Market Insider

A liquidity crisis at a large Chinese property developer has shaken global markets, and strategists say it could send ripples across the global economy.

But they also say the issue will likely be contained by the Chinese government before it wreaks damage in the banking system and it is not expected to lead to a broader global financial contagion.

The critical question for investors is how and when do leaders in Beijing handle the situation, and whether they launch a restructuring of China Evergrande Group as many market pros expect.

Investors have worried that Beijing is likely to let the company fail, wounding stockholders and domestic bondholders. Evergrande faces a debt payment on its offshore bonds this coming Thursday, after it said last week it was facing unprecedented difficulties.

“Everyone was expecting the government would have some kind of resolution given that Evergrande is a systemically important company,” said Jimmy Chang, chief investment officer at Rockefeller Global Family Office. “It has $300 billion in outstanding debt. There is a contagion issue if China Evergrande is not resolved. I think it will end up having some deep-pocketed state-owned enterprises to take over.”

Market pros don’t think that Evergrande could lead to the next financial crisis, but it could lead to more volatility.

“The hard thing about particularly understanding China is that it is an opaque system and oftentimes you don’t have answers until you get answers,” said Rick Rieder, chief investment officer of global fixed income at BlackRock.

“The banking system tends to be controlled by the government,” Rieder added. “There is government intervention that presumably would come in. I think for a period of time, when you wrap this into everything else there, there’s near-term financing questions around some of the other property entities and when that happens then it can create some volatility, and some financial contagion. My sense is the government will act and my sense is it will stabilize.”

Rieder said there could be some caution around Chinese property companies and multi-disciplinary companies for a period of time.

There is concern the already slowing China economy affected further and that could flow into other economies.

Chang said the Chinese government needs to act quickly since Evergrande is beginning to affect sentiment, after being ignored by global markets.

“It could be a self-fulfilling prophecy. This liquidity issue, real estate is so important to the Chinese economy and the financial well-being of so many Chinese families. Homeownership is over 90%,” said Chang. “So many people buy apartments as an investment, so if it this thing is not contained, it could become a real black swan.”

The fact that China’s economy is so large could affect the rest of the world, Chang added. “If China were to have a serious economic issue because of China Evergrande, the rest of the global economy would have contagion from it.”

The Dow Jones Industrial Average ended Monday’s trading session down more than 600 points, after steep stock market declines in Europe and Hong Kong and other parts of Asia. The 10-year Treasury yield, which moves opposite price, slid as low as 1.297% as investors sought safety in bonds.

Protecting the broader financial system

“I think ultimately the Chinese authorities will step in to make sure at least the wider financial system doesn’t run into crisis,” said Mark Williams, chief Asia economist at Capital Economics. “If you’re a property developer you’re facing a few bleak months ahead. The key distinction I think is policy makers will allow property developers to suffer considerable pain, but they’ll step in to make sure the banking system is okay.”

Jim Chanos, president and founder of Kynikos Associates, said it’s a critical moment for the Chinese leadership, which has been carrying out a regulatory crackdown on internet companies, education companies, gaming and other industries.

Chanos said it will be key to see how Beijing responds to Evergrande.

“We are seeing a different change in tone… the way the government is treating business, business leaders, western investors. How will they handle a bailout that everyone thinks is coming, in some way, shape or form?” he said on CNBC. “Will Western bondholders be bailed out? Will it only go to property owners who are owed apartments that are not yet constructed by Evergrande? Will banks take a haircut?”

Pain in the Chinese property market?

China has tried to stem the speculation in its property market four times since 2011, Chanos noted. “In each of those cases, the economy hit stall speed really quickly, and the authorities took their foot off the brakes and hit the accelerator again,” he said.

He said that the residential property market equals 20% of China’s GDP while real estate activity in general is about 30% of GDP. “These are just the off-the-chart kind of numbers, and they’ve gotten worse under President Xi, not better. We don’t think it’s systemic to the Western financial markets,” said Chanos, who has shorted China stocks.

Capital Economics’ Williams said there are about 1.4 million property owners who have paid deposits and await delivery of Evergrande properties. “We don’t know whether they can build the houses, but it seems unlikely,” he said, noting that some residences are already under underway and at different stages of construction.

The risk is if there is also trouble at other property companies, property values will suffer and there could be turmoil in the housing market. The consumer is a large factor in the Chinese economy, and a hit on housing could hurt consumption.

That would also bleed into other regional and global markets through a weakening in the Chinese imports market as well as a slowing of demand for all sorts of raw materials.

“When you couple it with some of  the regulatory changes in China, the clear slowdown in growth, the clear slowdown in commodity demand alongside that growth, there’s some reason to pause and be patient about what’ happening  in the region,” said Rieder. “But the growth of China economically and the intertwined nature of China in the global economy is massive, and so China as an important focus of the markets isn’t going away any time soon.”