There’s a lot going on in and around China right now, with concerns around their intentions with Taiwan, the South China Sea and escalating tensions with the US and its allies. But perhaps the biggest issue impacting markets right now is the imminent default and potential collapse of property giant Evergrande with over $300 billion in debts. There are many potential implications from this.
The default to bond holders, people who bought property, suppliers, the loss of equity, the impact on property and construction, will all make their way through to their domestic economy and ultimately result in slower growth and have an impact on global commodities. But it’s the fear of the unknown that is causing financial markets to become fearful.
The bigger concerns at the moment relate to the uncertainty around how it all unfolds, the potential contagion and impact on China’s financial system (including debt markets and liquidity). It is one thing for a company to go broke, that is a part of the risk inherent in doing business. But the calculus changes when the organisation at risk is a systemically important one.
My observations in relation to these types of events:
They take time to evolve
There will likely be contagion
The issue is usually bigger than we first think
There are probably other organisations in similar positions
Government can bail out the organisations involved if needed
We’ve seen this type of issue over the course of history including the US subprime issues resulting in the Federal takeover of institutions Fannie Mae and Freddie Mac. The indebtedness of this organisation occurred with China’s knowledge, and the factors leading to the current issue at Evergrande are as a result of the Chinese regulators demands to repay debt.
The next question will be, what do the financial positions of the other major property developers look like? Moreover, how are the other large corporations with huge debts positioned. I suspect that China ultimately wants to make an example of Evergrande and will force the organisation to resolve the matter. But this is equally a warning shot across the bow to all the corporations in China, not only Evergrande.
However, we should not assume that China wants to fix the problem in the same way a western nation would. That would be a mistake. China is a communist nation, and they operate accordingly. Their focus is not the wealth of investors or institutions. We have seen repeatedly now that China is prepared to destroy companies and damage industries if it serves their political objectives.
Perhaps one of the most counter intuitive lessons for investors from democratic capitalist nations to learn is that China isn’t ruled by money. We all assume they will act commercially because that is what business is all about, being pragmatic and obtaining the best commercial outcome. But we assume they believe the best outcome is what we think it is. It is not.
While China can potentially bail out Evergrande, it will be seen as a bad example. In my opinion, a bail out is only likely if there is an existential threat to the economy, financial system, or the political regime due to the fall out. Nonetheless its worth keeping in mind that, if the need arises, the backstop is a bailout. It will occur if it is essential.
The Western World is going to find out what an economic crisis in a communist state looks like and how it will be dealt with. Some sectors and nations will feel the pain more than others with iron ore and the big miners, here in Australia, the most obvious examples in the short term.
Overall, though, it is perhaps most important to remember that the long-term growth of China and their rising middle class is a theme that will continue for decades into the future.
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Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.