Market Thinking

making sense of the narrative

Creative Destruction

Print Friendly, PDF & Email

Coincident but Symbolic

The photo is from Kunming in China, where at the end of August 15 Skyscrapers were demolished simultaneously with controlled explosions.

The story is that a developer took over a site that had not been completed by the previous developer and was forced to knock down the buildings and start again. For readers that like to see this sort of thing on video, you can watch it here (from multiple angles).

Given the situation developing with Evergrande, the country’s biggest property developer, this is of course somewhat symbolic, albeit coincidental. However, it is symbolic not so much for the collapse of the buildings, but for the deliberate destruction of the bad buildings to replace them with better ones. Built properly. This is the sort of creative destruction that we should have had in the west post 2008, instead of too-big-to-fail and a decade of QE.

Ironically, the Evergrande ‘Crisis’ demonstrates that China is the only country allowing Market Forces to work

Meanwhile, this shouldn’t really have come as that much of a surprise. Evergrande bonds are high yield, the new euphemism for the more accurate term ‘junk’. They have a high yield because there is a high risk of default. The Equity Market knows this, which is why the associated Equities trade on low multiples and as the Chart shows, Evergrande (Orange), along with two other big HK quoted China developers, Kaisa and Country Garden (White and Green respectively) have been signaling problems for months, if not years.

The Equity Markets have been flagging risk in Property Developers for a long time

Source Bloomberg. Market Thinking

Part of the high profile problem with Evergrande is that it is a problem for western investors, who hold over $20bn of its, now largely worthless, bonds. For Equity investors who think that market cap weighted equity indices are stupid in that they require you to put 10x as much into the biggest company compared to even the one at the 94th percentile, spare a thought for the Corporate Bond guys. The weighting of companies in the Bond indices is a function of the amount of bonds in issue. Yes, that’s correct, the more debt you have, the more of your bonds the fund manager is required to hold in order to (apparently) reduce risk!

Thus the pain of the collapse will be reasonably evenly distributed offshore at least, as Asia High Yield Bond managers will most likely all be holding some Evergrande, whether they like the company or not (and most didn’t). The ones that will suffer the biggest mark to market hit will be those – especially some higher profile US bond Houses – where they have over 50% exposure to China property bonds.

Naturally, the usual suspects are out there talking their own book on China and are citing Evergrande as a key moment and a reason why their (long held) bearish views on China are about to finally pay off. The timing of the suspension of Evergrande Bond payments on the 13th Anniversary of the Lehman collapse is seen by some as somehow a reason why China is about to have its own Financial Crisis as opposed to a common or garden hit to the banking sector from a property bubble bursting. The sort of thing that every country sees periodically. Evergrande has $300bn of debt and is thus breathlessly described as ‘the biggest borrower in the world’, (for comparison, Washington Mutual’s assets were also a little over $300bn when it went bust in 2009) but for context this also needs to be set against $35trn of bank assets in China, a number incidentally that has tripled over the period since the GFC. Indeed, last time China needed to bail out some banks it used some of its huge FX reserves (currently at a 5 year high of $3.2trn) and there is no reason why this couldn’t happen again. More important perhaps is that Lehamn not only had more than $700bn in Assets when it went down, but it was so interlinked into the system that was itself so heavily leveraged that it represented a completely different scenario. Evergrande may have spillover effects into other property companies and their lenders, but it is not systematic in the way Lehman was.

If anything, Lehman was more similar to the recent troubles at Huarong, the State Owned Enterprise/Shadow Bank that was supposed to be facilitating restructuring of the Chinese Financial system but became a bad bank in every sense of the word and went bankrupt in 2020. Of course, their debt was around $40bn, while their external debt at the time was more than half of that, at around $23bn, similar to Evergrande’s today. Doubtless Dick Fuld and others will be mightily relieved not to have suffered the same fate as Huarong boss Lai Xiaomin. He was found guilty by a court in Tianjin of massive corruption (over $270m in bribes) and subsequently executed. Presumably in the manner of Admiral Bing “Pour encourager les autres”.

Bailing out Billionaires does not figure in China’s 5 year plan

Bottom line, allowing Evergrande to fail is a calculated policy in the same way as stopping for-profit education and reining in the power of big Tech are deliberate policies. While this has introduced a degree of uncertainty into asset prices – especially compared to previous assumptions about monopoly pricing opportunities – the most sensible option is probably one of assuming classical economic behaviour. Companies will be allowed to make profits, even very good profits, but they will not be allowed to create monopolies and extract large amounts of ‘economic rent’ from those positions. Nor will their owners ever be allowed to trade money for political influence. Public goods (like education) will not be allowed to be privatised, the Wall St corporate finance model of taking over existing businesses and extracting value through excessive debt burdens will not be tolerated and businesses that exploit consumer data will be ‘discouraged’. As noted previously, China is running things with an eye on social stability and is thus focused more on the 99% than the 1%. In particular, China is keen on building a prosperous middle class (who will continue to buy luxury goods in contrast to what some are saying). No wonder George Soros doesn’t like it.

Share this article

Leave a Reply

Your email address will not be published. Required fields are marked *