If you are a customer of a hedge fund that has piled its chips into Evergrande’s offshore bonds expecting lucrative returns, you should be psychologically prepared to kiss your money goodbye.
The Year of Dragon brings fortune, according to the Chinese zodiac.
However, this fortune is not for China’s foreign investors, including those from Taiwan.
After three years of multiple defaults on its offshore and onshore debt and unmaterialized restructuring, Evergrande has finally been laid to rest. Recently, the giant Chinese conglomerate was ordered to liquidate by a Hong Kong court.
Evergrande’s US$19 billion offshore bonds are worth less than 1 percent of their face value. Its final tally shows that while it has US$240 billion of assets, its total liabilities are more US$300 billion. As offshore bond holders are on the bottom of the list of creditors entitled to the proceeds of Evergrand’s liquidation, recovering this US$0.01 on the dollar is the best hope for foreign hedge fund clients.
The loss on Evergrande’s bond for international investors did not occur overnight, but the warning signs were largely ignored.
Evergrande’s long and dramatic demise started three years ago, when it defaulted on US$1.2 billion of offshore bonds in December 2021. Several of its domestic bond payments were also missed at about the same time.
Many foreign observers believed that Evergrande was too big to let fall, so the Chinese government would have to throw it a lifeline. They could not have been more wrong.
The Chinese government’s stance on corporate debts is to minimize social disruptions that could arise from financial instability.
Rescuing Evergrande was never the goal, let alone rescuing its creditors and investors.
As foreign creditors had been strong believers of the Chinese government’s resolve and ability to save the falling giant, they stayed quiet without taking action for three years until the the last straw finally crushed their hopes.
However, Evergrande is not the first Chinese real-estate developer to send warning signs to international investors, and China’s real-estate sector is not the only minefield that international investors have stepped into.
In April 2015, real-estate developer Kaisa Group Holdings Ltd defaulted on its bond payments, marking the first major offshore bond default by a darling Chinese corporate. Offshore bond defaults have become more frequent since.
In 2021 alone, the tally of offshore bond defaults by China’s corporates climbed to more than US$10 billion, of which only one-third came from China’s red-flagged real-estate sector. Like Evergrande, those defaulters had followed the same success-to-fail protocol: use debt to finance wild expansion and issue more bonds by selling their great expansion stories to investors, including those from overseas.
Their business strategy could be summarized as a “borrow-defer-default-bust” manual.
As far as the whereabouts of the borrowed money, finding the answer to that problem is beyond the scope of this brief analysis.
If China’s 2021 offshore bond defaults were not enough to alarm international investors, a louder wake-up call came in 2022.
During the first half of that year, 85 percent of China’s bond defaults were offshore.
This was a siren announcing the arrival of a tsunami that would wipe out everything international investors had put into China’s corporate coffers.
The Chinese government has since urged companies facing defaults to “optimize foreign debt structure,” but the core of those instructions was “debt rollover,” ie, pushing back the maturity date or replacing the defaulted bonds with newly issued and customized ones.
This default-to-defer tactic is not new to Chinese investors, as it has been deceitfully deployed in China’s domestic debt market for decades. It also worked miracles with many international investors, who still believed up to this point that the mighty Chinese government would keep their investments in corporate bonds in the nation safe.
Many international investors once again missed out on the opportunity to bail out from China’s offshore corporate bond trap.
With China’s corporate health deteriorating, more defaults are on the way. In October last year, heavily indebted Chinese real-estate developer Country Garden defaulted on interest payments on its US$500 million of offshore bonds. Early last month, another state-backed property developer, Sino-Ocean Group Holding Ltd, pushed back the payment of its four domestic notes by up to 30 months.
China’s outstanding offshore corporate debts stood at about US$ 870 billion at the beginning of 2022, about 80 times that of China’s 2021 total offshore defaults. A possible trajectory is that many, if not all, of China’s corporate borrowers will follow Evergrande’s debt-bust model, and international investors would have to write off nearly US$1 trillion from their balance sheets.
This is not an unimaginable scenario.
Evergrande and the like are deploying the borrow-default-defer-bust tactic to evade their offshore debt obligations and the Chinese government is downplaying the looming danger awaiting international creditors.
To calm the foreign capital already in China and attract more investment, the economically embattled Chinese government just a few weeks ago indicated that Beijing would make it easier for foreign investors.
However, the reality is that while international creditors are thrilled to find the too-good-to-be-true high returns for their investments in China’s corporates, the latter have already quietly booked the influx capital as their own fortune, with acquiescence from their government.
Foreign investors were fooled once and have missed several warning signs since. Will they cut their losses and run for cover, or jump back with more good money into the honey trap laid out for them?
Time will tell.
Daniel Jia is founder of consulting firm DJ LLC Integral Services in Spain.
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