China Evergrande, Contagion And What Does “Default” Mean?

November 11, 2021

By Orbex

By now it’s been a couple of months since the Evergrande issue hit the markets. Since then, a lot of the more pessimistic scenarios haven’t played out.

In fact, the worries about a collapse of the housing market in China have pretty much completely receded. That’s except occasional headlines coming out to spook the market for a little bit and then go away.

It can be a bit frustrating for traders, especially as the situation of housing in China can have a major impact around the world. But it’s notoriously hard to track. Not least of all because different actors use some complicated mechanisms to avoid technically running afoul of rules.

It’s all about predicting the future

The government is handling the “breakup” of Evergrande. It’s important to note that the government doesn’t respond to market forces, thus making future actions less predictable. This can be a problem for investors looking to calibrate the long-term effects on other markets.

Housing is one of the most materials-intensive industries. And given both the commodity prices and the logistics problems, housing is an important issue to pay attention to. Particularly the kinds of homes that large Chinese developers like Evergrande build.

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High-rise apartment complexes consume a lot of steel and cement, both of which are at a premium at the moment because of the high levels of energy needed to produce them. Then there are other elements, like copper for wiring and fixture alloys. In fact, construction is the largest consumer of copper.

Didn’t Evergrande go into default?

One of the key concerns over Evergrande was that they would be unable to make their debt payments. That condition is referred to as a “default”. However, it’s a more complicated process than a company simply not making a payment.

Many debt payment contracts have a 30-day grace period. Also, the creditor can opt to not exercise the payment. In turn, this would allow the company to not pay, and technically not fall into default.

Evergrande has been taking advantage of this delaying technique quite prolifically. And so have many other companies in the Chinese real estate sector.

The issues at stake are “wealth management products” (WMP), which are not traditional bonds. They are more of a hybrid mechanism, closer to MBS, and they are the issue behind the 2008 crisis. They pay back a set amount, invest primarily in housing, and are funded with “extra” savings that people hold.

Where could this be going?

Just this morning, Yango Group was the latest to announce that they would be delaying payments on their WMPs.

In addition, a lot of companies have made similar announcements over the last several days. They have been meeting with their creditors to secure agreements that would allow them to not pay interest on their debt, without technically falling into default.

While this avoids the worst-case scenario of the companies losing access to the credit markets because they defaulted on their debt, it’s just a way of kicking the can down the road.

Many companies are seeking to borrow further, in order to meet their short-term credit obligations, taking out higher interest loans. As long as home sales remain robust enough to ensure sufficient cash flow, it’s just a crack in the dam.

However, just because the media has moved on (because companies have technically been avoiding default) it doesn’t mean that the problem isn’t there still. It also doesn’t mean that the situation for housing companies isn’t going to get worse as raw material prices stay elevated.

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