Evergrande, Didi and the Bigger China Story
Evergrande’s default and the delisting of Didi Chuxing should be viewed as being part and parcel of the challenges of investing in China. The key to understanding such events is to see the bigger picture. In our latest Q&A, Portfolio Manager Andrew Mattock discusses why Xi Jinping’s regulatory interventions are in line with China’s reform agenda and why the short-term volatility and the challenges facing certain sectors in China make the market no less of a long-term opportunity for investors.
Do the defaults of China Evergrande Group and Kaisa Group impact your view of China’s real estate sector?
In 2021, a tighter policy environment and concerns about the outlook of the overall property market in China clearly weakened real estate businesses. There have been other defaults among property developers but Evergrande has garnered, and continues to garner, the most attention. But a little perspective is warranted. While Evergrande is the biggest developer to have defaulted in China, in the first half of 2021, it still only accounted for about 5% of the country’s new home sales by square meter.
What about the suspension of Evergrande’s shares on January 3?
The one-day trading halt followed reports that the company was ordered to demolish apartment blocks in Hainan Province because of illegally obtained building permits. It’s another twist in the Evergrande story and it adds to the negative sentiment hanging over the sector.
Do you expect further defaults among China’s property developers?
It’s entirely possible. In a massive place like China, which had about 103,000 property developers in 2020, there will inevitably be some defaults. The Chinese government brought in restrictions last year to curb higher-risk property development and those policies have had the desired effect. They targeted the bad actors. Real estate developers have a lot of debt to work through but China has made a lot of progress in deleveraging these companies. As active managers we can navigate what we consider to be an attractive sector.
Are these defaults potentially systemic?
We don’t think so. In general, there’s a lot of land on the balance sheets of property developers. Borrowers also tend to make large down payments and developers’ gross profit margins mean that property prices would need to fall by 30% to start causing problems. Last year, despite severe pressure from government policies, the average new home price rose 4% year-on-year. Average new home prices have been rising steadily for many years. At this point, average prices are 12% higher than two years ago, and are up 44% over five years, and 107% over 10 years. Still, we are cognizant of the risks of sentiment on the property market and we need to monitor them.
Will struggling Chinese property developers get financial aid?
China is encouraging private solutions, however, Chinese officials are involved on the ground. In Evergrande’s case, the central government has appointed the Guangdong provincial government to take an active role in managing the restructuring of the company.
Are there any good characteristics of real estate companies?
We believe certain real estate companies in China are fundamentally sound, attractively valued and may offer high dividend yields, making the risk/reward prospects more favorable. The good companies focus their operations on the key city clusters where there is both demand and capital. There will continue to be negative sentiment in the short term but longer term, the opportunities for value creation are undeniable. Home ownership in China is at 90% but urbanization is only at 65%, and the key socio-economic change that the government wants to see is more people moving to the cities to increase consumption and raise living standards. That’s the long- term driver.
Turning to Didi Chuxing, should investors be concerned that other Chinese stocks in the U.S. might be delisted?
Didi’s initial public offering (IPO) was rushed out, ahead of new guidelines from China related to the regulation of technology companies. Those rules reflected a concern by China about data security and are tied to geo-political tensions with the U.S. Didi’s IPO was done in the face of disapproval from China.
Is regulator scrutiny of variable interest entity (VIE) structures an added risk for Chinese companies listed in the U.S.?
Many Chinese companies listed outside of mainland China use VIE structures. They allow foreigners to invest in a Chinese company without owning shares in the underlying business. The Chinese government has reviewed sectors that include companies that have recently listed in the U.S. but it’s coincidence that some of these companies use VIE structures. In fact, Chinese regulators have recently given renewed support for VIEs and for continued overseas listings by Chinese companies. VIEs have also come under scrutiny in the U.S. but this is part of a dispute with China over the U.S. requirement that accounting firms that audit foreign companies listed in U.S. should themselves be audited. We’re hopeful the two sides can reach a deal on this bigger issue.
Is China's intervention in its public markets hindering the growth of Chinese companies?
Domestic investors in China don’t see it that way. In fact, they see abundant growth opportunities and they see the government promoting growth. The government is actively investing in local private funds which in turn are investing in local companies in growth areas like IT, solar energy and fintech. There’s also a disconnect on the public markets. The mainland China stock market gained in 2021, whereas Hong Kong stocks declined and Chinese American Depositary Receipt (ADR) listings also fell.
Why is there a disconnect in the markets?
Since he came to power, Xi Jinping’s remit has been to implement reforms to spread wealth and ensure not only that the economy grows, but that it grows in a stable manner and avoids speculative bubbles. Like all governments, China does sometimes stumble on the path toward those objectives and this can be disruptive for markets in the short term. The domestic investor community understands this but Chinese companies listed in Hong Kong and the U.S. are more susceptible to over-reaction and negative sentiment on issues such as government reforms. That’s where active management comes in. It gives us the opportunity to focus on a very small share of the listed universe, on quality companies that are best placed to anticipate changes in government policy.
Given the disconnect between Chinese stocks listed on local exchanges in China and Chinese stocks listed on U.S. exchanges, does that imply that investors should only focus on China A-Shares?
Not necessarily. If investors limited their portfolios to stocks only listed on mainland China, they would be reducing their exposure to growth opportunities in companies listed in Hong Kong and the U.S. which can—and do—deliver good returns irrespective of the geo-political climate. The key is to actively assess the fundamentals of companies wherever they are listed and identify value and growth.
Currently, which investment sectors and themes do you see as being favorable for investors to get exposure to China?
The government is investing in and heavily promoting companies in the IT sector, be it electrical components, semi-conductors, software or IT hardware. It’s an exploding area. In the electric vehicle (EV) space, for example, batteries are the most valued component and China makes a significant contribution to global battery production. Other growth sectors and themes we are looking at carefully include solar and renewables, financial services and health care and wellness.
Any final thoughts?
As we look ahead, we think Chinese stock prices may be less influenced by macro forces such as regulatory intervention and inflation fears and more influenced by company fundamentals and secular growth. Given the weaker performance of some sectors, valuations in China are also quite attractive in a global context. The bottom line is that China is aiming for quality growth and not just growth.
As of December 31, 2021, accounts managed by Matthews Asia did not hold positions in China Evergrande Group, Didi Chuxing or Kaisa Group.
Investing in Chinese securities involve risks. Heightened risks related to the regulatory environment and the potential actions by the Chinese government could negatively impact performance.