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Asia-Pacific | Equities

China Property Risks Small Relative to Global Capacity to Absorb

Global financial markets were rocked overnight with a highly correlated selloff across the world. Global equities fell about 2.0% with all regions and 10 of 11 sectors negative. US markets closed in the red with S&P 500 down 1.7%, Dow Jones -1.8%, and NASDAQ -2.2%. The catalyst was the well-telegraphed news that Chinese property developer Evergrande would not make loan payments yesterday (Sep 20).


The larger setting of “absent volatility” and heightened macro policy uncertainty seems critical background for Monday’s market actions. The US equity market has not experienced a drop larger than 4% in the year-to-date. Corrections of 5% have occurred 3X on average in annual periods of the past 70 years.


Evergrande’s bonds have fallen precipitously since May, to about 30% of their par value. Shares have fallen all year long. However, suspense over a Federal Reserve meeting on Wednesday (Sep 22), the US fiscal drama, and moderating economic growth have culminated in a round of risk aversion and profit-taking for shorter-term traders.


Evergrande has US$14 billion in external bonds, US$9 billion in onshore bonds and US$66 billion in bank loans, with the majority of this borrowing from domestic Chinese banks. The scope of direct financial losses from an Evergrande default could be easily absorbed by available risk capital and central government resources.


China Macro Policy: Inconsistent with Growth Goals


Evergrande’s woes can be linked directly to Chinese macro policy, including strong restrictions on housing developers. This weakness can now be seen in a severe erosion of financial conditions for most of the nation’s property developers, pointing to an economic slump in the sector.


What is worrying global investors is an apparent willingness of Chinese authorities to sacrifice growth to squeeze real estate sector to a point of a broadening spillover, not just within the sector, but also the larger financial industry. This is challenging Citi’s view that the authorities prioritise financial stability and have the means to “ring fence” the spillover.


If Chinese authorities tolerate this level of financial woe for the housing sector without compensating macro-level  easing, it may signal deteriorating overall growth prospects for China, with spillovers to the world economy. Markets will watch actions from Chinese authorities in coming days.


Citi analysts continue to believe that Chinese authorities have the ability and desire to limit economic weakness. China’s highest policy officials argue that common prosperity requires relatively robust economic growth, or else the middle income populations would not grow and social stability would be harder to sustain.


Spillover Effect


As examples of assets with negative exposure, iron ore futures fell 4% yesterday (Sep 20) with China’s trading partners such as Germany, Australia and Brazil seeing negative spillover in equities markets and/or foreign exchange.


Asian markets (including China) were closed for a holiday Monday, exacerbating liquidity issues for investors scrambling to address Evergrande. In the US, implied volatility has spiked, with the cost of downside protection particularly high versus upside exposure in derivatives.


Investment Implications


The probability seems high that investors may overstate Evergrande risk after strong market gains in 2021. This is partly because of building US policy uncertainties. However, if China acts to contain macroeconomic fallout and the Fed does not surprise markets with a hawkish policy turn this week, Citi analysts believe a sharp rebound could follow a near-term sharp decline.


Citi analysts have argued that the big “bounceback” in the economy from the COVID-19 shock has passed and have realigned equity portfolios for more sustainable sources of returns, such as favouring Healthcare over Cyclical areas. Market losses overall are small in historic scope so far, and a correction could gather speed. However, markets are now selling off assets that have little or no sensitivity to China’s economy. This can create potential opportunities. History shows the deepest daily declines and gains tend to be clustered closely together.