Life’s a bitch and then you get involved in the Chinese property sector.
That the roaring economy of the Middle Kingdom is over-borrowed to breaking point is nothing new although we appear to take the stoic position that the Beijing government is omnipotent and that, if push came to shove, lifeboats would be built and life preservers handed out to make sure that a drama didn’t grow into a crisis. There might be a game of pass the parcel going on, as there was with overrated and under-priced credit as in the West in the middle of the last decade, is a consideration best avoided; shut your eyes tightly for long enough and it might go away.
The spectre of a massive crash in Chinese credit has been the elephant in the room for a long time and the past 48 hours have seen the world peep through its fingers and see a quantity of grey. The piece of grey, for bond markets, was a three-tranche transaction for China Evergrande, a property company that came to market on Wednesday with a B3/B-/B- rated deal. Issuing US$598.181m of four-year notes at 6.25% and par, US$1.344bn at 7.5% and par and US$4.68bn at 8.75% and par, so some US$6.6bn in total, is not a bad wheeze.
Moody’s definition of single B credit is “judged as being speculative and a high credit risk” and B3 is just a sniff away from a Caa credit rating, which is “rated as poor quality and very high credit risk”. There are people out there who are desperate enough for yield to put up US$6.6bn to a lowly rated borrower in a sector stretched to breaking point.
Rumours started that the Chinese banking regulators are getting cold feet and that they had very politely asked banks to review their exposure to highly leveraged property groups. Evergrande bonds, with the ink barely dry and within hours of their having being priced at par, were trading somewhere in the region of 94.5, which translates to a capital loss of some US$365m. In the event, the bonds have since recovered a couple of points but they are still down on where they priced. Even so, regulators seem more concerned than investors.
That is plain wrong and if observers want to know where to go hunting for black swans, look no further.
Stressed out
Going into the global financial crisis, banks’ balance sheets were replete with first loss pieces of CDOs that had been acquired at zero on the basis that they were free bets with nothing but upside. Mark-to-market rules and bonus greed brought these free options to be priced at a positive number that pumped up the current P&L but led to big losses being taken when they proved to be worthless. Regulation has taken the risk off the banks’ balance sheets but the risks are still there and now they belong to somebody else. That somebody is the asset management world where the same risks are hiding, albeit with a lot less leverage.
Just a day after Morgan Stanley gave China its seal of approval by including China A-shares in the MSCI global index, the emerging markets hall of fame, we are treated to a renewed reminder of just how fragile the Chinese model is. As a cub banker at Barclays International in the 1970s I was taught never to lend on the strength of the guarantee but on the merits of the underlying loan. We now have Chinese corporations as the largest issuers in the global credit space and it seems that much of the money they are raising is coming their way because investors want to believe that Beijing will make sure nothing too dramatic goes wrong.
Last night we got the results of the most recent Fed-sponsored stress tests for the US banking system and, low and behold, all 34 banks passed. But it was not a bank but an asset manager that was caught short with half of Banco Popular’s AT1 bonds on its books. Despite assurances that this is not the case in the stress tests, it would appear that regulators are looking the wrong way. Maybe they should spend more time finding out where the risks are now parked and less on patting themselves on the back that they are no longer where they once were.
That said, the stake the authorities hold in the economic edifice, be that in China, the EU, the US or anywhere else, is now so great that markets have lost the ability to gauge the true risks and, to be frank, so have they. The hole in the Chinese property dyke is very large but then so is Beijing’s finger. In the Dutch tale the heroic little boy was relieved as the grown-ups came to repair the dyke. But who is there to help Beijing fix the cracks?
Alas, it is that time of the week again and all that remains is for me to wish you and yours a happy and peaceful weekend. As temperatures fall back to normal, so does my envy of those who have had the privilege of sitting in air-conditioned offices in the City or on the Mainzer Landstrasse. As the week draws to a close, so does the spectacle of Royal Ascot, a wonderful race meeting of the highest quality, spoilt by tabloid TV’s obsession with women on stilts decorated with obscenely overblown headgear parading as a hat. My focus tomorrow morning will be on the men in red as the British and Irish Lions take on the mighty All Blacks at Eden Park in Auckland. Rumour has it, by the way, that they are considering cancelling the Glastonbury festival due to a lack of mud… Enjoy!