Date: 09/27/2021
Author: Kent Moors, Ph.D.
On Friday, I provided the weekly portfolio reviews for my Sigma Trader and PRISM Profits members. One of the matters addressed about to impact the wider market is the impending collapse of the Chinese Evergrande property and finance holding.
Thus far, most analysts point out that foreigners have limited exposure to the unfolding debacle. Unfortunately, that will not remain the case as this crisis unfolds. Markets worldwide, and the flow of liquidity among them, could roil.
That seems especially likely with what my network contacts have been telling me over the weekend. Don’t look now but we may see a version of the derivative paper debacle that hit worldwide beginning in 2007-2008. Then, the initial source was subprime mortgages and the questionable mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) flowing from them. This time around the wider contagion will likely be ushered in by another kind of derivative paper.
In the earlier mess, paper cut on suspect mortgages moved into the broader stream of global finance by derivatives on which dollar-denominated debt paper became progressively poisoned by a rising default rate in mortgages given to non-credit worthy parties.
Given the expansion in how paper was collateralized worldwide, a relatively small amount of toxic mortgages wrapped within much larger tranches of MBS and CBO issues globally brought the entire international credit market under suspicion. Banks no longer would lend to banks and liquidity dried up overnight. It required unparalleled central bank intervention across the globe before the financial pandemic was overcome.
This time around, the initial wave of potentially wider infection involves paper called credit default swaps (CDSs). These are derivatives providing insurance against a party’s nonpayment of obligations under a credit, debt, or loan arrangement and are increasingly used to hedge against risk in highly volatile credit markets.
Dollar-denominated CDS paper has little use in the Chinese domestic credit market where debt is held in renminbi (RMB) or yuan (CNY). The former is the domestic currency of record, while the latter refers to the unit of account for the Chinese economic and financial systems.
Now there is at the moment little use for dollar-denominated insurance paper against the bulk of Evergrande’s estimated $305 billion and counting debt precipice. Just about all of that arise from highly questionable domestic real estate assets widely held by a population in search of an adequate return.
Unfortunately, that insolation may be more apparent than real. More on that in a moment. But first some necessary background on the broader Chinese morass.
The mortgage equivalent flow is part of a wider economic problem in China I addressed in an earlier CIB (see “The Distortion from a Chinese ‘Phantom’ Economy,” Classified Intelligence Brief, February 21, 2021). As I wrote then:
Analysts have been pointing to several unusual elements in the Chinese economy. These are beginning to (once again) project questions upon a broader geopolitical landscape.
And for some time, my folks have been watching how this has played out in wider global investment, credit, and cross-border trading environments.
What has been underway in China defies conventional views. It has either been the result of a fundamentally different way of doing things or the product of a lot of smoke and mirrors.
Progressively, many in my network are opting for the second view.
Thousands of factories continue to remain open despite parent companies either running at staggering losses or the locations apparently producing nothing at all. The existence of “ghost cities” costing billions but without residents, a cascading housing market hurtling well beyond ability to pay, and a mountain of non-performing debt all cast a curious shadow on the Chinese success story often touted by the central government and its still ruling party central committee.
Such concerns stand in marked contrast to the more highly visible accomplishments. These include the transformation of Shanghai into an impressive financial center, a national high-speed rail network the envy of the world, and the fastest growing airline industry on the face of the earth (at least before the onslaught of the coronavirus pandemic).
Nonetheless, the underpinnings of a remarkable economic advance have come under increasing scrutiny.
For the past decade (at least since central government decisions to stimulate the national economy), Beijing has engineered an internal approach that would seem curious in just about any other system. While most other countries would countenance official involvement in the domestic market to offset problems or set targets, the Chinese public sector drives investment by tying personal financial prospects to an ongoing tsunami of physical expansion.
In China, personal consumption patterns bear little relationship to actual income levels. The average person spends much more than a combination of wages and savings would appear to justify.
Some of this is “off the books” proceeds. The grey market in China provides an additional personal revenue flow for just about everybody. But that is not the primary source. Neither is interest from traditional bank accounts, the levels of which are held low by the government to encourage bank lending to brick-and-mortar projects.
Results from endemic paper called wealth management products (WMPs), peer-to-peer (P2P) investment services, creative ways of multiplying credit, and other ingredients permeating daily life and prospects have combined with a government decision to bail out the stock markets if things get bad. This has resulted in a population personally overextending across economic sectors.
More of the apparent personal wealth in China is found in the control over physical assets not actually employed in any traditional sense. For example, three of my contacts own multiple (and empty) apartments in the sprawling urban expansion now underway in many parts of the country.
What makes the spiraling cycle of acquisition at the expense of savings achievable is the government’s acquiescence to releasing ever greater amounts of currency into the domestic economy.
This has fueled an appreciating value for hard assets that well outstrips interest received from bank accounts, inflationary pressures on staple market commodities, or the cost of credit. Companies and lower-level governments are carrying heavy debt burdens because of this.
Production and urban facilities continue to be built not to service genuine need or expected levels of market demand but to absorb increasing levels of debt. The opaque nature of national banking combined with all levels of public administration finding creative ways to hide liabilities contribute to this construction urge. That non-performing older debt can be replaced with new lines of credit merely augments the cycle.
Much of the hallowed Chinese miracle is a result of an appreciating tide of asset book value, thanks to the complex network of overt and subsumed financial machinations. Among other observations, the Chinese way of doing things makes basic figures like state gross domestic product (GDP) and company quarterly reports less reliable as genuine barometers of economic health.
The number of new apartment and condo complexes dwarfs anything found elsewhere. Unfortunately, what had been portrayed as necessary in meeting the moving of rural populations into central locations to serve expanding factory production is now essentially over. The ever-expanding market of new housing is not intended for such internal migrants. Few in that population could afford the rising costs anyway.
So long as the value of residential units appreciate, they remain as domestic holders of asset value, and thereby attractive examples of paper wealth for many individual Chinese.
Meanwhile, the weight of empty new cities falls on the books of local governments who then rely on the shadow banking sector to offset the cost of the huge debt incurred in the construction of urban services, facilities, and support in the absence of residents.
The contemporary Chinese internal economy has increasingly operated in ways that seem to violate basic principles. Its expansion seems less a result of normal market demand and more an essential tool used to soak up excess credit.
To my amazement, the answer being offered by my Chinese colleagues is not what I had expected. While most recognize that the situation appears unsustainable by traditional Western analysis, they point out what is fundamentally different in this case.
As one put it succinctly during an email exchange: “There are important differences when it comes to China: the extent of the territory; the size of the population; and a central government committed to expansion.”
He then added this later: “Beijing will not allow the assets accumulated by the people to evaporate. The people, in turn, know that.”
It is against this expanding background that the current Evergrande crisis is unfolding. While the fund holds assets in several property classes, it is has become the world’s most indebted developer, with nonperforming liabilities rapidly growing.
On Thursday of last week (September 23), the next shoe dropped. Two interest payments came due. The fund did pay the smaller first, denominated in local currency. But it did not pay the second and this is the first tangible indicator of an avalanche of default on its way.
The nonpayment is of an $83 million interest payment on a dollar-denominated bond maturing in March 2022. Most of this paper is not held by domestic parties in China but by foreign investors. Technically, Evergrande has 30 days to make that payment before a genuine default occurs.
And that means this ongoing drama will extend throughout October. A default on any paper outstanding will trigger cross-defaults on other holdings, subject to decisions made by those creditors.
But well before late October, dominoes will cascade down. The multiplier effect will kick in, weakening and toppling considerably more asset and other based paper worldwide. At a minimum, global liquidity will be adversely affected.
Meanwhile, Evergrande is remaining silent on whether it will honor its interest payments. A full-blown Beijing government bailout cannot occur as the liabilities will be far too expansive, involve the reimbursement of outside creditors, and have much of the spreading impact landing abroad.
One of the private international investment groups I advise has foreign-held CDSs on this bond and related Chinese holdings. As is common in such exchanges, such swaps are collateralized by other dollar paper backed by other non-Chinese hard currency assets.
For the moment, the group’s CDS exposure can be mitigated by taking offsetting options. But that is hardly an effective ongoing strategy should the Evergrande default express expose more outside paper to devaluation.
Seems like déjà vu “all over again.”
Dr. Kent Moors
This is an installment of Classified Intelligence Brief, your guide to what’s really happening behind the headlines… and how to profit from it. Dr. Kent Moors served the United States for 30 years as one of the most highly decorated intelligence operatives alive today (including THREE Presidential commendations).
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