EVERGRANDE - Is it too big to impact? What are the important learnings

- Vikram Kotak

Dear Investors,

Hope this mail finds you in the best of health and spirit.

September 2021 is the first month where we have seen meaningful traction in volatility, the Dollar index, and significant correction in global markets across the asset classes. It all started with one name in China, “EVERGRANDE”.

Evergrande is the biggest Chinese real-estate developer and global fortune 500 company staring at bankruptcy. It has a debt of over $300 BN which is 2% of China’s GDP. It’s too small to move the world despite many global institutions and funds having exposure to Evergrande. Founded in 1996, Evergrande grew its real-estate business on high debt. Debt comesso easily in growth-hungry China, finally, Evergrande has become the topmost borrower in China.

Chinese regulators have become stringent in the repayment of the debt by industry. Also, the unrelated diversification by Evergrande has not gone down well. Evergrande bought a soccer team & it’s building an exquisite lotus-shaped soccer stadium at an investment of $1.7 BN. Some more unrelated diversification it got into is Bottled Water and Electric Vehicle business. The EV business was worth $87 BN, until April 2021 without selling a single car. All this diversification continued at the cost of Evergrande failing in its core business of the real estate. As per reports, Evergrande has not yet delivered 1.6 million properties to home buyers. From an exposure point, over 250 Institutions have lent money to Evergrande. Overall, the Evergrande issue involves serious numbers.

It looks like Evergrande isn’t too big to have an impact on Chinese markets, fully agree, but over the next 12 months, Chinese corporate have to repay debt worth $1.3 trillion. More than 200k companies have declared bankruptcy since the start of 2020.

3 important points for consideration of why Evergrande alone can’t impact China and the world market.

1) The Chinese government has ample resources to backstop Evergrande loan defaults and ring-fence potential spill over to other assets and markets. With around $7 TN of domestic savings and $3.2 TN Forex Reserves, China has enough capacity to absorb a worst-case Evergrande Implosion, recent large liquidity injections by the Bank of China underscores the point.

2) Evergrande is not a classic “black swan” crisis, but rather a conscious and deliberate consequence of Chinese policy aimed at derisking, deleveraging and restoring financial stability. To its credit, Chinese authorities did a great job in reducing shadow banking activity in recent years. Unlike Lehman and its devastating collateral damage, this is more of a China problem.

3) Risk of Evergrande to the real economy in China looks subdued. Urban migration is very strong in China and the underlying demand for real estate is more structural than cyclical.

To summarise, Evergrande can create some shimmers on the Chinese real estate market and financial market in the short -term, but I believe the Chinese government is working on containing the damage to its minimum.

However, a bigger worry for China today is a major rethinking of its growth model. Measures were taken by Chinese authorities on clamping done on China internet platform companies and suddenly tightening lending norms has impacted the confidence of local and global Investorsin a big way.

The Chinese President is strongly backing inclusive prosperity and addressing inequalities of income and wealth. Moreover, the government is broadening its regulatory net not to just ban crypto-currency, but also to become an instrument of social engineering with the government adding E-cigarettes, business drinking and celebrity fan culture to its ever-lengthening list of bad social habits.

The biggest challenge for China is, new approach runs counter or opposite to the thrust of many of its most powerful economic trends of the past 3-4 decades. Such as entrepreneurial activities, thriving start-up culture, private-sector dynamism and innovation. It is confusing that new policies in silos can create huge uncertainty and chaos for entrepreneurs and investors. A more clear and guided approach can save China from major growth challenges going forward. China remains a big growth engine to the world. It will be essential for Chinese authorities to take a rational path that can create a long-term approach to their social themes rather than clamping down on private enterprise in a hurry.

We continue to Invest in companies which are Conservative in leverage and focus on their core business models which is also most important learning from 'EVERGRANDE' Fiasco.