Evergrande: Volatility & What It Means For Your Margin Loan

Evergrande: Volatility & What It Means For Your Margin Loan

You will have seen scores of headlines about Evergrande, China’s largest homebuilder, across financial media in recent weeks. In this update, we share our thoughts on what Evergrande is, why everyone is focused on it, and how it affects your clients and their portfolios.

What is Evergrande?

Evergrande is China’s largest property developer. In 2021 it reported A$330 billion* dollars in property assets on its balance sheet (mostly in-progress developments), A$120 billion in borrowings, and a further A$201 billion in outstanding payables. Evergrande‚Äôs total debt is thought to be a lot higher than this due to off-balance-sheet financing, but nobody knows how high.

Recent regulations aimed at curbing excesses in the property market have placed pressure on house prices, reducing sale volumes, and making finance harder to access for property developers. Essentially, Evergrande has accumulated too many liabilities which it does not have cash to pay. The cash crunch has been so severe, Evergrande asked employees to contribute or risk losing their jobs.

Evergrande has reduced debt by delaying payments to suppliers, which greatly increases the risk of serious economic fallout.

A shortage of cash combined with new property regulation has made it hard for Evergrande to finish outstanding projects. This means it can’t easily sell property to generate enough cash to repay suppliers and creditors. China state-owned media recently reported that Evergrande has been offering to pay debtholders with property.

Why does this matter?

With four Chinese homebuilders – Fantasia, Modern Land, China Properties, & Sinic Holdings – defaulting on bond repayments recently and Evergrande teetering on the edge, investors are concerned about the potential for contagion throughout China’s economy, if not globally.

In a contagion scenario, the collapse of Chinese homebuilders leads to significant economic fallout in China, with failing businesses, rising unemployment, lower levels of investment & construction, and distressed banks. Global investors also risk losing their significant investments in Chinese bonds and stocks. While the Chinese government will go to great lengths to avoid a full contagion scenario, a downturn in the economy could have significant impacts on Australia, whose largest trade partner is China.

Residential construction activity accounted for nearly 20% of Chinese GDP (pre-COVID)

A significant amount of Australia’s top ten** exports – gold, coal, iron ore, aluminium, copper, education, tourism – are either destined for China or consumed by Chinese citizens. A reduction in economic activity or a shock to consumer purchasing power could easily reduce demand for Australian products.

What you can do about it:

As margin loan holders, your client’s first priority will be to maintain the integrity of their portfolio – avoid large losses and the dreaded “margin call”. What percentage of portfolios are in miners like BHP Billiton (ASX:BHP) or Rio Tinto (ASX:RIO), Asia-focused funds, or businesses strongly exposed to Chinese demand like a2 Milk Company, (ASX:A2M), Treasury Wine Estates (ASX:TWE), and IDP Education (ASX:IEL)?

We’d suggest looking at client portfolios in three ways:

  • How significant is their China exposure?

Stress test China-exposed positions. What percentage of the portfolio overall is exposed to businesses with significant earnings in China? If those stocks went down by 50%, would your client be at risk of a margin call?

  • How vulnerable are client portfolios to market volatility?

Stress-test the overall portfolio. How high are client loan to valuation ratios (LVRs)? If there was a shock, and markets fell 30% within a few days, would this cause a margin call? For context, during the COVID crash the ASX200 fell 33%, peak-to-trough, in 28 days from February to March 2020.

  • What is their liquidity position?

Do clients have cash reserves that could ease a margin call, or would they be forced to sell stock? Are investments sufficiently liquid that they can easily be sold to reduce exposure? Small caps and emerging market investments generally have much lower liquidity.

The bottom line

Remember that we are looking at potential risks. It’s not a given that Evergrande will cause a market shock or that the fallout will hurt China-exposed businesses. However given the potential severity of this event, it is prudent to examine how vulnerable clients may be in various scenarios.

If you’re concerned about client margin loans, ask us about Leveraged’s Investment Funds Multiplier product, which allows margin calls to be relieved at the rate of 1% of the portfolio a month, without forced selling at the bottom of the market. This product, which is unique to Leveraged, lets client portfolios recover in line with market, and alleviates the need for significant amounts of cash in a short period of time (credit checks required).

May the markets treat you well,

The Leveraged Team

*all numbers converted using AUD-RMB spot rate on 27.10.2021, source: Google Finance

**(using 2019 DFAT figures to exclude the Covid impact)