turn into an echo of the 2008 collapse of Lehman Brothers, which set off the chronic phase of the global financial crisis.

Read: Will Evergrande be China’s ‘Lehman moment’? Wall Street says no

But many of those same experts have noted that a number of unknowns continue to surround Evergrande, including exactly how Beijing plans to manage a widely expected default.

The Wall Street Journal reported that holders of the company’s U.S. dollar bonds hadn’t received an interest payment from the property giant by Thursday’s deadline. Evergrande was due to make $83.5 million in coupon payments. The company has a 30-day grace period, after which it could be formally declared to be in default.

If that happens, it would mark the largest ever dollar-bond default by an Asian company, according to the Journal.

So what can Beijing do?

“The Chinese central government could let Evergrande fall, but we think it will likely attempt to ring fence the effects on the country’s financial sector to avoid a broader crisis,” wrote analysts at Danske Bank, in a Friday note.

Danske Chief Market Analyst Alan von Mehren earlier this week noted that Evergande has $669 million in coupon payments remaining this year. A default could trigger further volatility in Chinese markets with some spillover to global markets, he said, arguing that some sort of “circuit breaker” would be needed to keep investors calm and halt a negative spiral.

Von Mehren described one scenario in which Evergrande ends up in bankruptcy, with the government then ordering state banks to buy high-yield bonds in the market and as well as freshly issued bonds from other developers in an effort to keep the crisis from spreading across the property sector.

Also, state banks could lend developers enough money to keep others from defaulting, he said, while a cut in the reserve-requirement ratio by the PBOC would add liquidity to the financial system allowing banks to buy more bonds, he explained.

Shah, at Principal Global Investors, noted that Chinese regulators have experience in containing risk posed by troubled insittutions, but said short-term volatility should be expected, at least until the Chinese Golden Week holiday that begins Oct. 1. Meanwhile, international investors were likely to sit on the sidelines and take a more risk-off approach to China and the wider Asian economy, waiting for attractive re-entry points.

“If bondholders are forced to the table to discuss a restructuring, all eyes will be on the way in which the discussions are conducted as they will serve as a window into the extent of China’s efficiency as an international capital market,” she said.

Link to MarketWatch's Slice.