Would you like to know how the Evergrande crisis could develop for Indian investors? Listen to this fictional water cooler conversation between stock analyst Sarojini, investor Balan and banker Mukherjee.
Sarojini: What a rally in the Sensex! I think it’s partly a relief that Evergrande hasn’t (technically) defaulted on interest payments this week.
Mukherjee: The relief is premature if you ask me. What is a $ 36 million interest payment when a company owes $ 300 billion? Evergrande has a number of repayments ahead of them over the next year, and the market will be in suspense every time. Keep in mind that rating agencies like S&P and Fitch are now rating Evergrande bonds negatively, which means they are highly susceptible to default.
Balan: But as China’s second largest real estate developer, it has plenty of assets, right? Evergrande sold RMB 723 million worth of land last year and sits on 231 million square feet of land.
Mukherjee: As with many Indian property developers, Evergrande’s main problem is that it has sold most of its homes for advances from clients who are now wondering if they will ever get their apartments. It also seems to have promised people high returns on some wealth management products. So Evergrande’s problem is whether it has the liquidity to meet short-term claims on customers, suppliers and investors. It is not assets but cash that is lacking. I read that she has liquidity to meet only half of her short-term commitments.
Balan: I expect the Chinese government will save you. You certainly wouldn’t want something this size to fail!
Sarojini: I’m not sure. It is the Chinese government that set the game against the Evergrande hedge last year by creating new rules to cool the overheated Chinese real estate market. In 2020, the Department of Housing introduced a new “three red lines” policy that prevented banks from lending to a property developer if three red lines were crossed – a debt-to-asset ratio of 70 percent, 100 percent net debt 1st Evergrandes’ equity and cash to short-term debt ratio began having fundraising problems because it crossed those red lines.
Mukherjee: Yes, S&P agrees. It has said that the Chinese government can let events take their course as Evergrande cannot jeopardize financial stability in China. Evergrande’s loans of RMB 571 billion apparently make up a small fraction of China’s RMB 160 trillion bank loans. Evergrande’s suppliers already knew of the company’s financial difficulties. Any bailout by the Chinese government can help private homebuyers or investors, but not bondholders.
Balan: Then why are the global markets so nervous?
Sarojini: I think they are concerned about what this will do with the rosy growth outlook for the Chinese economy, on which the global recovery currently depends. Global agencies forecast China’s growth in 2021 to be 8.5 to 9.5 percent. According to Evergrande, they’re hastily downgrading it to about 8 percent. Investment in residential real estate accounts for 10 percent of China’s GDP and real estate is said to indirectly contribute a quarter of GDP.
Balan: Oh, this is terrible news for the latest party in iron ore, steel and metals stocks based on the commodity “super cycle” story. China’s real estate sector accounts for about 20 percent of the world’s steel and copper withdrawal and 9 percent of aluminum demand, I read in FT. This artificial implosion in the Chinese real estate sector could therefore lead to lower forecasts for demand for these commodities.
Mukherjee: Don’t forget how such events can affect India’s bond markets and the rupee. This will reduce the popularity of emerging market (EM) bonds with overseas investors. Chinese developers make up a large part of the “high yield” EM bonds that are so popular with overseas investors. If they suddenly get cold feet, the Indian bond markets could also see outflows. Global bond investors are already struggling with the Fed’s taper plans. I think Evergrande could affect Indian bonds and the rupee more than the stock market.
Sarojini: Yes, the participation of foreign portfolio investors (FPI) in the Indian bond markets has increased vertically since the taper rage. FPI debt assets in India were around ₹ 15 lakh crore in 2013, now they are ₹ 42 lakh crore! Unlike our equity markets, where domestic retail investors and institutions may be waiting to grab stocks at lower levels, bond investors may be cautious about entering those levels.
Balan: RBI hai na! It sits on record forex reserves and will save the rupee.
Mukherjee: It is not so easy. When the RBI sells dollars to save the rupee, it drains liquidity from the system and raises local interest rates. You know how hard the RBI worked to keep borrowing costs down for the government.
Balan: You are such pessimists, man. Cooling off raw materials also has a good side. If crude oil, metal and steel prices fall globally, it would be good for India Inc.’s bottom line and for the budget too. Aren’t you reading all of the reports from overseas brokers that this is not a Lehman moment for the markets?
Sarojini: Balan, you are too young to remember. But just before the Sensex crashed about 50 percent in 2008, we had very reasoned research notes on how India was “decoupled” from developed markets and could not be affected by the global financial crisis because its banks or bond markets’ had no derivative exposures.
Mukherjee: I would agree. When a market is overvalued, it needs a trigger to correct. The trigger doesn’t have to be logical or even have a deep fundamental impact. Only the first card has to be knocked over for the domino effect to start. I certainly wouldn’t panic and sell all of my stocks. But I would certainly take some money off the table.
Balan: Just like the FPIs!