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Is China’s High-Yield Real Estate Debt A Buy? This Asia Hand Says “Yes,” Selectively

Tumult at the China Evergrande Group may have rattled global capital markets in the past month yet it at same time has pressured other real estate titans in the country to improve their finances. In turn, that has selectively boosted the appeal of China’s high-yield real estate debt.

So says Michel Lowy, CEO of SC Lowy, a privately-owned global financial services group that specializes in distressed and high-yield fixed income markets in Asia and Europe. “We are definitely adding exposure to the Chinese high-yield property market, but we are extremely selective about our picks,” Lowy said in a Zoom interview from Hong Kong on Thursday.

On Evergrande itself, Lowy said: “I think the government is trying to teach them a lesson. I don’t think that the government is going to save them and is happy to show that even a group as large as Evergrande can be restructured and default.”

The Belgian-born, long-time Asia hand co-founded SC Lowy in Hong Kong 2009, after earlier working at Deutsche Bank, Cargill and Arthur Andersen. Edited interview excerpts follow.

Flannery:  How do you size up the Chinese government’s response to Evergrande’s problems so far?

Lowy:  Our view is that the government’s intention in the past couple of years has been pretty clear. They are trying to cool down the real estate market and prevent speculation and excess leverage in the system. They came up with those three “red lines” that have been well-publicized to try to limit leverage. There have been other measures to make it more difficult for homebuyers to obtain mortgages and to put caps on banks’ exposure to real estate. 

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Ultimately, some groups have tried to play by the new rules and follow — roughly — the instructions of the sheriff in town. Evergrande has, in my opinion, paid lip service by trying to improve its (debt) ratios. But in reality, it hasn’t really. If you look at the history of the group, this is not the first time that they’ve gone too far ahead. They have a history of surviving regardless. We’ve thought a number of times in the last 20 years that the game was over for them, and it wasn’t. This time, what they did is create leverage through instruments like commercial bills with suppliers who were not part of the criteria monitored by (government) authorities. In reality, they did not deleverage.

I think the government is trying to teach them a lesson. I don’t think that the government is going to save them and is happy to show that even a group as large as Evergrande can be restructured and default. I believe that the group is going to be restructured, and that is going to be very painful for offshore bondholders. I also believe that the government has sufficient tools to limit the impact. While there may be other borrowers that will also default and be restructured, I do not believe that we are in a situation where we are facing systemic risk.

Flannery:  Who else is facing restructuring? Or, to put it another way, are there others that haven’t been listening to the sheriff?

Lowy: A group like Guangzhou R&F or Fantasia was at risk of following the same fate. I believe that they’ve seen the Evergrande warning, and that explains Fantasia rushing to sell some of its non-core assets and Guangzhou R&F selling some of its non-core assets and injecting more liquidity in the group. They both realize that money and help from the central government are not coming. They’ve made major moves in the last few weeks. Guangzhou R&F tried to protect their equity and maintain their ability to act on their own without having to go to a restructuring where the equity would be wiped out.

Flannery:  How do you size up the performance of China’s central bank through this?

Lowy: I’m going to add a disclaimer: I’m not an economist, and this is less my field of expertise; we focus on corporate debt and look more at the micro level at specific corporates.  What I can say at the macro level is: if you look at all of the measures that have been put in place by the central government — limiting leverage for banks and caping at 40 % exposure to real estate, they are making it much more difficult to obtain a mortgage and making it difficult for developers to sell assets. I understand why they do it.

But when you put all that together, you’re making it almost impossible for a developer to be successful in the short term. The guy who wants to buy an (apartment) unit from you can’t get any money, and you can’t get any money from the banks, either. So what are you meant to do? And you need to complete the unit that you’ve already built to deliver them.  Unless you are sitting in a huge amount of liquidity, you are going to be squeezed regardless.

I understand the motivations — those are sound motivations. But by (adopting) all those measures at the same time, you are making it quite impossible for a developer who doesn’t have a large amount of liquidity to really survive. I do think that they may have gone one step too far. By injecting liquidity in the system, which the central bank did a few days ago, there’s a first step, but I think the next step is to going to be to relax some of those measures.

And maybe the ultimate goal is:  all right, let’s squeeze the weak ones, and make sure that the Evergrandes of the world are defaulting, for their equity to be wiped out, get some SOE (state-owned enterprise) to take over the equity, and then very quickly put some measures in place to save and help the others. Maybe that is what they’re trying to do — to teach a couple lessons.

And that, by the way, that is the only tie-in I see with Lehman, where (U.S. regulators) provided a lesson with Lehman and then you bailed out Morgan Stanley, Goldman and the others. But I do not see Evergrande’s falling as having the same ramification as one of the major banks falling.

Flannery: Are you continuing to buy Chinese real estate debt?

Lowy:  Yes, we are, but not indiscriminately. We try to focus on the ones that have more liquidity and the ones that have more exposure to tier one cities because that means they will be able to access more liquidity and sell the land they purchase. We are definitely adding exposure to the Chinese high-yield property market, but we are extremely selective about our picks.

Flannery: Can you say what a couple of those are?

Lowy: We are, for example, a lot more comfortable with a company like Kasia that has a lot of exposure to tier one cities.

Flannery: Country Garden?

Lowy: Country Garden is attractive from a profile standpoint, but not from a pricing standpoint. It doesn’t move down as much as we would hope. I believe that Guangzhou R&F has its issues, but has a profile that is interesting because they’ve got a lot of assets offshore and have been injecting a lower liquidity, so that puts them in a better position. (See related post here.)

Flannery: Looking beyond Evergrande, how concerned are you about some of the reports this week about the size of local government debt and systematic risk?

Lowy: I’m concerned about that. I’m concerned about that because you have local and provincial governments in weak regions in tier three or four cities that already have budgetary issues, and that to a certain extent have been generating most of the revenue by selling land. You’re not going to be selling land for a long time in tier three and tier four cities. You’ve taken away their ability to generate revenue, so their situation is only worsening. I think that’s problematic.

And by the way, some of the property developers have exposure to those local governments because they’ve been doing public projects – whether public housing, whether it’s public infrastructure, and you see some of them increasingly have receivables from them. And that is also problematic.

Again, I don’t necessarily see this as a systematic risk, but the central government will need to figure out what to do. And one answer, maybe introduction of a property tax that will replace revenues by selling land. But if you have property tax, you generate revenue (from) assets controlled by everyone and obviously, that is not going to be very popular in an environment where property values are not going up.

Flannery: Yes. Where else are you investing in Asia these days besides China?

Lowy: India is a very large exposure for us. It sits on a very large amount of NPLs from overleveraged corporates for a number of years, so we’ve been very focused on that country. We have an office in Mumbai that’s growing. We are looking to establish an onshore presence in China, as well. In India, in addition to historical problems and historical NPLs, you have a crisis of the non-bank financial sector (NBFC), which is equivalent to trust companies in China in that complementary financing that was available next to the large banks isn’t available anymore, because many of those NBFCs have got their own problems. That’s creating quite a bit of liquidity issues and very interesting opportunities for us. So India and China are certainly two major focuses for us.

See related posts:

Investors May Be Further “Left Smarting” After Evergrande As China Retools Economic Policy

Battered Guangzhou R&F Gets Financial Pledge From Two Billionaire Shareholders

Hong Kong, Mainland China Bourses Close For National Day Holiday

@rflannerychina

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