Chinese financial system near “peak of stress”, but fallout is yet to come (analysts)

Chinese financial markets are approaching “peak stress” levels, with growing concerns over its heavily leveraged real estate sector as the saga around ailing developer China Evergrande Group unfolds.

And investors shouldn’t expect a sustained rebound in the country’s stock market until the credit cycle improves, Danske Bank analysts said.

But assets indirectly linked to the world’s second-largest economy have yet to feel the ripple effects of China’s economic slowdown, they also warned, in a note Friday.

“While Chinese stock markets have been more stable in recent times, tensions in developer credit markets have continued unabated, with high yield credit rates hitting new highs day by day,” wrote Allan von Mehren and Lars Sparresø Merklin, based in Copenhagen (see graphic below.).

Danske Bank

Evergrande 708,
+ 4.63%,
the highly leveraged developer with more than $ 300 billion in debt, has been in the limelight, reportedly missed several coupon payments in recent weeks, and was at risk of being declared in default as the grace periods for those payments grew. exhaust. Evergrande chief executive Xia Haijun was in talks in Hong Kong with creditors and investors over restructuring and possible asset sales, Reuters reported on Friday, citing two people familiar with the matter.

Last week, a liquidation of Chinese developer dollar bonds was triggered after luxury developer Fantasia Holdings Group Co. failed to repay $ 206 million in dollar bonds that matured on October 4. .

Amid fears of a spillover, China’s central bank announced on Friday that threats to the financial system from the real estate sector, which would account for nearly 30% of the country’s gross domestic product once backlinks and downsize. downstream taken into account, were controllable, the Wall Street Journal reported, citing state media.

Zou Lan, head of financial markets at the People’s Bank of China, said officials urged Evergrande to speed up asset disposals and resume projects to protect the interests of homebuyers, according to the report. The official said financial authorities, the housing ministry and local governments will work together to provide financial support so that stalled projects can restart.

The Shanghai Composite SHCOMP,
+ 0.40%
fell 0.6% this week, while the larger CSI 300,000,300,
+ 0.38%
made a minor gain. The Shanghai Composite is up 2.9% for the year so far, but down more than 4% from its 2021 high set in February. The CSI 300 is down 5.4% for the year and is down nearly 17% from its 2021 high.

The S&P 500 SPX US Large Cap Benchmark,
+ 0.76%
is up over 19% so far this year, while the Dow Jones Industrial Average DJIA,
gained more than 15%.

Danske analysts noted that major state-owned banks have been urged to ease restrictions on mortgage lending and have been allowed to securitize loans again, in a bid to support home sales.

They said Beijing would likely take steps to ‘unfreeze’ credit markets soon, “because very few developers can survive this kind of funding and liquidity crunch for long.”

Among the options, the PBOC could lower the reserve requirement ratio and prompt large state-owned banks to start buying high-yield bonds, they said. Analysts argued that if conditions calm down, buying 20% ​​bonds would likely prove to be a “fairly favorable” investment for banks, while private investors would also be encouraged to start buying if the government gets involved.

They are also seeing more direct bank lending to developers, with authorities likely to ease regulations that cut lending last year.

However, Danske analysts and other Chinese watchers argued that Evergrande and the real estate industry were unlikely to threaten a “Lehman moment,” a reference to the Lehman Brothers collapse in 2008 that temporarily froze markets. global credit markets and marked the darkest phase of the global crisis. financial crisis. This is because the government’s ability to dictate the actions of lenders and the like gives Beijing more flexibility.

But the crackdown on excesses in the real estate sector and other factors was still likely to ensure a continued slowdown in the Chinese economy.

“Even after an orderly restructuring of the most affected developers with minimal contagion to the financial system, construction activity would almost inevitably slow down much more. As we have been warning for some time, this is the logical consequence of the ‘three red lines’ policy imposed on developers last year, as well as the huge demographic headwinds the industry is facing, ”said Oliver Jones, Senior Markets Economist at Capital Economics, in an October 12 Note.

Danske analysts have pointed out that there is a long way to go between peaking financial stress and restarting the credit cycle.

“For Chinese equities, this may just be a time when we are seeing more sideways movement, waiting for the next big cyclical credit reboot,” they wrote. “For assets that are more indirectly tied to Chinese assets and the credit cycle, we think this will mean little.”

For example, the euro EURUSD,
is likely to continue to decline against the dollar “as the effects of the historic Chinese tightening trickle down to the global manufacturing sector.”

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