This is Part 2 of a two-part series of free posts about Evergrande. For Part 1, please click the link below:

Value Investing Substack

Evergrande: A Deep Dive (Part 1)

This is Part 1 of a two part series of free posts about Evergrande. For Part 2, please click the link below: Evergrande’s woes are not a function of fraud, but overbuilding. With Inventory Days hovering at around 4 years, they have been pulling forward future revenue growth in an unsustainable manner…

a year ago · 1 like · Aaron Pek

Open letter: the Chinese Communist Party's rule by fear endangers Chinese citizens – and the world

China’s economy today bears many similarities with Japan’s economy in 1989, and the USA’s economy in 1929.
The policy objective of China’s policymakers today is to implement a smooth deleveraging of the economy, without inciting the market panic that led to Japan’s Lost Decades.
An Evergrande bailout is highly unlikely, because it doesn’t present contagion risk to the wider economy - and flies in the face of the stated policy objective of deleveraging the wider economy.
In that context, an Evergrande collapse is a highly likely occurrence - but it will be done in an orderly manner to prevent panic (e.g. via restructurings).
Evergrande shareholders are likely to be wiped out; but Evergrande bondholders still stand a chance to make a 200% return over time.

As I’ve covered in Part 1 of this topic, Evergrande is facing serious liquidity issues owing to its business prerogative to overbuild. In order to figure out what its likely future might look like - with respect to policymaker’s initiatives and investor’s responses - we need to have some context into the overarching economic and political backdrop that serves as Evergrande’s operating environment.

And yes, you will find out why I think buying Evergrande bonds today might not actually be such a bad idea by the end of this article.

In order to figure out what might happen to Evergrande going forward, there are several angles that we have to cover independently and pull together to form a cohesive overarching picture. These are:

Evergrande the Company
The current state of China’s Economy
Putting Evergrande and the Chinese economy together
Chinese policymaker’s likely response to Evergrande (will they bailout Evergrande?)

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Evergrande the Company

We start with Evergrande, the company itself. As I explained in Part 1 of this post, the company is quite clearly in a little bit of a bind with regards to the serviceability of its debt. The prevailing conspiracy theory that has been floating around and getting the most attention in the press so far is that Evergrande was running a Ponzi scheme of sorts (which isn’t entirely true, as you can read in Part 1). Just to recap, the way this would have worked would have gone something like this:

Evergrande starts by borrowing a certain sum to build the first house
Before that house has been completely built, it would sell the house to a home buyer (i.e. pre-sale).
Using the cash inflow from that pre-sale as collateral, it would turn around and borrow more money.
This money would then be used to build a second house.
Rinse and repeat.

Very quickly, you can see where the problem lies. If the new money earned from the pre-sale of the first house is used to build the second house… where will the money to repay the borrowings to build the first house come from? Obviously this model is an oversimplification - but it illustrates how without perpetual growth, the entire house of cards collapses on itself, i.e. a Ponzi scheme.

However, as we’ve already covered in Part 1 of this post, Evergrande was never actually engaged in actual fraud - but rather an overbuilding problem that just appeared like fraud on the surface. As evidenced by their Inventory Days of 4 years and Payable Days of 3 years - the latter of which consisted of supplier financing which enabled their overbuilding addiction - they actually had a legitimate business underneath that was just embracing too much risk.

This is what I think the China permabears like Kyle Bass meant when they talk about China having non-productive GDP growth. Quite clearly, the investments in overbuilding that Evergrande had engaged in are not delivering actual productivity to the real economy - as a perpetually unoccupied house is basically just a gigantic toy sitting on a plot of dirt that doesn’t actually do anything. However, the revenue growth that Evergrande generates does eventually get captured in China’s wider GDP growth; despite the fact that it doesn’t contribute any value to society. By frontloading revenue in an unsustainable manner the way Evergrande has, you can bring forward future GDP growth into the present using risky levels of leverage - but if that risk materializes, it will be all for naught.

Hence, when China introduced the ‘three red lines’ deleveraging policy in August 2020, the writing was already on the wall for Evergrande. Keep in mind that all the signs that I’ve discussed above were already readily observable in their historical financial statements, even way back in August last year (share price has fallen -80% since then) - so this isn’t some sort of shady conspiracy that only the upper echelons of China were privy to. When Chinese regulators announced the ‘three red lines' deleveraging policy, it was impossible that they did not know that they had effectively sealed Evergrande’s demise. The countdown had begun; and they were the ones who had pulled the trigger.

The Chinese Economy in a post-Evergrande world

To be sure, a failure on the scale of a catastrophic Evergrande bankruptcy is going to leave a mark - not even the Chinese government with its mandate from heaven will escape unscathed. If Xi Jinping is Zeus, then Evergrande is a vengeful Kratos scaling the walls of Mt. Olympus on the back of the Titans - represented by the excessive leverage of the wider Chinese economy. In order to understand what Chinese policymakers are likely to do next, we first need to understand the current state of the Chinese economy that Evergrande occupies.

The Deleveraging Dilemma of the Overgeared Dragon

China’s systemic debt-to-GDP (D2G) is currently about 270%, rivaling the USA’s ultra-high systemic D2G and Japan’s record-breaking government D2G - and in stark contrast to China’s relatively healthy government D2G of only about 60%. The reason why I feel that China’s systemic D2G is more relevant than its government D2G (in the context of the country’s policy flexibility), is because China’s communist government is unique in its ability to be able to request its corporates to stimulate the economy at its behest. It’s certainly no secret that the post-2008 GFC global economy was rescued by China’s corporates in their adoption of massive amounts of leverage to stimulate international trade - and we should be thankful to them for that. But that doesn’t change the fact that high levels of debt incurs a cost to policy flexibility; and with China’s household D2G standing at only around 60%, that implies that their govt + corporate D2G (i.e. effective govt D2G) stands at a mind-blowing 210% - easily on par with many overleveraged developed Western economies today.

Acknowledging the high levels of leverage inherent in the Chinese economy is important, because it informs the available policy paths that policymakers have before them. For one, it prevents Chinese policymakers from repeating their post-2008 stimulus trick by pulling the corporate debt rabbit out of the magic hat again. Any future stimulus this time around is going to come out of the Chinese government’s pocket - and current realities do not afford them the luxury of being cavalier about how they increase leverage today.

The most obvious challenge for Chinese policymakers is that there is an irreconcilable difference between pursuing their 6% GDP growth target and their stated goals of deleveraging the economy. Even under best-case scenarios, going from a dovish stimulus-friendly economic policy to a debt-unhappy hawkish policy will easily cut baseline GDP growth by half, i.e. 3% - the same as if any other country did it. And as clearly apparent by their decision to sacrifice Evergrande when announcing the “three red lines” deleveraging policy, abandoning the deleveraging plan is a no-go (this will be explained in more detail later below).

The only way to both stimulate the economy and deleverage at the same time is to monetize debt, i.e. the PBOC prints yuan to buy up debt from Chinese corporates. This is similar to what the US Fed has been doing with its infinite QE monetary policies - the only difference being that it has been monetizing US Treasury debt rather than corporate debt. A more accurate parallel to draw would be the BOJ’s wholesale permeation of the Japanese corporate debt markets. However, this raises the risk of inflation of the yuan, as excess monetary creation entering the real economy raises aggregate demand and hikes prices.

Now infinite QE might not be a problem for the USD (yet), owing to its unique status as the world’s reserve currency. But it certainly can be a problem for any other currency, the Chinese yuan notwithstanding - as inflation would result in a weakening of foreign exchange vs other currencies, ceteris paribus. Excessive inflation would be a unique double whammy for the yuan, given its peg to the USD that is already under strain with capital controls in place. The traditional way to maintain the peg would be to deploy foreign reserves - but China’s foreign reserves are surprisingly low at USD3.24 trillion, or only about 22% of their FY20 GDP.

I would like to digress a little in this paragraph to explain why I think having a 22% foreign-reserve-to-GDP ratio might be a problem for China; when it might not be for other countries. Firstly, it’s no secret that if capital controls were lifted, a huge amount of capital flight would take place among the country’s wealthy - which might explain their recent decision to ban the onshore trading of Bitcoin a few days ago. Secondly, China’s economy is unique in its scale and dependence on international trade, especially since the yuan is pegged. Thirdly, China’s wish for the yuan to become the world’s reserve currency is DOA as long as capital controls remain - since no other country would trust another government to maintain the real value of their foreign reserves (especially post-Nixon’s abandonment of the gold standard). Hence, simply having a baseline level of foreign-reserves-to-GDP doesn’t bode well for China’s reserve currency ambitions to replace the USD with the yuan - if not for the yuan’s overall health.

Regardless of reserve currency ambitions, having insufficient foreign reserves doesn’t leave much room for the PBOC to defend the peg if a currency risk event were to materialize. Reasonably assuming that the maintenance of the yuan’s peg to the USD is non-negotiable, excessive inflation would be highly threatening to the PBOC’s ability to maintain capital controls. For reference, just look at how easily a scruffy ragtag bunch of no-good reflexivists broke the BOE’s peg to the ERM on Black Wednesday.

So if printing money to achieve the dual policy objective of deleveraging - while at the same time pursuing a 6% GDP growth target - is an unacceptable policy initiative, that leaves increasing government debt to stimulate the economy as the only option. To be fair, this remains a highly viable option for Chinese policymakers as increasing government debt to stimulate the economy a la Western democracies is the basic stimulus playbook. The goal of this would be to transfer leverage from the private sector to the public sector, a la Japan. If done properly, this would allow Chinese policymakers to shift economic leverage to the government’s balance sheet while allowing the corporate sector to deleverage and heal. We shall see why executing this properly is so important below.

China 2021 vs Japan 1989 vs USA 1929

History does not repeat itself, but it does rhyme.” Mark Twain [1080x280: QuotesPorn

If you’re a student of history, you’ll probably agree with the above sentiment that everything that will ever happen in the future has probably already happened before in the past (in some shape or form) - hence if you want to know what the future might look like, look to the past. The parallel to draw between China’s economy today is Japan in 1989 (prior to its Lost Decades), and the USA in 1929.

Before you think I’m some sort of USA bro, I would like to point out how the USA today is also in a very similar situation - together with its over-levered cousin, the 100% debt-to-GDP Eurozone (the worst offenders there are literally referred to as “PIGS”). So just to be clear, this is not a China-specific issue; the entire world is being held hostage in concert by a late-cycle global credit supercycle. But still, that doesn’t change the fact that China’s economy does occupy that precarious credit situation today.

Allow me to start from the end to provide context, and circle back to the beginning to flesh out the details. China’s (and the USA’s) economy today is currently in a very similar position as Japan’s economy was pre-1989. What happened in Japan during the 80’s was that Japan experienced a consumer export boom, as a result of widespread Western adoption of their electronics and automobiles. This ultimately led to the Plaza Accord - where Japan was very politely asked to voluntarily appreciate its currency (which hurts exports) to satisfy Western interests. Japan also very politely obliged in exchange for increased food and energy imports - but in order to nip the expected collapse in aggregate demand from a stronger yen in the bud, the Bank of Japan (BOJ) preemptively lowered interest rates to counter the fallout from expected yen strengthening. This resulted in a massive consumer and real estate boom in Japan’s economy that culminated in the Tokyo Palace having the most expensive real estate unit price in the world. You can read the excessively gory details of the bubble in this exceedingly wonderful historical account here (the best I’ve ever come across):

Voss Capital

Roaring Eighties

This overview of the Japanese Bubble during the 1980s is a precursor to our Inflation Investigation Series Part 2: Japan. It draws on notes from the book Devil Take the Hindmost by Edward Chancellor – Chapter 9, Kamikaze Capitalism, and Boom Bust by David Turner and William Quinn– Chapter 8, Blowing Bubbles for Political Purposes: Japan in the 1980s…

2 years ago · 12 likes · 1 comment · Voss Capital

When an economy overheats, it is the central bank’s job to prick the bubble by raising interest rates - which is exactly what the BOJ governor did. On Christmas day 1989, the newly-selected BOJ governor Yasushi Mieno raised the official discount rate abruptly to 4.25%, and the Nikkei reached its all-time peak just four days later - thus precipitating the following three Lost Decades that an entire generation of Japanese millennials have grown up with. As we are well aware by now, the consequences of hiking interest rates in such a manner were catastrophic for the Japanese economy. To understand why, we need to segue into an explanation of inflation expectations and animal spirits, which you can read about in more detail in the post below:

Value Investing Substack

My thoughts on US inflation

Should we worry about US inflation? Arguably not. Can we do better with US inflation? Arguably not. If inflation transitory? Maybe. Is inflation persistent? …Maybe. (this is why economics is called the dismal science!) What is going on in Jay Powell’s head today…

2 years ago · 5 likes · 3 comments · Aaron Pek

In the late 70’s, the Federal Reserve learned the hard way that not only did economic fundamentals contribute to the inflation phenomenon, but inflation expectations (psychology) as well. This is because when people expect the value of their money to be worth less tomorrow, they will rush to spend it today - thus driving inflation higher and resulting in a perpetual upward spiral. These unquantifiable macroeconomic elements that cannot be measured precisely with hard data are endearingly termed “animal spirits”, which basically reflects economic sentiment (consumer, business, investor, etc). Also, there is a reflexive process involved in markets (coined by George Soros) which makes both good and bad market psychology influence their underlying economic fundamentals - rather than just economic fundamentals influencing market psychology. So reflexivity ends up contributing to a positive feedback loop in both bull markets and bear markets.

A similar phenomenon happened in Japan in the post-1989 bubble era, except this time in reverse. When the BOJ governor insisted that he would tame the roaring bubble ala Mario Draghi’s “Whatever It Takes”, the hopeful animal spirits were slayed in a psychological bloodbath that gripped the markets - giving way for depressive animal spirits to take roost in the Japanese economy and leading it into an uncontrollable downward spiral. As businesses realized that they wouldn't be breaking even on their investments, they began to hoard cash in anticipation of the coming recession - leading others to do the same and spreading a wave of depression across the entire country.

In isolation, this would actually not be too big of an issue - at least, not akin to a “Too Big To Fail” situation. But the excessively overhyped bubble that occurred prior to Japan’s Lost Decades had been allowed to inflate way too far, which made the structural framework of the underlying economy very fragile.

The way this manifests is that those who made their investments at the peak of the bubble (typically with leverage amidst late-cycle environments) had done so at such ludicrous prices, that they could never hope to breakeven based on fundamental yields alone - the only way they could ever recoup their investment was by selling to a greater fool. When the BOJ governor made it clear that the party was over, these parties who bought at the top quickly rushed to sell no matter the price (similarly to how they initially bought no matter the price) - resulting in a proverbial rush for the exits by these “greatest fools”.

As the selling continued, market prices of investments began to crater. The above phenomenon then repeated itself on a lower tier of investors, who had invested at a lower price tier but who now similarly wouldn’t be able to recoup their costs now that they were the “greatest fools”. This phenomenon rinses and repeats with successive lower tiers of investors, finally driving all investors out of the market and leading to those depressive animal spirits settling in.

This excessively combative response from the BOJ was probably contributed by the fear of hyperinflation that had just occurred in the USA roughly a decade ago - where then-Fed Chair Paul Volcker pretty much did the same thing to break the back of inflation. Unfortunately for Japan, the hindsight interpretation that can be made is that they took things too far into the other direction, contributing to “hyper-depression”. As economic sentiment spiraled out of control downwards resulting from the depressive animal spirits transmogrifying into Dementors, a perpetual state of depression took hold of the entire economy - and settled into the three Lost Decades that gave birth to the asset class known as “Asia ex-Japan”.

We saw a similar thing happen in USA in 1929, when then-President Herbert Hoover basically did the same thing by refusing to provide economic stimulus when the bubble burst - as prescribed by Austrian economics - resulting in the decade-long Great Depression. This ultimately gave birth to the widespread adoption of the Keynesian countercyclical fiscal framework that has permeated fiscal policy amongst governments worldwide today; and which is arguably contributing to the vices of the global credit supercycle today.

What Lessons Can China 2021 learn from Japan 1989?

The above historical account of the bursting of the 1989 bubble by the BOJ serves to demonstrate what China’s PBOC should not do today. At this point where the economy reflects bubblelicious characteristics, it is the job of policymakers to remove the excess leverage that contributed to the bubble in the first place (i.e. deleveraging the economy). This is what Chinese policymakers have been firmly stating as their policy goal since August 2020, when they announced the “three red lines” deleveraging policy.

However, what they need to do at the same time while deleveraging the economy is to ensure it is implemented in an orderly manner - with the intention of keeping enough hopeful animal spirits alive when the deleveraging is completed so as to revive the economy (i.e. what Japan utterly failed to do post-1989). Hence, the goal of policymakers when a country has reached this stage is to deleverage the economy, but in an orderly manner. This is called a “smooth deleveraging”, or what Ray Dalio calls a “beautiful deleveraging”:

Basically what this involves is that when the panic selling when tightening is implemented (as experienced by Japan described above) occurs, policymakers step in to provide support so as to dispel the panic. An example of this is pulling back slightly on tightening, while at the same time clearly communicating the deleveraging policy well in advance so that markets know what to expect. This way, while those who bought at the market peak recognize that they will never recoup their investment (as prices will never recover), depressive economic sentiment/animal spirits won’t run amok and precipitate a race to the bottom (spurring more downward racing for an infinitely uncertain amount of time).

As investors realize that the government has got their back in terms of preventing a market panic, they gain assurance that they can liquidate their depreciating assets at a loss in an orderly manner without having to resort to fire sales. Over successive rounds of policymaker support provided every time markets panic, the economy as a whole will be able to deleverage smoothly downwards over time - with the goal of at least keeping some of the hopeful animal spirits alive when the deleveraging is completed. We can sort of see this being implemented successfully in Australia - which has managed to avoid a disorderly recession for almost two decades.

So back to China today, their policy objective is to implement a smooth deleveraging of the economy. This means allowing deleveraging to occur and letting markets fall; but stepping in to provide support anytime the panic gets too much, so that the downward slide happens in an orderly manner.

Putting Evergrande and the Chinese Economy Together

Will China Bail Out Evergrande and Avert a Housing Crisis?

So if the goal is to deleverage the economy smoothly but also avoid a financial panic at the same time, what are Chinese policymakers likely to do in the context of Evergrande’s impending bankruptcy today?

It is an empirical fact that the Chinese economy today badly requires deleveraging. This requirement is almost non-negotiable - unless policymakers want to forego attaining their future 6% GDP growth target in a sustainable manner. The reason why I say this is because if you don’t deleverage, the likely outcome is what happened to Japan - where the bubble inflates to such an unrestrained extent, that markets become structurally uber-fragile to even the slightest pinprick once the bubble pops; and the depressive animal spirits rage such intractable destruction that even policymakers cannot provide sufficient support anymore. You can sort of see a manifestation of this phenomenon happening in the USA today, with the hypervolatility of US markets in response to any signs of Fed tapering. (as a reminder, tapering = slower growth not negative growth, and shouldn’t be causing this much market volatility)

So if the question is will Evergrande be bailed out?, my wager is NO. Firstly, Evergrande is not a Lehman. There is no systemic risk involved in the sense of contagion risk visualized as a chain of dominos falling atop each other. To be sure, an Evergrande bankruptcy will have tremendous impact on the Chinese economy simply due to its sheer scale; but its impact won’t create new impacts the way one nuclear fission reaction leads to another nuclear fission reaction. An Evergrande failure will be like one gigantic contained explosion; not an explosion which creates other new explosions (e.g. Lehman).

The nature of Lehman’s failure was quite special because it was a bank that levered up to invest in bad assets by borrowing from other banks - which borrowed from other banks, which borrowed from other financial institutions abroad ad infinitum. So when Lehman alone couldn’t pay its debts, it represented a falling domino which triggered a wave of defaults across not just the USA, but across the entire globe. Evergrande is NOT like that. If it fails, it will impact all its immediate creditors/investors, and it will also impact the wider real estate market and economic sentiment because of its sheer size - but it shouldn’t spark any other new fires the way Lehman did. The financial chain of defaults should only stretch so far before it ultimately runs out of tinder to burn.

So if that’s the case, the question then becomes: can the Chinese economy tank a default the size of Evergrande? To put this into perspective, imagine if a gigantic Archegos Capital defaulted - and it took loans from 180 US banks. It also happens to have borrowed from millions of US residents (i.e. Evergrande’s WMPs); and its shares are also held by plenty of other US and foreign financial institutions. The Chinese equivalent to this analogy is basically Evergrande right now. All stakeholders with a direct or indirect tie to Evergrande will have to brace for impact; but that impact should be contained to just those Evergrande stakeholders. The issue is less one of contagion risk, and more just due to the sheer breadth of exposure that the Chinese economy has to this one single company.

So can the Chinese economy as a whole take a hit as big as this? This is something that I cannot really answer with confidence without analyzing all the individual Evergrande stakeholders one by one. But what I can say for sure is that the impact will largely not be felt by foreign markets. This is largely a problem contained to just China - not the rest of the global economy, like Lehman was.

China policymakers’ likely response to Evergrande (will they bailout Evergrande?)

The next question would be: how will Chinese policymakers likely respond to Evergrande today?

Keep in mind that the policy goal is still an orderly deleveraging of the wider economy. If the Ponzi scheme theory is true for Evergrande, it would have been impossible for Chinese policymakers to not have anticipated this happening when they announced the “three red lines” policy in August 2020. They already knew that this would happen - it was a deliberately planned move by policymakers to allow Evergrande to fail. So everything you see in the news about actions taken by Chinese policymakers today has likely already been planned out all the way down to the last detail - and they are just following the Evergrande default playbook in a calm and orderly manner. I can assure you that nobody is panicking within the upper echelons of the CCP and PBOC.

So if Chinese policymakers already knew that this would happen and STILL did it, that makes it incredibly likely that they will not bailout Evergrande. An orderly Evergrande collapse would actually allow deleveraging to take place in the wider economy - where the economy recovers at the expense of Evergrande investors taking a haircut. Having said that, since the policy goal is also to avoid a market panic, policymakers are likely to step in whenever necessary and “save the day” when the pain becomes too real for investors (e.g. I believe individual retail WMP investors will either be made whole, or only asked to take a small haircut). Or Evergrande investors will be offered something where the policy goal is to avoid panic, NOT to help recover asset values. So if you’re a wealthy institutional Evergrande creditor, you’re probably not part of the rescue plan.

How I think this will manifest in real life is that the government will pursue successive rounds of restructuring - but with a clearly communicated downwards trajectory that ultimately ends in a soft landing. They will take as much time as they need, but it will happen eventually. So you can draw your own conclusions about how such an orderly failure of Evergrande will impact each individual stakeholder group.

Conversely, try and consider a scenario where Chinese policymakers actually did bail out Evergrande. All that achieves is: 1) perpetuate the problem of excessive leverage, or 2) result in the monetization of debt in order to effect deleveraging. Since the government has been exceedingly clear about its policy goal of deleveraging, I see the former scenario of further enabling the leverage problem as very unlikely. Whereas the latter scenario of debt monetization is just going to make their forex situation worse - as monetizing debt risks inflation when your currency isn’t the mighty US Dollar. This is one reason why I keep harping on China’s low foreign-reserves-to-GDP ratio - it really helps them to have a substantial amount of foreign reserves in this situation; and not having them means having one less policy tool at your disposal.

One way I can see an easy way out of this problem is for the PBOC to print money, distribute it to local banks - and then let them retire Evergrande’s debt in exchange for the latter’s valuable land assets. This would solve the creditor default issue with respect to local banks (i.e. mitigating contagion risk), and help local banks to recapitalize so as to offset the hit they will take from the Evergrande loans that will be eventually defaulted on (or depreciation of their collaterized assets confiscated).

As I mentioned in Part 1 of this article, Evergrande’s problem isn’t being underwater on its balance sheet; it’s that its valuable land assets cannot be liquidated anywhere near quickly enough at book value in order to meet debt redemptions. So if the PBOC can finagle a legal way to exchange bank creditor loan assets for Evergrande’s land assets as confiscated collateral, it’s very likely that they can solve this problem in an orderly manner by performing an asset swap that leapfrogs the markets. We can kind of see them experimenting with this when they offered to exchange Evergrande’s WMP investments for property assets - and I fully expect them to do this on a larger scale with larger creditors. However, the resulting post-restructuring Evergrande will come out of this exercise as a shadow of its former self - and if you’re an equity investor, it seems that you’re screwed either way.

In summary, the government likely already has a game plan for every possible outcome, and they’re just responding to different market events as they develop. I actually do think that the Chinese economy as a whole will end up fine from ONLY this Evergrande issue. But if the China permabears are correct (as they were correct about Evergrande since roughly 2018), there might be a dozen more of these blow-ups waiting in the wings for their turn at the news headlines.

In hindsight, this might provide a plausible explanation as to why the Chinese government was so unnecessarily quick in implementing “common prosperity” at such breakneck speed. They likely wanted to quickly get it out of the way so they could start justifying taboo (according to capitalists) policy moves - e.g. confiscating/nationalizing assets and redistributing wealth - should the need to address such risks ever arise; which to be fair is actually not that uncommon among socialist regimes historically. It also might explain why Chinese policymakers bailed out Huarong - as Huarong specializes in absorbing bad assets and tapering their defaults over many years in a smooth manner - and a Huarong failure might also lead to contagion risk (since it’s a bank).

Should I buy Evergrande’s bonds today?

Evergrande: What would China's biggest debt restructuring look like? | Financial Times

Let’s just get this out of the way at the outset: no, you shouldn’t buy Evergrande shares. Even if a controlled Evergrande failure were successfully implemented by policymakers, the resulting wealth transfer of their land assets to creditors in a credit restructuring will just leave shareholders holding an empty husk.

However, a different story might potentially be in store for Evergrande bondholders. As I’ve described earlier, it is in the utmost interests of Chinese policymakers to ensure that a smooth deleveraging of the economy is carried out. This necessarily involves an orderly restructuring of Evergrande - especially considering the immense impact that a catastrophic failure of this scale could have on the wider economy. Hence, an orderly liquidation of Evergrande is very high on the list of the Chinese government’s priorities.

If we assume that Chinese policymakers can successfully pull off an orderly restructuring of Evergrande, then there is actually a decent chance of existing bondholders recovering 50% of the book value of their bonds. This is because the book value of Evergrande’s inventories + investment properties (i.e. property & land assets) are 219% of the book value of their bonds. I’m going to be completely honest in that I haven’t actually done a deep dive to verify the value of these assets - but given how apparently 67% of the book value of their land assets are located in Tier 1 and Tier 2 cities, it’s not such a stretch of the imagination to envision that they can eventually recover at least 25% of those asset values in order to redeem 50% of the book value of their bonds:

Evergrande’s debt serviceability as of FY20

p.10 of Evergrande’s FY20 Annual Report MD&A

Now obviously, only being able to recover 50% of the face value of your bonds is never a good thing. But here’s the thing - some of Evergrande’s bonds have fallen to 25% of their par value (see Bloomberg charts below). This could mean that in the event of a successful Evergrande restructuring that recovers 50% of the bond’s carrying value on the books, you’d still earn 200% on your investment if you bought that particular Evergrande bond today. Obviously it’s probably going to take 5 years or so before you see a dime from the restructuring process, but that’s still a pretty decent 15% CAGR:

Market price of one of Evergrande’s bonds, at 24 cents to par (30 Sept)

YTM on one of Evergrande’s bonds, at 64% yield (30 Sept)

And by the way, it seems that I’m not alone in thinking this way:

Click the picture above to visit the Bloomberg article

I mean, if Marathon is buying Evergrande bonds, I’ll take that as a vote of confidence that my narrative may be correct. (caveat: it is possible that foreign investors might end up facing discriminatory restructuring terms vs local investors; so the above thesis assumes the existence of an apples-to-apples comparison with capitalist regimes).

(Edit: a reader correctly pointed out in the comments how there could be potential holes in my 200% return thesis. Please scroll down to the comments section to follow the discussion; or click here to jump to the comments section: https://valueinvesting.substack.com/p/evergrande-part-2/comments)

Conclusion

So let’s sum up everything we’ve discussed thus far:

China’s economy today bears many similarities with Japan’s economy in 1989, and the USA’s economy in 1929.
The policy objective of Chinese policymakers today is to implement a smooth deleveraging of the economy; without inciting the market panic which led to Japan’s Lost Decades.
An Evergrande bailout is highly unlikely, because it doesn’t present contagion risk to the wider economy - and flies in the face of the stated policy objective of deleveraging the economy.
In that context, an Evergrande collapse is a highly likely occurrence - but it will be done in an orderly manner to prevent a market panic.
Evergrande shareholders are likely to be wiped out; but Evergrande bondholders might still stand a chance to make a 200% return if they bought today.

There is actually plenty more to discuss that would provide incremental valuable context about the current state of Chinese macroeconomics, and the likely next moves of Chinese policymakers. But this article is long enough as it is, and at least we’ve managed to sufficiently cover the background context behind Evergrande’s recent creditor default.

Interesting reading:

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Disclaimer: The above analysis merely represents the opinion of the author for entertainment purposes, and the author is not responsible for any risk or reward resulting from the assumption of the above opinions. Please do your own due diligence and invest at your own risk.

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Evergrande: What Happens Next? (Part 2)