Is China Evergrande an isolated problem or should we be concerned that this is a common problem throughout the Chinese economy (and thus much more to be concerned about)?

Eoin Treacy's view

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The unfolding Evergrande saga is taking a toll on the Chinese offshore bond market, as yields on the ICE BofA Asian Dollar High Yield Corporate China Index rose to 9.93% on Friday, up from 8.5% as recently as May 26 and far above the 4.65% on offer for the equivalent U.S. gauge. That 536 basis point spread marks a near-decade high, apart from a brief spasm during the March 2020 liquidation. Yet, that rough price action hasnʼt derailed insatiable investor appetite for yield: Chinese developers sold $20.3 billion in dollar bonds through June 2 per Refinitiv, up 16% from last yearʼs pace and running “completely contrary” to investor expectations for subsiding deal flow, Owen Gallimore, head of credit-trading strategy at ANZ, commented to The Wall Street Journal.

More broadly, as a debt-fueled fixed asset investment and a bloated financial system (featuring $50.3 trillion in banking assets as of March 31, more than half the $84.5 trillion in global GDP last year) stand as the centerpieces of the Chinese economic miracle, a brisk pace of economic growth is paramount for avoiding trouble.

Yet on that score, recent data are less than encouraging, as total social financing (i.e., aggregate credit and liquidity flows) came to RMB 1.92 trillion in May, light of the RMB 2 trillion consensus estimate to mark the third straight negative surprise. Similarly, M2 money supply growth registered at 8.3% year-over-year in May, down from 10.1% three months earlier and near the lowest level since at least 1996, while the credit impulse (or growth in borrowing as a percentage of GDP) slipped to 25.6% last month, down from 31% in February and the lowest reading since early 2020.

Quid pro quo is a dangerous mix when it comes to debt markets because one of the easiest ways to raise funds is to boost leverage through convenient relationships. If I need more funds, it is easy for me to buy a portion of your bank in return for your boosting leverage to invest in my company. The challenge is this is a simple transaction but the underlying web of interconnectedness across the developer/bank/materials/local and national government level is probably impossible to clearly identify.

Ahead of the credit crisis Hypovereinsbank and GM had so many bonds they had their own yield curves. That’s the paradox of the debt markets. The biggest most liquid issues are always from the most indebted companies and countries. China Evergrande is the biggest debtor in the entire high yield emerging sector globally. Rising yields for Evergrande mean higher borrowing costs for every other issuer since the company has such a large weighting in bond indices.

That risk has moderated over the last 48 hours with Evergrande meeting a short-term repayment deadline. The challenge is this issue is likely to continue to emerge every time a coupon payment comes up. China’s efforts to rein in credit expansion will continue to pressure highly leveraged companies. The great known unknown in China is what is the natural default rate? The one thing we do know is the quantity of outstanding debt is extraordinarily high.

The iShares JPMorgan EM High Yield Bond ETF has lost momentum over the six months and continues to pause below $46.