Recently the world’s largest and most indebted real estate developer, China’s Evergrande, has been on the verge of defaulting. In the midst of China’s attempts to move its economy towards a more free market model, free from heavy government intervention, this crisis presents the Chinese government with a challenging decision: should it bail out Evergrande from its self-inflicted crisis, caused by the company’s own excessive greed? The impact on the bond market could also be significant, with many commentators labelling this as ‘China’s Lehman’ moment due to the size of the debt; Evergrande’s off-balance-sheet balance liabilities total 2% of China’s GDP. Premiums have been shooting up in the speculative Asian debt market, making this a very interesting situation to watch, with finance giants such as Soros competing against HSBC and BlackRock. The way in which this situation is eventually resolved will provide an insight into the CCP’s priority between ideological stubbornness and financial stability, as well as setting a precedent for future companies within the industry.
First, it is helpful to understand exactly what Evergrande does. Essentially their business model is developing real estate projects, but importantly selling flats in advance to customers, before their completion. They operate using commercial bills, a form of short-term debt not backed by collateral, meaning that only firms with good credit ratings are able to issue these bonds successfully. This model has caused further problems for Evergrande in its liquidity crisis, as missed payments lead to the suspension of building real estate, creating a debilitating cycle. It is important too to recognise the sheer size of this industry; real estate has contributed to 29% of China‘s GDP growth, and now we could easily fit the entire population of the UK or even Germany into the 65 million empty Chinese apartments, symptoms of an industry gone into overdrive. Evergrande plays a monumental role within this industry, with $355bn of assets across its developers, as well as hiring between 3-4m labourers each year for its projects. This size only adds a sense of urgency to the Chinese government’s attempts to prevent such a pillar of their economy from collapsing.
How did it end up in this crisis?
The reason Evergrande has reached its current stage of desperation can be pinned down to one important factor: debt. Since the financial crisis of 2008, China as a whole has been rapidly accumulating private debt from firms and individuals, and has now reached a stage where debt is approximately 260% of GDP as well as contributing nearly two thirds to the global increase in debt since this time. Again the real estate sector is especially leveraged, tying up about 40% of the Chinese banking system’s assets. Evergrande itself has 0.6% of the total credit supply from outstanding debts within the country. When considering the risk of contagion to other sectors, we can see exactly how this has the potential to inflict huge amounts of economic damage, similar to what was seen in the US real estate sector in 2008.
This high level of debt has come under high levels of scrutiny recently from China’s president, Xi Jinping, as he begins to recognise that the growth model and financial fragility arising from high debt levels is not sustainable for the country. Chinacurrently faces its own crisis as economic growth begins to fall from its previous highs, when it contributed 28% of GDP growth worldwide between 2013-2018. Currently China’s population is in decline, with a fall of 2m in the number of babies born in 2020 compared to 2019, suggesting that it may have to switch to more traditional means of growth such as high-tech manufacturing. Xi is not keen on this property reliance, and since 2020 has been pushing a disorderly expansion of capital for the sector. The ‘three red lines’ are a set of rules to target this, which limit future access to financing to insist that a firm adheres to the following strict criteria: ability to asset ratio of less than 70%, net gearing ratio of less than 100%, and a cash to short-term debt ratio of over 1x. Evergrande meets none of these criteria, meaning since late 2020 it has been cut off from further credit, throwing a firm already heavily dependent on leverage into a crisis which is just now beginning to take hold.
By the end of June this year, Evergrande had managed to cut down its debt by $89bn, around 20% of the outstanding amount at the end of 2020, but this was still not enough. On September 23rd, it missed a crucial interest rate payment of $83.5m for offshore bond holders without making a statement, leading it to enter a 30 day grace period before a default would be officially declared. It was somehow able to resolve a $35.9m payment for onshore suppliers, but exact details of how were not given, leading some to speculate it may have been trading in property assets to pay off debts. The advisory firm Moelis & Company and the law firm Kirkland & Ellis LLP have been brought in to help with possibly one of the biggest debt restructurings in history. With this first missed payment, tensions are beginning to rise in Beijing as officials weigh up the possible consequences.
What happens now
The bond market surrounding Evergrande has taken a particular hit, with Evergrande dollar bonds (bonds denominated in dollars issued outside of the US, whose interest payment was missed) trading at $0.33 on the dollar. In fact this $428bn corner of the Asian debt market has seen yields shoot up by 12% on the recent news, with 11% of the market seeing yields of over 50%, suggesting a default is likely. Many big name investors have been caught up in this crisis, including Blackrock, HSBC, and UBS, who are also worried by the fact that, with stringent Chinese regulation, offshore bond holders are most likely to be paid last in the event of a default. Some firms such as Credit Suisse did cut their exposure in recent years, but for many, high yields in our low-rate economy were simply too enticing. It is clear that in the worst case scenario, the impact could echo all over the market.
In terms of the impact of China, we could see the book on government intervention rewritten. Currently many investors in the Chinese economy take it for granted that most firms and assets will be prevented from entering any major crisis by the government, in an attempt to maintain financial stability and growth. As the FT’s Tett puts it, either the government needs to be a ‘pillar of faith’ for investors, or else the investors must have enough confidence within the company’s financial health for the company to survive in the free market. By potentially removing government support by letting the company reach this level, we are seeing the role of the government as a ‘pillar of faith’ begin to weaken, and it is certain no investor has enough faith for the second option, leaving the company, in this case Evergrande, in a dire situation. A similar situation occurred in the Japanese financial system in the late 1990s, which resulted in a period of deflation and economic hardship across the country. To maintain faith, the government must take action to instil confidence in the short run for this company.
Overall, China is facing one of the first major symptoms of its need to adapt to structurally change the economy. The ‘three red lines’ present a long-term solution to make the real estate sector more sustainable, but in the meantime the government will have to deal with the creative destruction that accompanies it. Additionally, to maintain offshore investors’ confidence, additional steps will need to be taken if China wishes to continue to take a role on the international economic stage. In reality, we are likely to see a balance between the government providing support to Evergrande to minimise the wider damage and ensure the large workforce are not left behind, while also making an example of Evergrande to demonstrate what happens if firms ignore the regulations for a new, sustainable, less fragile China.