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Is China heading for a Junk Bond Crisis?

It has been 14 years now, but many of our clients will remember the collapse of Lehman Brothers.

The collapse of Lehmans, a global financial empire founded in 1847, happened in September 2008 and was the climax of the subprime mortgage crisis. Lehman Brothers was notified of a pending downgrade in its credit rating, due to its heavy exposure to subprime mortgages. The US Federal Reserve failed in its efforts to re-negotiate financing for Lehman, which subsequently filed the largest bankruptcy in US history, involving more than $600bn, at the time approximately £333bn.

Lehman Brothers’ bankruptcy triggered a 4.5% one-day drop in the US Dow Jones index, similar falls around the world and a general financial panic. Fourteen years on, the question is now being asked, could the same thing be about to happen in China?

Originally called the Hengda Group, the Chinese company Evergrande was founded in the southern city of Guangzhou in 1996, during a period of mass urbanisation in China. In 2009 it raised approximately £400m in an initial public offering on the Hong Kong stock exchange.

Its principal business is selling apartments, mostly to middle and upper income buyers, and in 2018 it was ranked the most valuable real estate company in the world. It also has interests in any number of other companies from tourism to health to a large investment in electric cars and the Guangzhou Evergrande football team.

However, Evergrande has hundreds of billions of dollars in debt, and there are increasing concerns over whether the company will be able to service the debt. As long ago as 2012 Andrew Left, a well-known short-seller in the US, was highlighting concerns about the company. In 2016 Left was suspended by the Hong Kong stock exchange, due to his publication of a highly critical report on Evergrande, a company he has labelled “insolvent.”

More recently many stock markets fell on September 20th of this year, over fears that Evergrande would not be able to meet debt payments that had become due. Earlier in the month the Shanghai Stock Exchange temporarily suspended trading in the company’s bonds (specifically, its 6.98% July 2022 Corporate Bond) over what it called “abnormal fluctuations” following a ratings downgrade.

Evergrande has been dubbed “China’s Lehman” and supposedly has more than $300bn (£219bn) of debt. If the company were unable to service this debt and subsequently collapsed then the fallout could spread throughout the Chinese property sector and, indeed, the wider Chinese economy.

Would the Chinese authorities allow such a big company to fail? The answer is, “quite possibly” as there are clear signs Beijing wants to rein in excessive corporate borrowing. According to a report in the Guardian, Evergrande owes money to 171 domestic banks and 121 other financial firms. Bankers UBS also estimate that there are ten property developers in China with combined debt nearly three times the size of Evergrande. In other words, if Evergrande defaults other companies could quickly follow, which would be bad news for China and the wider global economy.

Most worryingly of all, perhaps, the private sector of the US economy added just 374,000 jobs in August, well below the expected figure of 613,000. There was, though, some good news coming out of the US. The manufacturing sector strengthened, largely driven by an increase in new orders. The Purchasing Managers’ Index rose from 59.5 in July to 59.9 in August. The housing sector remained strong, with one index measuring US house prices showing a 19.1% annual increase in June 2021.

…And remember those retail sales that fell in July? In August they were up, albeit by only 0.7%.

The simple fact is that the picture from the US, like so many countries, is mixed. Some sectors are doing well, some are doing badly and that is quite likely to change on a month-to-month basis. There are also other, external factors at work. Sales of cars and auto parts were down by 4.5% in August, but that was caused as much by a shortage of computer chips as it was by any unwillingness to buy on the part of the American consumer.

So is the US recovery about to stall? The simple answer is that the recovery from the pandemic will not be smooth. Different countries will recover at different rates and likewise different economic sectors within individual countries. The US is no different although, very clearly, what happens in the US will continue to affect other economies, especially those in the West.

We should also make one final, important point. This article was written in late September. All the figures were correct at the time of writing: clearly, in today’s fast-moving, interconnected world, they may have been updated by the time you read the article. Does that make the comments above invalid? Far from it, it simply emphasises that financial planning is a journey, and it underscores the importance of regular contact with our clients. Rest assured that we are always working on your behalf.

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