Evergrande: why most analysis is dead in water and how best to understand and navigate what’s happening? Both denialists and alarmists are getting it wrong. Let’s start by understanding this: what is happening is the result of a CCP-initiated policy change to curb leverage.
It started a while back and has seen other defaults, including SOEs. What are the specific policy changes? Most important is the introduction of the 3 red lines a year ago:
- L/A < 70%
- net leverage < 100%
- cash to ST debt > 1
What’s the point of the 3 red lines?
First and foremost to forestall a systemic crisis that could have brought down the whole financial sector if left unchecked. Real estate amounts to a significant chunk of China GDP with strong linkages upstream and downstream.
And believe it or not, the sector was levered to the gills. The 3 red lines are hardly draconian, yet all the CCC, a large chunk of the B and a good 1/3 of the BB did not pass them a year ago. Needless to say, it was really not too early. But there is more to it than leverage
One common practice of these construction companies,a game Evergrande excelled at, was to bid land at prices significantly higher than market. It didn’t matter to them, coz the risk got transferred to flat buyers and banks that financed the purchase.
That model worked well for local governments, banks and households because house prices were going up. So much so over the last 15 years, that a serious affordability crisis emerged in major cities AND HH debt soared way above disposable inc - below HH debt as % GDP
6/N Image
So it wasn’t hard to figure out the economic disaster in the making: exponential price rises with explosive HH and Construction leverage. But that’s not all. There is another problem that escapes most China analysts.
As a result of years of seeking easy growth through construction and leverage, the misallocation of capital was : 1- capital starving more innovative and high tech sectors (see chart) and 2- creating a headwind for a re-balancing towards a more consumption driven growth.
8/N Image
At some point, reigning in lending to the RE sector became vital in order to address the structural issue of capital misallocation. That also explains the curbs on VC investments in RE and most importantly, a curb on all the irregularities that characterized RE.
Tte issue of irregularities is at the core of what is happening with Evergrande. More on that later. It’s a long introduction, but it seemed important to explain these issues to understand the long term nature of this problem and why it’s resolution will be tedious.
So there is a new paradigm dictated by a set of economic realities that CCP could no longer ignore and most importantly, they can relax the rules a bit, but can’t reverse course. They can’t allow consumers to be bust nor a rogue unproductive sector to balloon further.
The tail risk emanating from the implementation of this new paradigm is being priced in. It’s not only Evergrande’s credit that is collapsing but the whole HY market. Contagion is AT work. China HY is some 10% away from it’s March 20 low….that’s not benign
12/N Image
Within construction many weak operators are seeing their credit collapse: Fantasia, R&F, Suna, China Aoyuan. But that’s not all. The stress is spreading to the banks and financials. Here is Minsheng and Ping An - next level up would be IG starting to show stress
13/N Image
So we established that we are in the phase of pricing the tail risk. All in all pretty China centric for now. How could it create contagion beyond. There are significant losses already for the international holders of China credit and equities. That’s one channel.
Any broader contango on towards the financial sector in China will prompt temporary policy responses like liquidity injection (done this week). But don’t expect a turnaround. They can’t. How will it resolve itself? Well, it started with leverage as the big issue.
So it will get resolved through asset sales. Idiosyncratic stories will dominate. Stronger balance sheet players will snap land and construction sites. SOEs will snap some assets. State will unwind bad players to help make whole employees and home buyers.
There is a shady side to many of these construction cies, non more so than Evergrande and their Wealth management products sold mostly to employees. They can’t discharge the guarantees on many of these products and there are rumors of insider selling.
Expect more rot to be exposed, trials, accountability, compensation, etc…Stabilizing the onshore property market will be long, arduous, and risky. Evergrande alone has an order book of 1,7 m residential units. Those are down paid for, yet unfinished.
Uncertainty and volatility will remain elevated. None of the ill-informed « they will bail them out » scenarii is possible. One thing is certain, there will be a protracted construction slump in activity and price increases. CCP might not allow for house and land price ⬇️
There’s obviously a read- cross for all commodities, but mostly steel. Dalian Iron Ore started collapsing in July and never looked back. Unsurprisingly, August showed the biggest drop in steel output on record…
20/N Image
And guess who is taking note? The miners are. That’s how contagion works. Aussie miners are the obvious play here: you can see that RIO has established a downtrend and is looking primed for a large move down. $BHP and $FMG looking equally awful.
21/N Image
It’s not only a commo issue. China’s consumers are very levered and while output has been restored to pre-COVID levels, consumers can’t keep up. Retail sales plunged recently to 11% below trend and all high frequency measures are showing sluggish spending. Chart Pictet
22/N Image
And China is looking at a winter of power shortages that’s gonna challenge it’s output further. It’s looking pretty dire and a last level of pernicious contagion will come from the losses all unsuspecting US moms and pops will incur following years of reckless inflows.
While some signs of funding stress are emerging like the Onshore USD/CNY 1y swap rates ticking up, it’s still largely benign. China is a financial system where state and banks are 1 and liabilities locally dominated and held.
If funding stress signs don’t emerge, don’t conclude that there is no contagion. Contagion is playing out already if you know where to look.

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More from @INArteCarloDoss

13 Oct
There is something very troubling in European Gas storage. This is not about conspiracy theories, but I doubt there is any convincing explanation, and if there is, please share. Let’s start with a look at NatGas prices across Europe. Prices really took off towards end June
So market took off in Q3. Let’s look at NE inventories (data is for FR, Bel, NLD and GER). If we look back over last 6 years, 2021 was the lowest Q3 storage level. That makes sense as low level of inventories left market more exposed to supply shocks.
Now let’s look at all storage facilities that are independently managed in NE. Surprise, they fall within (albeit towards the bottom) of historically seasonal levels. Hmmm…
Read 7 tweets
9 Oct
Awww…my dude….you wanna come at me choosing violence, you better come prepared. I don’t have a thesis, I analyze data and attach the data to my analysis for transparency.
You could have saved yourself the embarrassment if you had spent 10$ on a Casio calculator.
Let’s dig into it.
Total Chinese thermal coal output before the ban: 1,2 billion Mt
Total imports before the ban: 0.2 billion Mt
Total imports represented 14% of thermal coal available. So imports as a whole are not what helps run China’s grid, they’re an add on.
Now let’s do Australia.
Total imports from Australia before the ban: 0.04 bn Mt. That’s 20% of total imports, but just 1.4% of total coal available.
Now you can see that your claim comes from ignorance, but you still could have express it graciously vs roguishly.
Read 5 tweets
8 Oct
Power situation in China is getting worse, not better, despite the lesser media focus. Here is a quick thread to show how bad the situation is and how it stacks-up with the construction deleveraging to continue posing significant growth and supply chain challenges
At the heart of this energy crisis is coal, that supplies 2/3rd of power generation. As many know, coal in China had a similar parabolic price acceleration to that of NatGas in Europe. Let’s look at Coal prices and the Backwardation that denotes tightness
Many factors have led to this tightness which is currently getting worse as inventories at power generators fell as low as 11 days of supply, lowest in 5 years. One of the key factors was the production caps imposed on domestic coal mines, part of Xi’s de-carbonization agenda
Read 9 tweets
23 Sep
The pyramid of RE financing and why most who are taking position on how contained the construction deleveraging will be are often talking out of a blind spot. We have established that RE is the largest HH asset (40%) and largest exposure of financial sector.
But how does it stack for the financial sector and what are the feed-back loops? First pillar is mortgage loans but those represent under a third of total exposure (while a large chunk of HH debt and that has ballooned rel to GDP).
Then comes property developers loans which is a relatively small 15% of total financial sector exposure. But the issue lies in all the « other loans » that have been collateralized by property/land. That is almost half of the total banking sector exposure.
Read 5 tweets
20 Sep
This thread is a super condensed version of a body of work I have been doing for months, and the contagion section is more illustrative than exhaustive. Today I would like to show another direct channel of contagion from the weakening consumer sentiment in China into Luxury
Property = 40% of consumers assets and their liabilities have ballooned over the last 15 years (see thread), with the leverage clean-up / protracted restructuring of the property sector / an energy crisis / new redistributive party line, consumer spending is faltering
European Luxury groups realize around 30% of their sales in China, a high growth market. In August $120 bn were wiped out in 2 days after Xi announced the common prosperity goal. The sector never looked back and has formed or confirmed a top. Here is LVMH
Read 5 tweets
15 Sep
Many loud voices been clamoring for a while now that Evergrande is isolated and no ripple through. Here is a quick demonstration of how out of (market) touch these statements are. As explained in many previous posts, China HY stress started with Construction and spread.
As is evident, China HY is breaking down. But the denialist argument is that no ripple through has been observed. You can see on the chart that the same index (ICE - BoA HY) for the US is disconnecting. But is it so? Let’s look at the 3m RoC of of the option-adjusted spread
That moved up to positive territory…it does show that things have been moving under the surface for a while. Now let’s see how the same option-ad spread has been doing in terms of correlation with $VIX - and we have a corr break that usually heralds move up in spreads
Read 5 tweets

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