Investors unnerved but Evergrande unlikely to turn into China's 'Lehman moment'

Evergande is the world's most indebted developer with US$300 billion in liabilities.
Evergande is the world's most indebted developer with US$300 billion in liabilities.PHOTO: REUTERS

NEW YORK (REUTERS, BLOOMBERG) - Investors unnerved by the fallout from China Evergrande Group were gauging the potential for a wider shakeout after a sell-off hit stocks around the world on Monday (Sept 20).

For now, many US-based investors believe there is little chance that the woes of Evergande, the world's most indebted developer with US$300 billion (S$405.6 billion) in liabilities, could morph into a systemic crisis reminiscent of the 2008 collapse of United States investment banking giant Lehman Brothers.

Lehman went bankrupt as a result of excessive sub-prime mortgage lending, and the knock-on effects brought the global financial system to a standstill.

It is hard to see how this Chinese developer - which is massive but only about half as indebted as Lehman was - would trigger another global financial crisis, especially when China has no interest in staging their own Lehman, Bloomberg editor John Authers wrote.

"Another reason to expect the Chinese government to do something to ensure an orderly process is that they have no choice. To use another familiar phrase from the Lehman debacle, Evergrande is far too big to fail."

Beijing will take action to prevent the China Evergrande Group crisis becoming a “Lehman moment” for the nation, but some banks may become victims, according to analysts at Citigroup. 

“Policy makers will likely uphold the bottom line of preventing systematic risk to buy time for resolving the debt risk, and push forward marginal easing for the overall credit environment,” analysts including Judy Zhang wrote in a note.

“While we think the government doesn’t want to be seen as engineering a bail out, we expect it to step in to conduct a managed restructuring of the firm’s debt to prevent disorderly debt recovery efforts, reduce systemic risk, and contain economic disruption,” Oxford Economics lead economist Tommy Wu and head of Asia economics Louis Kuijs wrote in a note.

But, financial conditions for the broader property sector will remain tense for some time, with some spill-over into wider financial sector stress, they said.

Growing investor angst about Evergrande and a crackdown on China’s real-estate sector have caused a chain reaction across global risk assets this week, even ensnaring stocks with less tangible links to China. 

Citigroup’s analysis of banks’ loan exposure to high-risk developers suggest credit risk is the highest for China Minsheng Banking Corp, Ping An Bank and China Everbright Bank.

Jefferies Financial Group analyst Chen Shujin Chen also sees “little chance of systemic risk” from Evergrande and advises investors to buy bank stocks on dips, Ms Chen’s top picks in the sector include China Construction Bank and Bank of Ningbo, she wrote in a note.

Still, with valuations on US equities stretched on a historical basis and an unwind of the Federal Reserve's easy money policies looming, some investors worry that a sudden drop in risk appetite could leave global markets vulnerable to a broader sell-off.

"We have a very cautious view on the market given elevated valuation levels," said Mr Rob Romero, portfolio manager at Connective Capital, a technology hedge fund with US$100 million in assets under management. "It is hard to know how far the contagion will spread. We are looking for signs of resilience in US market; if that doesn't happen, that means contagion has more risk to snowball."

The concerns over the extent of Evergrande's reverberations through the global financial system come at a time when high valuations in the equities markets had many investors and analysts calling for a pullback.

The benchmark S&P 500 traded at 21.6 times forward earnings as at Friday, near its highest levels since the late 1990s dot.com bubble, and prior to Monday's trading had rallied more than 18 per cent for the year to date.

Fears brewing

While Evergrande's woes have been playing out for several months, its shares tumbled more than 10 per cent on Monday as Chinese regulators warned that its US$305 billion in liabilities could lead to widespread losses in China's financial system if its debts are not stabilised.

Late payments by the company could trigger cross-defaults.

Worries over a broader default spread around the world, with the MSCI Global down 1.62 per cent, on pace for its worst performance in two months. Investors rushed into havens such as Treasuries, taking the yield on the benchmark US 10-year to one-week lows, while the 10-year US interest rate swaps over Treasuries stood at their widest in almost six months.

In another sign of concern brewing in money markets, analysts cited the three-month Libor, which rose to 12.5 basis points, a four-week peak, reflecting worries over potential stress in the global banking system.

At the same time, there appeared to be few signs that institutional investors took an over-leveraged position in Evergrande that would spark a liquidity crisis, said Capital Generation Partners chief investment officer Robert Sears.

"So far most of the negative action been in the Chinese property sector," he said. "I don't think this has had a major impact on most hedge funds so far."

In the US equity options market, traders appeared more intent on taking profits from existing hedges than on buying up protection against a sharper sell-off, even as the VIX, an index measuring volatility known as a “fear gauge”, stood around its highest level in four months.

Mr Andrew Left, founder of Citron Research, which in June 2012 published a report that said Evergrande was insolvent and had defrauded investors, was also not expecting widespread pain.

"I don't think that this is going to be the straw that breaks the global economy's back," he said.

Indeed, some investors said that Monday's price declines should have been expected given the rally in the S&P 500 over the summer and concerns ranging from the debt ceiling debate in Washington to the prospect of higher capital gains taxes.

Wells Fargo Asset Management senior investment strategist Brian Jacobsen said: "Coming into September we thought that with valuations and optimism so high that investor sentiment seemed a little vulnerable to a dramatic but short-lived shift."