At this point, near-term resolution is more about the Chinese government’s willingness/actions and less about Evergrande’s bottom-up credit fundamentals. Until now, Chinese policymakers have not clearly disclosed their plans for Evergrande. However, their rhetoric indicates they have been in touch with Evergrande for quite some time and are taking steps to contain fallout from the company’s deepening financial stress. Also, on a broader level, policymakers have expressed willingness to sacrifice near-term growth for longer-term macro-financial stability and regulatory objectives. In other words, regulatory risk has been a well-telegraphed theme in China lately.

What Can History Tell Us?

The key lesson from the recent Huarong AMC experience is that the government was less concerned about the secondary market price of the issuer’s USD bonds and didn't feel the need to reassure markets as long as the broader system's fundamentals weren't affected. As investors, we tend to like to see “big-bang” actions that give instant results. The Chinese government, however, deals with problems at its own pace and timetable. For example, it took three years from reports of HNA first missing debt payments in 2018 to its bankruptcy restructuring in 2021. The Evergrande restructuring could drag on for a while, but it’s fine from the government’s perspective as long as homes continue to get built and delivered to homebuyers, and suppliers and employees continue to get paid. At the same time, it's likely that investors, particularly foreign market participants, may not have the same level of patience.

The Chinese government may not feel the need to reassure markets as long as the broader system fundamentals are not affected.

The timing of Evergrande's potential default also coincides with major central bank meetings, including Norges Bank, which is likely to hike rates; Bank of England, which is likely to wait and assess the impact of the end of the furlough scheme on the labor market; and the Fed, which is expected to signal that it's on track to scale back asset purchases starting around year-end. The recent spate of US-China geopolitical headlines, e.g., the Australia, UK, and US partnership regarding nuclear-powered submarines, has also dampened sentiment.

However, there are notable differences from the “Lehman moment” because:

• The Chinese government has strong regulatory control and coordination over the major banks and financial institutions. Despite all the doom and gloom press about Evergrande, it's important to stress that this is the result of “self-imposed” deleveraging by the government that's intended to reduce longer-term risks of moral hazard and debt buildup in the property sector.
• Evergrande is largely a known issue for the government, so some kind of restructuring is likely that pulls China back from the financial brink. We think none of the major lenders will be allowed to pull the plug and trigger a margin call that would encourage other lenders to also rush for the exits and lead to a disorderly collapse.
• Largely already priced into markets: In the case of Evergrande, it's increasingly clear that equity holders will get wiped out, offshore unsecured bondholders will get restructured (bonds are priced at about 20 cents for this already), and banks and wholesale creditors will suffer some pain (albeit less for those lending on a secured basis). But it's also clear the government will protect the vulnerable homebuyers and ensure that most of them get final delivery of their homes, somewhat roughly analogous to depositor insurance at banks. In other words, the central government might want finally to tackle the power of the developers, but it won’t want individual households in China being the casualties.
  
  

Market Implications

At the same time, however, China is a huge country, and Evergrande is a big company, so it's impossible for Beijing to control every detail. Hence, there is clearly a risk of miscalculation, and even if Evergrande is resolved, enough has happened in the property sector to drag down the real economy, at least in Q4. There are several factors roiling the Chinese property market, but the biggest is the trouble at Evergrande. It's unlikely anyone now wants to forward-buy a property from Evergrande—especially as there are reports of one city disqualifying Evergrande homes for eligibility for mortgages from local banks. And, if a firm as big as Evergrande can get in trouble, then buyer-beware likely slows sales for just about every developer in China.

Beyond China, this macro picture should set the scene for the rest of the Asia Pacific region in Q4 2021. A weakness in China’s growth pulse will feed into the rest of the region before the end of the year in a way that could be important for currencies and fixed income. Cross-country policy divergences will illustrate a notable contrast with the Fed and other central banks in Europe that are contemplating gradual policy normalization, while Asia-Pacific central banks will likely retain an accommodative stance or even ease policy further. As an example, we think it will be hard for the Bank of Korea to remain so hawkish after its recent rate hike given the backdrop in China, although labor-market data last week showed employment edging back toward pre-COVID levels in Korea, and a local boost is likely from the continued rise in the vaccination rate there.

Weakness in China’s growth could feed into the rest of the region before the end of the year in a way that could be important for currencies and fixed income.

In summary, we expect to see continued market pressure on the Chinese real-estate sector in general as the Evergrande events continue to unfold, given it’s the second-largest property developer by sales in China. However, we view the recent steps that the Chinese government has taken to clean up the real-estate sector to be positive in the long term as those measures (including the “Three Red Lines” policy) are aimed at deleveraging to ensure long-term sustainable growth. In the near-term, China’s economy and asset prices have been hit by a convergence of many external and domestic shocks, some of which have to do with the political calendar and recent regulatory actions. However, for now, none of the shocks appear to have derailed the development or long-term momentum trends of the economy. We will continue to monitor whether the fallout from recent events derails normalization of economic conditions over the next few months.