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COVID-19 is why the 'music stopped' for Evergrande: Analyst

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Brendan Ahern, KraneShares ETFs Chief Investment Officer joins the Yahoo Finance Live panel with the latest on China’s Evergrande.

Video Transcript

AKIKO FUJITA: Of course, investors are going to be watching the mainland Chinese markets very closely, after they come back from a two day holiday. This coming on the back of some headlines out of China on Chinese real estate giant Evergrande. They missed their bank repayment on Monday. Now face a Thursday deadline for repayment or payments of interest, on some of its bonds. Let's bring in Brendan Ahern, KraneShare's ETFs Chief Investment Officer.

And Brendan, I have to say, I really appreciate the note you put out today because I think it really puts all of this in context. Clearly, we saw a huge reaction in the US markets yesterday to what played out over in Asia, specifically in Hong Kong. Walk me through what you're watching next, as we look to that Thursday deadline for Evergrande.

BRENDAN AHERN: We're very likely going to see the Chinese government facilitate a debt restructuring that we felt like the market reaction, Akiko, as you pointed out, was really driven by a lack of liquidity in the Hong Kong market, driven by market holidays in China, South Korea, Japan, and Taiwan. So literally, you had four of the five largest, most important markets were on holiday on Monday. Today you had Japan come online but you still had China, South Korea, and Taiwan on high on holiday.

So volumes, 80%-- 83% of the one year average on Monday, only 70% today in Hong Kong. Likely an exaggerated move due to a lack of liquidity. But I think, again, I think you're very likely going to see a facilitation and encouragement of a debt restructuring, which Evergrande bonds are already pricing in, being that they're trading around $25 versus par value at $100.

AKIKO FUJITA: What is that debt restructuring look like and what do you think the calculation is for the Chinese leadership? On the one hand, you've got Xi Jinping calling for these debt piles to be reined in and yet, there are concerns about if you allow Evergrande to fail in some way, the ripple effects that's going to have across the Chinese economy.

BRENDAN AHERN: Yeah, 100%. Letting the company just go would have a significant effect, not only on say, 120 Chinese banks, another 129 financial institutions, suppliers to have Evergrande. So just letting the company go, you would potentially have a systematic threat to China's financial system. So that's kind of a bit of a no-go, just letting the company default. At the same time, a government takeover really goes against what we've heard from policymakers in China. They don't want to encourage bad corporate behavior by saying, take a lot of risk and if you come up snake eyes, we're going to bail you out. I don't think that's something they want to do.

So a restructuring would mean bondholders are going to take a significant haircut. At the same time, we don't know how that will play out for equity holders. If you look at the ticker 3333 Evergrande's Hong Kong listing, this has been a train wreck in slow motion. It's been going down for about a year now and we're just at this critical juncture where unfortunately, they've hit a situation where they have some bonds due on Thursday. So overnights, we're going to see some movement very likely from the Chinese policymakers to encourage this restructuring.

AKIKO FUJITA: What kind of movement do you think that's going to be? Are we likely to get a signal from the PBOC, for example?

BRENDAN AHERN: It's just hard for me to imagine that you're not going to see one movement to inject cash into the financial system, potentially a bank reserve requirement ratio cut. You're going to see some policy movements to make sure that the mainland markets, Shanghai and Shenzhen, which reopen tonight, don't follow what happened in say, the Hong Kong market. At the same time, you're going to see potentially some announcements about some of the banks that have exposure to Evergrande, entering into restructuring deals.

They've been on holiday both Monday and Tuesday. So they've got another 20-- the clock is ticking, so they've got to get this restructuring in place. Make sure that Evergrande doesn't be an outright default, which would be a significant risk off event, not only for China, but for global markets.

AKIKO FUJITA: Brendan, to what extent are the debt concerns specific to Evergrande? I mean, we've seen over the last 10 years at least, how the real estate, the property market, has been fueling the growth over in China. Even if there's no contagion effect outside of China, what does this mean for the sector specifically, domestically?

BRENDAN AHERN: Well they've been saying for a number of years now, housing is for living, not for speculating. That Chinese cities kind of grow outward. If you've ever been to Denver over the last 20 years, Denver just keeps going further and further away from the downtown. And that's kind of how Chinese cities. So investing in real estate it's been nothing but a winning trade. But for Evergrande, due to COVID, the stopping of projects really was when the music stopped. And historically, Evergrande's been like a cat with nine lives. They've run into solvency issues in the past, but this time it's a little different in a post-COVID world.

Certainly, I think for China, they do want to see real estate prices to kind of level out. They don't want to destroy real estate prices because it's such a store of value for Chinese wealth, but they'd rather see that money that historically went into real estate, go into the technologies that China needs in the future. Things like semiconductors, high end manufacturing, biotech. So there is a little bit of a read here for investors that real estate probably isn't going to enjoy the same returns it has historically. They'd rather see that capital go to parts of the technology sphere that China needs in the future.

AKIKO FUJITA: Brendan, I'm curious to get your thoughts on this story out from "The Wall Street Journal" today about Xi Jinping moving more towards a Mao like system, if you will. Really looking to try to rein in these big enterprises, but also at least looking to level the playing field. I'm not sure if that's the right way to describe it. How much of what we're likely to see in the management of Evergrande's collapse you think is about that messaging, and if that's the case, are we looking at a more slower growth period coming up in China?

BRENDAN AHERN: Well, I think one, you have China's census came out a few months ago that showed that the average woman in China is having 1.3 kids. That's well below a replacement value of 2.1. So China has a demographic issue. It's not a problem for today because they have a massive Gen Z population, but they've got to figure out why are parents in China not having more kids. And some element is having children and a highly urbanized city environment is expensive. And an element of that is high real estate prices.

So they need more affordable housing from the real estate sector. They need potentially to develop suburbs like we have here in the West. And so I think for sure, an element of real estate is about trying to get real estate developers to make multi bedroom apartments affordable. At the same time, I think some element of the regulation we've seen around China, within the internet space, we've seen anti-competitive practices, user data, user privacy. So they're adhering, adopting what we saw in Europe, with the GDPR, the General Data Protection Rights that say, just because I download a free app doesn't mean you get to read everything, hear everything I say on my phone.

AKIKO FUJITA: And Brendan, finally, you've really been a supporter-- I don't know if that's the right word. You've been talking-- you've been investing a lot in China's growth and saying that regardless of all the noise, with regulation, that the growth story still remains in tact. I know the real estate story is a separate one, but is that growth investment, is that still there? Has your thesis changed at all in terms of investing in China?

BRENDAN AHERN: You know, Akiko. You look at the Q2 earnings we got in August, Alibaba grew revenue 34%, Tencent, 20%, Pinduoduo 89%. I know the price action doesn't agree when you pull up a chart or say, or China internet ETF K web, but it doesn't agree with that these companies are adhering and adopting to the regulation. But I can tell you, we did a call with jd.com last week. They said, yeah, Q2, a little. Soft things are going to be fine. There was a lot of flooding, rainfall in China in the second quarter. The companies themselves are buying back stock. Alibaba, Badu, Tencent, a smaller company called Joy, the ticker YY.

So the companies do believe that the stock is cheap, and they're proving it by deploying cash. If they thought they were going away, wouldn't they be hoarding cash, not buying back stock?

AKIKO FUJITA: We'll leave it there. Brendan, it's always good to get your take. Brenton Ahern, KraneShare's ETFs Chief Investment Officer.