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Counsel Views – Episode 16: Siguo Chen

Typhoon Evergrande – Expert insights on the Evergrande Group real estate crisis and recent government policy actions

Counsel Views, hosted by Stu Morrow, Chief Investment Strategist, RBC PH&N Investment Counsel, is an audio series aimed at bringing insights to clients from thought leaders and experts across Canada’s leading wealth management firm.

Episode guest: Siguo Chen: RBC Global Asset Management (Asia) Limited

Direct from Hong Kong, Siguo Chen of RBC Global Asset Management Asia (RBC GAM Asia), joins Stu to provide timely and important insights into the ongoing crisis at Evergrande Group, the massive Chinese real estate company sinking under a seemingly insurmountable mountain of debt. The reverberations from the crisis that have been felt across the world, and the recent government policy changes impacting other important Chinese companies such as Alibaba and Tencent, are addressed through Siguo’s thoughtful perspective as a top industry analyst.

Siguo Chen joined RBC GAM Asian Equity team as a China specialist in 2018. Prior to joining RBC, Siguo was an equity research analyst at UBS Hong Kong since 2012, covering H-Share consumer sectors and Hong Kong strategy. Siguo holds a Master’s degree in Finance from HEC Paris and a Bachelor’s degree in Mathematics & Applied Mathematics from Beijing University of Aeronautics and Astronautics.

View transcript

Stuart Morrow:
Welcome to Counsel Views. I’m your host, Stu Morrow, Chief Investment Strategist at RBC PH&N Investment Counsel.

For most of the last decade, the world has worried about the sharp increase in China’s net and gross leverage. High-profile investors, multinational institutions, and regulators have repeatedly warned about the dangers posed by rising levels of Chinese debt. The noise and concerns die down from time to time, but inevitably resurface in the event of a prominent default or a sudden slowdown in growth.

Over the last number of weeks, Evergrande Group, the largest property developer in China by sales, has come into the global market spotlight. Some observers have said that this could be China’s Lehman Brothers crisis, although I’m not sure I’d agree with the analogy. Nonetheless, Evergrande is one of the biggest financial worries in China at the moment.

In a nutshell, the China real estate developer is $300 billion in debt and widely expected to default on bond payments. The group owns 1,300 projects in more than 280 cities, but its reach goes way beyond building homes, to include electric vehicles, to media production, to mineral water, and to soccer.

To put things in context, estimates are the real estate sector is indirectly responsible for around 25% of Chinese GDP and that Evergrande is around 3% to 4% of the overall market, so what makes it unique, therefore, is its size.

Earlier this week, there were rumours of a restructuring involving another property developer. But at the time of this recording, Evergrande has yet to publish an update since halting shares pending an announcement on a major transaction.

Also this week, another Chinese property developer, Fantasia Holdings Group, missed a payment on its bonds, suggesting fundraising difficulties may be getting more severe.

With me in our virtual studio to discuss what is happening in China is Siguo Chen, at RBC Global Asset Management on the Asian Equity Team based in Hong Kong. She co-manages the team’s China strategy and is also the team’s health care specialist.

Prior to joining the organization in 2017, she was at a multinational investment bank as a sell-side equity analyst focused on Hong Kong/China consumer stocks and investment strategy research. She began her career in the investment industry in 2012.

Hi, Siguo. How are you?

Siguo Chen:
Hi, Stu. Thanks for having me.

Stuart Morrow:
No. Great. Thank you for joining me. I’m wondering if we could jump right into it and maybe just ask you what’s the latest news on the Evergrande Group?

Siguo Chen:
Yeah. So you mentioned the company is basically expected to default on its debt within this month I think. So there’s one interest payment that was due on September 23rd, and that has a one-month grace period and there will be a couple more in one to two months. The market consensus is that within two weeks it will default on its debt.

And I think the government and regulators have had their hands on the pretty complicated situation at Evergrande for about a month now, but most part of the liquidation process can’t start until the default actually happens. So we will probably see more chain reaction when the process actually starts.

Still, I mean, there have been strong indications that the government intends to ring fence parts of the business' likely returns to dispose to other developers at a later stage. I think what’s clear is that there won’t be a grand finale per se. It’ll be an ongoing process and it will take at least one to two years to resolve.

But to me, the government has made its priority very clear. First is to complete the unfinished projects. That is to ensure delivery to buyers. Evergrande’s unfinished projects across the country will probably be divided by provinces and require investment from other developers. Like you mentioned, Stu, the scale is huge, so that will take two years at least to resolve. And secondly, they want to make sure the suppliers get paid and after that, the retail investor gets paid.

There’s an estimated, I think, RMB 40 billion to RMB 100 billion of Evergrande asset-linked wealth management product which is mainly sold to Evergrande’s employee, but there’s other people as well. This is of high importance for the Chinese government because for them, it is key to address social stability issues.

And lastly, if there’s anything left, that’ll be used to pay off its bank loans and then it’s the domestic bond. And after that will be foreign bond investors.

Stuart Morrow:
Gotcha. Thanks, Siguo. Is the situation then with Evergrande, is that perhaps symptomatic of something bigger that could be going on in the Chinese property market? So I mentioned Fantasia Holdings is one, but are there more sort of dominos to potentially fall?

Siguo Chen:
Yeah. I think you’re spot on. I mean Evergrande is not the first property developer to go under and certainly won’t be the last. A few months ago, we had China Fortune Land; I’m not sure you’ve heard of this one or not. It defaulted, but risk was contained mainly because of its smaller size and far less foreign debt exposure, so that you don’t see a lot of cross-default happening.

And this week, you mentioned there’s Fantasia default on its dollar debt which interestingly had bigger spillover effect despite its smaller debt size. And the thing is, Fantasia, it has enough cash to have paid back this dollar bond and the size was not particularly large, but they opt to default anyway as they have bigger repayments approaching in December that they think—it’s not they think—they were unlikely to meet. This took the market by surprise because the company had a sure investor not long ago, in fact, a few days ago that they were going to repay. So this caused really a broader sell-off in the entire BB credit space.

I think on one hand, you see the Chinese government is trying everything to avoid an asset price crisis, like you mentioned, a domino effect. But on the other hand, I think we need to see that a series of orderly defaults, hopefully orderly, are probably healthy and what the Chinese government wants to happen. Because they realize that first, they can’t be bailing out everyone forever, which they did, and a few times, such as the bailout of the largest distressed debt management company, Huarong, this year. And secondly, there’s clearly moral hazard implications that they’re very aware.

Stuart Morrow:
Yeah. No, it’s a fine line. And is the view then that the sort of risk of contagion, you know, that despite the intervention and sort of the handholding of the government through the process, is there still a risk of contagion maybe to the broader financial system global markets in any way that you could see?

Siguo Chen:
I would say risk of direct contagion from Evergrande default in the near term is low. We did see some B grade credit issues, but haven’t seen it spill over much outside of the property sector, let alone the broader global credit system. But I think we still don’t know to what extent this is going to hit the property investment in China, which accounts for a large share of fixed asset investment and fiscal revenue for the government. And, therefore, this could have a significant macro spillover effect, although I think the base case is property investment to slow down by low single digit next year, but if credit condition for developers get worse, then this could go to double digit, which would start to represent very significant drag for the China economy, perhaps on the order of 2% of the GDP.

Ultimately, it depends on government’s tolerance and the policy response they give, which is hard to gauge right now. The recent property investment is trending kind of flattish year on year and sales are down around 20% year on year, but I think our estimate is that the government will be patient for at least another one to two quarters before they start to pull some policy levers.

This is kind of unique to this administration. They are more strict in a sense. And even if they do, it will most likely be taxation on the buyers’ end instead of on developers, such as there will be things like shortening mortgage approval time, et cetera.

Stuart Morrow:
Right. Gotcha. Siguo, do you think that the Evergrande issues or property development and property developer issues, does this change the investment case on China in any way do you think?

Siguo Chen:
For Evergrande specifically, not really.

Stuart Morrow:

Siguo Chen:
The company’s case, yeah. But I mean the debt problem has been an issue since the so-called three red line policy crackdown which was introduced last year, so doesn’t really come as a large surprise to us or any investors.

Saying that, the pace of the default and credit risk of other developers, like you mentioned, is making us more cautious on the sector than otherwise. But I think more broadly, Evergrande is actually a good example of the potential fallout from policy crackdowns which have been widely seen not just in property but across all sectors this year. You probably know the education sector, internet as well.

Stuart Morrow:

Siguo Chen:
Yeah, exactly. So on this basis, we have definitely recalibrated our investment portfolios in China. I think, objectively speaking, the regulatory risk has increased the uncertainty around investing in certain sectors. We went underweight Chinese internet at the start of the year and went overweight sectors [favoured] by these policy makers, like we invested in sectors such as renewables, innovation, advanced manufacturing, you know, [innovative] pharma, which has paid off.

I think if we look with a longer horizon, one thing about China is that it is highly cyclical, especially if you compare it to U.S., and those cycles tend to get punctuated by exogenous factors such as trade war, deleveraging campaign, and now policy changes.

I think the silver lining of the Evergrande risk is that less speculative expectations on property could actually accelerate household increasing their saving allocations to equity, which is currently dominated by [inaudible].

And on top of that, you still have the normal strong, long-term consumption potential, continued upside to urbanization, significant room for productivity gain. So China’s GDP per capita is still only one—I think still a quarter that of the U.S. and also much lower than Japan, and that still has room to improve. So I would say there are still a lot of strong foundations to the long-term China equity outlook.

Stuart Morrow:
Well said. Well said. Maybe one last question, Siguo, is what do you see as the long-term goal of the Chinese government, as it relates to global capital markets? Like you touched on sort of like the more recent sort of regulatory tax in the internet, in education, but what is their long-term goal as it relates to the global capital markets in China?

Siguo Chen:
Yeah. I think the recent moves by the Chinese government definitely scared—and I don’t know whether that’s a right word or not—but scared the international institutional investors a little bit. The regulations, however, on the internet sector, I think this anti-monopoly rules are not too dissimilar to the intention of the policy makers in the Western market. The key difference though with China is their capacity to implement sweeping reforms to sectors or industries without much communications beforehand to investor or stakeholders. Unlike in the West, you will have legislation, you will have a lot of communication and it’s basically well communicated. Lack of transparency and lack of visibility, that being the difficulties for a lot of investors which has been a big driver to this year’s volatility.

I think for investors, the questions now are how much of these changes are reflected in the price and how much more to go in terms of pipeline. I think if you look at the valuation of one of the biggest tech company, Tencent, the multiple has come down a lot; at historical low now. It’s a company with double-digit earnings growth, the sum of the parts, basically account for 40% of the market cap. It’s only trading at high-teens multiples.

On the other hand, it’s very hard to determine the full timeline of the upcoming regulatory announcement, but we can certainly frame it around some key events; the most notable, the 20th Party Congress next year.

To us, that points to a reason why actually the government has been so aggressive in pushing regulatory actions this year. And, therefore, going into next year, you could see a normalization in regulatory announcement because they also want to avoid too much volatility as well.

And what they want in the long term from the global capital market, they definitely need it, and that’s why they are trying to open up. And in some short period of time, we’re seeing back and forth, but I think the trend is clear. They need the global market and they really just need to deliver the message clearer and avoid this kind of lack of communication situation again and again.

Stuart Morrow:
That is a great update. Thank you, Siguo, for taking the time to speak with me today out of your busy day and providing our clients with a valuable insight into both the Chinese property market and the Chinese equity market.

Siguo Chen:
Thank you, Stu.

Stuart Morrow:
And to our clients, thank you for taking the time to listen to our podcast. If you have any questions about the content presented here, or have any questions about your portfolio in general, please contact your investment counselor.

Take care and be well.


This “Counsel Views” podcast, episode 16, was recorded on October 7, 2021.

Stuart Morrow is the Chief Investment Strategist of RBC Phillips, Hager & North Investment Counsel Inc. (RBC PH&N IC). All opinions of Stuart Morrow and his podcast guests are solely their own opinions and do not reflect the opinion of RBC PH&N IC nor of any of its affiliates including RBC Global Asset Management Inc. (RBC GAM). This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This podcast is not an offer to sell or a solicitation of an offer to buy any securities. The information provided in this podcast is not investment, tax or legal advice. Individuals should consult with qualified tax and legal advisors before taking any action based upon any information contained in this podcast. Neither RBC PH&N IC, nor any of its affiliates, nor any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of the information contained in this podcast. Clients of RBC PH&N IC may maintain positions in the securities discussed in this podcast.

RBC GAM is the asset management division of Royal Bank of Canada and includes RBC Global Asset Management (Asia) Limited (RBC GAM Asia). RBC PH&N IC, RBC GAM, RBC GAM Asia and Royal Bank of Canada are all separate corporate entities that are affiliated. RBC PH&N IC is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. ® / ™ Trademark(s) of Royal Bank of Canada.