There have been significant losses over the past couple of months for international holders of China credit and equities. China’s highly distressed real estate companies are at risk of collapse as the country’s second largest real-estate developer, Evergrande Group, wavers on the brink of default of over 300 million dollars in loans. Any broader contango towards the financial sector in China will prompt major policy responses to stabilize conditions in the market, and it is unclear whether there will be a government bailout from Chinese authorities at this time.

The global market sell off on Monday highlights investor fear that Evergrande’s predicament would hurt China’s economic growth and ripple through its financial system. The potential for prolonged uncertainty is likely to continue fueling these sell offs, and several conditions will need to exist in order to find a durable bottom across markets:

Strategic systemic risk correction: Last August, China tried to forestall a systemic crisis after imposing strict rules on the Chinese real estate industry known as the ‘Three Red Lines’ limit. These rules were instated to put a cap on how much debt these companies can take on to expand operations, and were aimed at making real estate more affordable for the average family. These new rules dictated by the economic realities rooted in China’s financial system left Evergrande in a liquidity crunch—unable to repay its debt or fund new development in order to sell off assets. It will be interesting to see how China will go about new policy change to curb the problem of leverage on a forward looking basis.

Acknowledgement of deep capital misallocation in China’s market: As a result of years of seeking growth through real-estate construction and leverage, capital has been starving more innovative and high-tech industry developments. In turn, this has created a headwind for a re-balancing towards a more sustainable consumption-driven growth model. (Real estate accounts for 30% of China’s GDP, while consumption accounts for 70% of GDP in the U.S.)

Sustained and credible monetary and fiscal policy response: Chinese authorities will have to launch measures and devise policies capable of supporting its financial system. Liquidity was injected into the market last week, but there will need to be more temporary policy measures put in place for correction.

HY Corporate Credit Market
The problems at Evergrande have escalated rapidly in recent weeks and we looked to Solve’s market data to help track the evolution of Evergrande’s declining bond prices over the last three months.

Evergrande HY Corporate Credit Prices Relative to Average HY Price Composites for the Real Estate & Other Industries

Source: Solve Advisors Market Data

In the graph above, we see prices hit a pre-sell-off peak of $98.94 in late May and then slid 74%, bottoming out at $25.83 on September 3rd. This is all while average price composites for real-estate and all other industries as a whole remain steady. It is unclear whether the shock to global markets has been priced in, but high yield credit prices for Evergrande seem to be making a slow recovery from their September 3rd levels, and the data does not yet suggest the entire industry has been affected.

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