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Credit Event at China’s Evergrande Could Have Broader Effects

Numerous sectors could be exposed to heightened credit risk if Chinese property developer Evergrande were to default, says Fitch Ratings. We believe a default would reinforce credit polarisation among homebuilders and could result in headwinds for some smaller banks, although we believe the overall impact on the banking sector would be manageable.

Fitch downgraded China Evergrande Group to ‘CC’ from ‘CCC+’ on 7 September, indicating that we view a default of some kind as probable. Mounting investor concern about Evergrande’s creditworthiness has already exacerbated credit polarisation among developers, which has left those with weaker credit metrics struggling to tap debt markets at sustainable interest rates, increasing refinancing risk.

Evergrande is one of China’s top-three developers, although the residential property market is highly fragmented. Evergrande’s market share in 2020 was only around 4%. We believe the risk of significant pressure on house prices in the event of a default would be low, unless the restructuring or liquidation of its assets becomes disorderly. Fitch believes this is something the authorities will want to avoid.

We see the government’s priority in a default scenario as being the completion of Evergrande’s sold projects. Debt associated with the project companies is typically manageable, but we expect potential acquirers would still want to prevent any adverse impact on their operations – or creditworthiness – given tight industry funding conditions.

Banks have direct loan and bond exposure to Evergrande, as well as exposure to off-balance-sheet wealth-management products, through trust loans. The firm’s liabilities in these areas amounted to about CNY572 billion at end-1H21, much of which we believe was held by banks and other financial institutions. Banks may also have indirect exposure to Evergrande’s suppliers – the developer’s trade payables stood at CNY667 billion. Smaller banks with higher exposure to Evergrande or to other vulnerable developers could face significant increases in non-performing loans (NPLs), depending on how any credit event involving Evergrande develops.

A recent People’s Bank of China sensitivity test indicated that if the NPL ratio for property-development loans were to rise by 15pp and that for mortgages by 10pp, the average capital adequacy ratio of the 4,015 banks assessed would only drop modestly, to 12.3% from 14.4%. (This stress level is well above what we would expect from an Evergrande default alone.)

Growth in banks’ residential mortgages and property development loans decelerated in 1H21 following the introduction of new regulatory caps in January 2021. Sector-wide residential mortgages were only 2% higher at end-1H21 than at end-2020, and our rated banks saw low-single-digit growth or declines in property-related loans in general. Our baseline assumption is that this trend would not be affected by an Evergrande default, with banks continuing to curb property-sector exposure in order to meet regulatory requirements.

At the macro level, an Evergrande default could damage consumer confidence if it were to affect households’ deposits for homes that have not yet been completed, but we assume the government would act to protect households’ interests, making this outcome unlikely.

In the unlikely event that a default unsettles the broader property market, significantly disrupting sales and investment, this could have farther-reaching macroeconomic effects. We estimate the sector accounts for approximately 14% of GDP. Risks to our growth outlook on China are mitigated by the government’s capacity to intervene with policies to shore up the housing market, but we believe the threshold for such support will be high – as it might set back other priorities such as reducing real-estate lending concentration and tackling the high cost of housing. Other forms of stimulus to support economic growth would also be possible in this scenario.
Source: Fitch Ratings

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