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Credit FAQ: Evergrande Default Contagion Risk--Ripple Or Wave?

This report does not constitute a rating action.

Property developer China Evergrande Group (CC/Negative/--) is on the brink of defaulting. If this does happen, should we anticipate a tidal wave of defaults swamping the credit markets or will it seem more like ripples from a pebble in a pond? S&P Global Ratings thinks the fallout will lie somewhere in between.

Evergrande is scheduled to make a number of interest payments on its public debt starting on Sept. 23, 2021. A default is likely. Evergrande's project companies (which are subsidiaries) might have interest payments on banks loans due before Sept. 23. But whether a missed payment on the part of subsidiaries would directly constitute a default at the Evergrande level would depend on whether there is a guarantee relationship between the parent and the subsidiaries.

Events could broadly rattle investors' confidence in China's property sector and for speculative-grade markets broadly, possibly diminishing funding access for unrelated names.

Evergrande's difficulties are also weighing on China's property market. This could have wide-reaching negative ramifications for other developers, suppliers and contractors, and the banks and financial institutions that lend to them. We expect the default risks of weaker, highly leveraged property developers to rise.

Evergrande's difficulties are playing out just as China Huarong Asset Management Co. Ltd. is in the middle of a recapitalization exercise. This means that two of China's largest bond issuers of offshore debt may be both testing the capacity and appetite of the government to backstop potentially substantial failures.

We do not expect the government to provide any direct support to Evergrande, and have therefore not factored this into our analysis. It is a privately owned company in a highly commercialized sector. We believe Beijing would only be compelled to step in if there is a far-reaching contagion causing multiple major developers to fail and posing systemic risks to the economy. Evergrande failing alone would unlikely result in such a scenario.

Investors are keen to understand the possibility of contagion effects of a likely Evergrande default, and the implications of this for China's property sector, economy, speculative-grade market, and government appetite to back substantial issuers. We offer our perspectives here.

Frequently Asked Questions

What is the key factor contributing to Evergrande's distress situation?

Evergrande's liquidity is deteriorating quickly. We recently downgraded the company and its subsidiaries to 'CC' with a negative outlook (see "Evergrande And Subsidiaries Downgraded To 'CC' On Depleted Liquidity; Outlook Negative," published Sept. 15 2021, on RatingsDirect).

Will guarantees or subordination factors make any difference in a recovery process?

It's complicated. There are two main U.S.-dollar senior notes issuing entities within the group: Evergrande and Tianji Holding Ltd. The key difference is that the latter only has a "keepwell" support from Hengda Real Estate Group Co. Ltd., the group's real estate arm in China. It does not carry any guarantees from either Hengda or Evergrande. Tianji is the smaller offshore operating and financing platform and guarantees the bonds one of its vehicles issued.

The fundamental question in front of investors is whether the keepwell agreement is enforceable and what difference that may make in the recovery process should the group default. In a recent case, court-appointed administrators for the defaulted Peking University Founder Group Co. Ltd. ruled they would not recognize the keepwell deeds of the group's defaulted offshore bonds (see "Peking University Ruling Raises Refinancing Risk On US$93 Billion Of Keepwell Bonds," Sept. 2, 2020).

Some have pointed out that project companies guarantee some of the bonds issued by Evergrande, a fact that may raise recovery prospects. However, these guarantors might also be intermediate holding companies that may not directly hold any assets themselves. Tianji itself was just an intermediate holding company before it started to issue offshore bonds on its own, starting in 2018.

Debt at the intermediate holding company level is still structurally subordinated to that directly owed by project companies. No default involving a Chinese property issuer has involved a keepwell structure. For this and many more reasons, a potential Evergrande default would be a landmark.

What do losses on wealth management products mean for Evergrande and for the sector at large?

The group said this month that its subsidiaries only guaranteed Chinese renminbi (RMB) 934 million of wealth management products (WMPs) issued by third-party platforms to retail investors. Evergrande accounts for this sum as contingent liability. The rest, which could be multiples of that amount, are largely off-balance sheet, according to media reports.

WMP investors still identify Evergrande as the ultimate obligor, because the proceeds raised were deployed into Evergrande's projects. Other developers in China commonly use such instruments the same way, we believe.

Failure to fulfil such guarantees has not directly constituted a default by Evergrande. However, to ensure social stability, the Chinese government is likely to manage the potential fallout from defaults of such WMPs by limiting the losses of average retail investors. Institutional funds and high-net-worth individuals might share more pain under Beijing's current policy focus to make investors take responsibility for their risks.

This also raises a broader question about entities' reliance on hidden debt. We have discussed at length about Chinese developers' use of off-balance sheet or hidden debt through the deployment of joint ventures. Issuance of WMPs is another means to this end. An Evergrande default may impede these funding channels for developers, which would add to their strains as more conventional capital raising, such as bonds and bank loans, is also tightening.

What is unique about Evergrande's distress situation compared with that of other Chinese developers?

Evergrande's contracted sales have fallen more than other issuers in the sector that have experienced distress. We expect such sales to continue to slide. While most large Chinese developers were able to continue project sales and construction cycles even after defaulting, Evergrande's operations are slowing significantly. The key reason lay in its heavy use of supplier commercial bills as a way to alleviate its working capital and debt needs.

From what we understand, the commercial bills have a more rigid repayment date. The instruments are tradable in nature and may have changed hands multiple times. Suppliers and contractors that have gone unpaid have filed lawsuits against Evergrande and have managed to freeze assets, rejecting any further bills as payments. This had led to substantial halts in project construction, hitting Evergrande's sales and creating concerns about its ability to deliver projects. This has hurt homebuyers' confidence in its projects, hitting sales.

Financial institutions also appear to be quickly cutting Evergrande's financing, likely as a reaction to the frequent negative news about the borrower. Without sufficient project financing, it makes even harder to sustain construction and salable resources. This is shutting down Evergrande's most important source of cash flow: contracted sales of its property projects.

Chart 1

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How severe would the contagion risks be for the sector if Evergrande defaults?

We think some weaker property names in China have been hurt by the Evergrande situation for some months. As bond prices sink for a number of more marginal operators, they have lost access to offshore refinancing. Developers with concentrated maturities and deteriorating liquidity are exposed.

Such developers have devised repayment plans to adapt to conditions, but these plans may yet prove overly optimistic and difficult to execute. Even if they manage to pay down maturities with internally generated cash, it would be at the expense of funding their business operations and expansions.

We have recently taken negative rating actions on property firms facing such conditions. These include Central China Real Estate Ltd., Fantasia Holdings Group Co. Ltd., Risesun Real Estate Development Co. Ltd., and Sinic Holdings (Group) Co. Ltd. We also downgraded E-House (China) Enterprise Holdings Ltd. given the possible delayed repayment of bills by Evergrande.

The market is still willing to provide capital to large players with solid fundamentals. We've observed little spill-over effects on such entities. New issuance, although somewhat dampened, remains open to them.

Evergrande contagion would exert just a slight hit for property prices. Property sales momentum is slowing in China as policy tightening has taken hold in recent months. Room for further fire-sale values is limited given Evergrande has already drastically cut prices, sometimes selling units at a loss. The Chinese property market is very fragmented. While Evergrande is one of the largest developers, its market share remains relatively low. We anticipate Evergrande's direct negative effects on other major players' projects would be manageable, even in a default scenario.

Will the government step in to address contagion?

We don't expect government actions to help Evergrande unless systemic stability is at risk. A government bailout would undermine the campaign to instill greater financial discipline in the property sector. Government support to prevent a default is only likely if contagion risks cause other large developers to fail. This could threaten the stability of the financial system and economy. We think the hit to the financial system from Evergrande alone will be manageable.

We assume Beijing's focus would be to ease Evergrande through an orderly debt restructuring or bankruptcy process that maximizes the value of its substantial assets. The developer, for example, owns one of the country's biggest land banks. That would uphold the government's messaging for greater discipline in the sector while minimizing moral hazard.

Instead of a bailout, the government may facilitate negotiations and funding to ensure individual investors and homebuyers are protected as much as possible. According to public information, Beijing has ordered the Guangdong provincial government to help Evergrande. This includes speeding up Evergrande's asset sales and supporting the company in its negotiations with its creditors. The developer is headquartered in Shenzhen and is a major employer in Guangdong province.

In our view, these measures remain largely aligned with China's policy preference for market-based resolutions of distress situation. The government is willing to help, but also wants events to take their course. Even in Evergrande's home province, the developer is insignificant to Guangdong's vast local economy--it is not too big to fail.

What are the implications for the financial sector?

We believe the Chinese banking sector can digest an Evergrande default with no significant disruption, although we will be mindful of potential knock-on effects. With total debt, including onshore and offshore bonds, of about RMB571 billion at the end of June 2021, Evergrande is small relative to Chinese banks' total loans of about RMB160 trillion (0.35%) and total assets of RMB280 trillion (0.2%).

The banking sector's direct exposure to Evergrande appears well distributed. Their lending--mostly project loans--are largely secured. Further, Evergrande is not one of biggest users of joint ventures. Hidden liabilities are a risk, but these are unlikely to cause systemic issues in the banking sector by themselves.

Some banks also indirectly exposed to Evergrande via the WMPs that they originated. Banks could be remain on the hook to share the loss should these products fail. Trust companies that housed these products could also be affected.

Evergrande had RMB951 billion of trade and other payables at the end of June 2021. Delayed settlement of these payables could squeeze its suppliers and contractors. We expect such strains will put some suppliers and contractors in financial stress, denting the asset quality of the banking sector. However, many of these suppliers and contractors have already taken actions to protect their interests and limit their exposures. The banking system is likely to be able to manage any such second-order effects.

How well placed is the banking sector to deal with property sector stress and will ratings be affected?

The Chinese banking sector has reasonable buffer to absorb any Evergrande fallout, assuming it doesn't engulf a number of other large developers. Nonperforming loan (NPL; 1.76%) and special mention loan (SML; 2.36%) ratios are stable. Institutions' provision levels have edged up to 82% at the end of June 2021 from 77% at the end of 2020. Exposures to property developers across the industry was about 8% of total loans at the end of 2020. These loans were mostly made with a minimum 70% loan to value (LTV) at origination. Residential mortgages were about 23% of the loan portfolio and the quality remains sound.

An Evergrande failure in itself would not destabilize the banking system. However, if such an event were followed by the defaults of a few more highly leveraged major developers, it could evolve into a challenging situation. The central bank recently did a scenario test that probed banks' exposure to the property sector. In the "most severe" scenario, the regulator said a potential 15 percentage point increase in developers' NPL ratio, and a 10 percentage point rise in the housing NPL ratio, would reduce banks' overall capital adequacy ratio by 2.1 percentage points, to 12.3%.

This is not a small hit. The effect would be more extreme for some weak banks, whose CAR would drop to a much lower level than 12.3%.

Banks' exposure to Evergrande (direct and indirect) was about RMB400 billion at the end of June 2021. Banks and other creditors have been managing down their exposure to the entity in the past couple of years. Evergrande's bank and other borrowings dropped to RMB507 billion at the end of 2020 from RMB604 billion at the end of 2019. In a default scenario, a few banks would be hurt, and they probably would have to deal with a lot of repossessed properties.

Shengjing Bank Co. Ltd. (not rated), in which Evergrande has an interest, has significant exposure to the company. The already stretched bank would likely bear more strain should Evergrande default.

China Minsheng Banking Corp. Ltd. is one of Evergrande's main banks, but it has also been cutting its exposure to Evergrande in the past year. We have a positive outlook on Minsheng Bank because we expect its capitalization to improve. We will continue to monitor the appropriateness of keeping a positive outlook as more details of its exposure to Evergrande emerges. The prospects for improving capitalization will be assessed against asset quality considerations concerning property exposures.

What would an Evergrande default mean for rated engineering and construction firms?

In our view, any fallout should be largely manageable. The engineering and construction (E&C) entities that we rate generally have diversified end-market exposure, spanning railways, highways, municipal works, housing, and power projects.

The entities typically minimize their exposure to housing construction, which is highly competitive and low margin.

Even those heavily skewed toward this business have limited exposure to Evergrande. For example, China State Construction Engineering Corp. Ltd. derives over 60% of its sales from housing construction, but its receivables due from Evergrande are minimal (about 1%, by our estimate).

Shanghai Construction Group Co. Ltd. also obtains most of its revenue from housing construction. We assume this company has about 5%-10% receivables exposure to Evergrande. However, we expect it to have sufficient headroom to absorb any potential receivables or inventory impairment.

China Aluminum International Engineering Corp. Ltd. has 1%-2% of its receivables due from Evergrande. As a smaller entity we rate, additional impairment could heighten the rating pressure given the already thin financial buffer on the entity.

We believe that Jiangsu Nantong Sanjian Construction Group Co. Ltd. has the highest exposure to Evergrande. The company had RMB1.2 billion of accounts and bills receivable due from Evergrande as of June 2021, out of a total of RMB4.7 billion of such receivables on its balance sheet. Moreover, the company has endorsed or discounted RMB3.1 billion of Evergrande commercial bills, which may result in recourse risk.

Jiangsu Zhongnan Construction Group Co. Ltd. a rated developer with a construction arm, also has some exposure to Evergrande. The percentage exposure is not huge, but there could still be downside if investors start to heavily associate the issuer with Evergrande.

We think the smaller privately owned construction firms are more at risk regarding Evergrande's distress. These firms tend to be more focused on housing construction and rely heavily on a few large customers.

The E&C firms in general have been tightening their controls on the receipt of commercial bills that can become problematic. However, they differ on their bargaining power to push for cash payment.

What would a downside scenario look like?

Although we don't expect a large systemic event if Evergrande defaults, the situation could worsen if a disorderly bankruptcy of the group coincided with a deeper market downturn in the sector. This would set off a vicious cycle. We believe that the sector itself is already seeing some weakness in sales and pricing since August and could slip further, as government policies squeeze the sector. The risk for policy overshoot has increased.

A key consideration is whether investors would accept any resolution or set proposals in an unwinding scenario. This includes small retail investors, homebuyers that are end users, and employees. The government would have little tolerance for disruptions or losses for these groups, affecting social stability. Furthermore, if losses are deep for institutional creditors and investors, it may cause them pull back their exposure from the sector faster than anticipated.

The sector continues to be one of the largest contributors to China's economy. The sector is entwined with issues of housing, employment, middle-class wealth, and the health of other related industries. A severe downturn could have significant implications for overall economic stability. The balancing act rests on the tautness of policy.

Writing: Jasper Moiseiwitsch

Related Research

Primary Credit Analysts:Matthew Chow, CFA, Hong Kong + 852 2532 8046;
matthew.chow@spglobal.com
Christopher Yip, Hong Kong + 852 2533 3593;
christopher.yip@spglobal.com
Gavin J Gunning, Melbourne + 61 3 9631 2092;
gavin.gunning@spglobal.com
Ryan Tsang, CFA, Hong Kong + 852 2533 3532;
ryan.tsang@spglobal.com
Ming Tan, CFA, Singapore + 65 6216 1095;
ming.tan@spglobal.com
KimEng Tan, Singapore + 65 6239 6350;
kimeng.tan@spglobal.com
Claire Yuan, Hong Kong + 852 2533 3542;
Claire.Yuan@spglobal.com
Susan Chu, Hong Kong (852) 2912-3055;
susan.chu@spglobal.com

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