Domestic Bonds

Amid China’s default drama, buyers of dollar bonds are bullish


(MENAFN – Asia Times) As investors tremble at the default seismic drama surrounding China Evergrande Group, it looks like a vital crowd hasn’t received the memo: buyers of continental dollar bonds.

Demand for Chinese dollar banknotes made a comeback in August even as Evergrande’s concerns in China wreaked havoc on broader credit markets in Asia’s largest economy, especially in the area of junk-bonds. Average monthly returns recently hit their highest level in at least eight years.

Yet in August, Chinese offers recorded orders nearly eight times their issue volume. That’s about double the over-subscription rate in July.

On one level, there is some logic to bidding on debt sold by mainland borrowers who can still operate in offshore debt circles – even amid the risk of contagion. On the other hand, this could be rare good news for a Beijing that scares investors left, right and center.

A great disaster for China?

Evergrande’s default watch in China coincides with signs that the broader economy was hit hard in August. Covid-19 lockdowns hit consumer demand and business confidence.

The missing data includes a disappointing 2.5% increase in retail sales, a fraction of the 7% pace predicted by economists. Construction investment, meanwhile, fell 3.2% in the first eight months of 2021, as Beijing tightens restrictions to reduce the foam in the asset market.

For investors wondering where the world’s second-largest economy would be in 2022, China Evergrande is Exhibit A.

As Teresa Kong, head of fixed income at Matthews Asia puts it, investors holding the company’s debt are “definitely sweating” right now.

Ocean Flower Island, an artificial archipelago off the north coast of Danzhou in Hainan, was built by the Evergrande group. Photo: AFP

The world’s most indebted real estate developer – with an estimated $ 305 billion in liabilities – scrambles to raise money to pay lenders and suppliers. Local press reports that the Ministry of Housing and Urban and Rural Development is warning banks that China Evergrande will not be able to pay the obligations due on September 20.

“We believe that further disruption to the company’s property development operations can be very negative for sentiment among domestic property buyers and investors, and potentially spill over into the wider property industry,” said analyst Kenneth Ho at Goldman Sachs.

Fitch Ratings says a default “looks likely”. Moody’s Investors Service agrees that China Evergrande is accountable.

In addition to crushing debt, the business is at the center of countless unfinished residential buildings. Construction sites across China are changing. The suppliers are desperate.

As analysts at JPMorgan wrote in a note this week: “With recent events accelerating to the downside, we believe the government needs further maneuvering to avoid a possible spillover. “

The $ 305 billion question, of course, is whether President Xi Jinping’s government is intervening to prevent contagion.

Why punters stay cool

JPMorgan expects regulators to ensure that things don’t get too out of hand.

“If politicians abide by government guidelines to ensure a stable housing market, we don’t expect the impending corporate default to be too disruptive for the industry,” the bank hopes.

Police are in training at Evergrande headquarters in Shenzhen, where concerned investors have gathered. Photo credit: AFP / Noël Celis

Fitch analyst Samuel Hui offers perhaps the best explanation for why investors are still gorging themselves on Chinese dollar debt. be manageable, ”Hui says.

In other words, China Evergrande is unlikely to trigger the larger debt that investors have long feared in the most populous country.

A fault alone would of course be very damaging.

“At the macro level,” Hui notes, “an Evergrande default could hurt consumer confidence if it were to affect household deposits for homes that have yet to be completed.” But, he adds, “we assume that the government would act to protect the interests of households, which makes this outcome unlikely.”

If China Evergrande’s problems disrupt the wider financial system, Hui says, “it could have larger macroeconomic effects.”

Fitch estimates that the real estate sector accounts for around 14% of gross domestic product. Overall, however, Hui said that “the risks to our growth prospects in China are mitigated by the government’s ability to intervene with policies to support the housing market.”

China’s slowdown in long-term growth

Beyond China Evergrande, there are two jokers in play.

One: the extent to which the Delta variant, and others to come, puts the global economy off the road to recovery. Two: the fallout from Xi’s technological crackdown.

New waves of infection are slamming growth prospects from the United States to Europe to Japan. Adding to this air of uncertainty are divergent views on the outlook for global inflation.

Police watch people gather at Evergrande’s headquarters in Shenzhen as the Chinese real estate giant says it faces unprecedented hardship. Photo: AFP / Noël Celis)

China, notes analyst Michael Hirson of Eurasia Group, is attempting to control commodity price speculation by drawing on strategic reserves, as this cools demand by reducing steel production, but so far micromanagement of commodity markets has failed to control volatility. “

Policymakers at the People’s Bank of China, Hirson adds, do not yet see inflationary pressure as strong enough to warrant monetary tightening.

Still, he says, “regulators remain open to a targeted reduction in the reserve requirement ratio this year, especially as the impending restructuring of property developer Evergrande will pressure its creditors to extend repayment terms,” thus risking contagion to real estate-related companies and lower-level regional banks. “

It is not clear, however, whether investors understand the broader contours of China’s decline in GDP in the second half of 2021.

Chances are, “China is now on a permanently slower growth path,” says Morningstar economist Preston Caldwell.

It would be a far cry from the 6% pace that too many investors saw as a given for Xi’s economy.

And that puts China on a path that could make it harder for heavily indebted companies to repay their debts.

Caldwell adds, “We have long argued that the investment boom in China is unsustainable. Recent government policies have led to a slowdown in debt growth which has fueled this investment boom, especially in sectors such as real estate. We are also concerned about a possible abandonment of free market reforms in China, as evidenced by the notable crackdowns on big corporations and wealthy businessmen. “

Opacity and uncertainty , risk and … trust

Market reforms are now obscured by confusion as Xi’s crackdown on tech giants Ant Group, Didi Global, Tencent Holdings and others turns into a regulatory war on seemingly everything.

The China Evergrande Center in Hong Kong. Rating agencies say default is likely. Photo: AFP / Peter Parks

This war forced investors from George Soros to Cathie Wood at ARK Investment Management LLC to either avoid China altogether or reduce the bets.

Caldwell’s worry is that the level of multitasking needed to wean China off exports, increase domestic demand-led growth, and spur innovation appears to be lacking.

And then there’s a very uncertain world scene to worry about, including sudden changes in US interest rate policies, says economist Ira Kalish at Deloitte Touche Tohmatsu.

“While August’s weak US employment report will likely cause the Federal Reserve to delay reducing asset purchases, many investors and officials around the world remain worried about what will happen when the reduction will eventually begin, ”Kalish said.

Unlike many emerging countries, Kalish says, China limits capital outflows and, theoretically, is not vulnerable to capital flight if US yields rise. Yet, with China having worked hard over the past five years to attract foreign investment, there is much to be lost if capital leaks.

“Despite the restrictions on capital outflows,” says Kalish, “many investors often find ways to facilitate outflows – for example by inflating bills for imported goods.”

Would China act to limit the latitude of foreign investors to repatriate funds? This could do irreparable damage to Beijing’s capitalist credentials.

Soaring US yields would put China, especially its private borrowers, in a very difficult position. Besides the chaos in the markets, any upward pressure on the US dollar would make dollar loans more difficult to repay.

“For China,” says Kalish, “the challenge will be to manage this process in a way that does not disrupt the Chinese economy tremendously. The weakening of the United States and a subsequent outflow of capital from China could lead to lower Chinese asset prices and downward pressure on the Chinese currency. “

Still, investors taking on Chinese dollar bonds seem unfazed as they place more and more orders. Only time will tell if their bet on China navigating the turmoil that awaits Asia next week and beyond will bring honey or heartache.

For now, however, it’s a ray of good news shining on an economy that benefits very little.