China Evergrande finally defaults – what should I do with my Chinese holdings?

Since September 2021, Evergrande has been trying to turn around its situation by improving its capital structure and liquidity conditions through evaluating strategic options, and maintaining ongoing dialogue with all creditors including those of its offshore bonds.

This week, Evergrande have finally announced that based on its current liquidity status, there is no guarantee that they will have sufficient funds to continue to meet its financial obligations.

They have announced plans to formulate a viable restructuring plan of the Company’s offshore indebtedness for the benefit of all stakeholders.

Is this the end of Evergrande’s (and the property sector‘s) woes?

After months of barely avoiding default by paying interest dues on its bonds and borrowings within the cure period, Evergrande has finally defaulted. This has led to cross defaults and allowed creditors to now commence legal actions such as demanding acceleration of repayment and seizing assets.

Another large developer, China’s Kaisa Group has also started work on restructuring its offshore debt worth US$12 billion after it was unable to repay US$400 million of bonds that matured this week triggering cross default provisions on all its offshore bonds and prompting a downgrade to the lowest credit by rating agencies.

What’s next for Evergrande and the other defaulters?

When a Chinese company defaults, the legal process in which it undertakes is largely similar to that of western countries.

Yi Gang, the People’s Bank of China governor has also made a statement saying that Evergrande’s risk problem is a market event and that the rights and interests of creditors and shareholders will be respected in the order of legal compensation.

Here’s a rough sequence of events that is likely to occur:

1. Voluntary restructuring – this is an orderly negotiation between all creditors to agree on new terms such as reducing interest rate, delayed repayment and a reduction applied to the principal of the debt (also commonly known as a haircut) or a debt to equity swap. This is also where negotiations may concurrently occur for potential merger and acquisitions.
2. Insolvency – If negotiations do not succeed, all creditors will have to make a claim for the assets and the claims are ranked based on security and seniority. Claims that are rank higher include debt secured by collateral and deposits by new home buyers. Unsecured creditors such as employees and other bank borrowings will be paid thereafter.

It is unlikely for equity holders to receive any value but some value may be reserved to get the support of all parties involved.

It is clear to everyone that with the Chinese government’s presence, we expect the negotiations to succeed and for an orderly restructuring of Evergrande. The Chinese government’s presence in the process will also ensure that minority creditors have their rights protected. It is highly unlikely that they will allow Evergrande to be insolvent as this may lead to a fire sale on its assets and contagion throughout the industry and economy.

China is also doing everything it can to manage the broader economic risks by easing economic policy through the reduction of the reserve requirement ratio to ensure liquidity in the market.

What’s next for investors?

There are 2 main schools of thought when it comes to investing in China:

1. China is uninvestable – People who take this view believe that China is uninvestable at any valuation. That the Chinese government has overarching control into every corner of the economy and wants to maintain its dominance.
   
2. Best investment opportunity of the year/decade/century/millennium – This view is formed by taking into consideration the low valuations currently and future high growth estimates underpinned by strong macroeconomic growth.

At this stage of the situation, investors on either ends of the spectrum would have already made a decision with their money and those who have invested have taken the view that this is one big step closer to the end.

For those who are sitting in the middle, diversification with prudent risk management could mean an opportunity to gain exposure into one of the biggest economies of the world at a decent valuation.

What should you not do?

The entire restructuring and turnaround process can be lengthy and at times opaque due to complexities surrounding legalities and the considerations by every stakeholder. These would have an impact on the negotiation process.

Not only may stocks decline further, but one should also not expect a quick resolution. You definitely should not take up positions which requires stocks to recover within a certain duration such as this trader who entered into call options in Alibaba without the appropriate risk management measures and lost almost everything.

Conclusion

We thought that instead of sharing one quote by Warren Buffett on long term and value investing, why not go with a few to remind ourselves of some of the wise statements the great Sage of Omaha lives by.

The fallout has led to favourable valuations across many sectors, whether directly or indirectly due to the Evergrande saga, slowing economy or government clamp down leading to stricter regulations. There could be longer term opportunities present now but one has to be mindful that the recovery process maybe lengthy and be able to tolerate the volatility at hand.

Since we are on a roll, one final quote – Fortune favours the bold.