Troubles at Evergrande and their ramifications

The Chinese construction giant Evergrande is teetering on the verge of bankruptcy.  With a debt of over $300bn, it missed an interest payment of $83.5m in September, triggering a grace period of 30 days within which to make the payment or default.  In the last week of October it just managed to make the interest payment.

But Evergrande is by no means out of the woods.  Foreign investors are owed $7.4bn in bond payments from Evergrande next year alone. The plight of Evergrande has rattled the global markets.  Its main share listing in Hong Kong has lost three-quarters of its value over the past year.  If it goes down, all the money owed to the foreign investors will vanish into thin air.

Evergrande is not the only construction company in deep trouble.  Fantasia, a luxury developer founded by the niece of a former Chinese Vice President, Zheng Qinghong, defaulted in October, sending shock waves through the market.  Other construction companies under water include Modern Land, which has asked for a deferral of a $250m payment, and Sinic.  Contagion has already engulfed Vanke, County Garden and Kaisa, among others.

Founded by the billionaire, Xu Jiayin (a member of the Chinese People’s Political Consultative Conference, a very influential body, which gave creditors confidence to maintain lending), Evergrande resorted to using the money paid by buyers of apartments that were still to be built for discharging its existing liabilities.  As a result, 1.6 million people are waiting to move into new homes which they have paid for but which have not been built.  Evergrande has 800 projects across China that are unfinished.  It has slashed prices and yet failed to lure new customers.  A clip widely shared on social media recently showed an entire development of recently-built skyscrapers being demolished.

Evergrande, with a series of missed payments and a $300bn debt, is at the centre of a property sector representing 29% of China’s GDP and debt in excess of $5tn. Nearly 41% of the country’s banking assets are tied to the property sector; and 78% of the invested wealth of urban Chinese is in housing.

With several million creditors, shareholders and bondholders, as well as the owners of unbuilt apartments, Evergrande presents a huge problem for the authorities – economically and politically, with global ramifications.

The government has three options: (1) let Evergrande be bankrupted; (2) bail it out because it is ‘too big to fail’; or (3) facilitate an orderly distribution of its assets.

President Xi’s government frowns on all forms of speculative investment, especially in property, as belonging to a fictitious economy which crowds out investment in the real economy – manufacturing, technology and infrastructure, all of which will be decisive in determining China’s fate in the global economic league. “Houses are for people to live in, not to speculate on”, President Xi told the 19th Congress of the Communist Party of China in 2017. 

While saving Evergrande sends entirely the wrong message that reckless borrowers will always be saved by the government, letting it fail would have a disastrous effect on the 1.6m people waiting for unfinished apartments and on hundreds of small businesses, creditors and banks. Panic among investors and home buyers could spill over into the property market and have a devastating effect on household wealth.

What is more, allowing Evergrande to go down might set in train an avalanche effect across not just the property sector but also the banking institutions that presently finance its debt mountain.

China has considerable experience in dealing with such type of crisis.  In 2018, Anbang, a private insurance group, was brought under state control and restructured following its collapse with liabilities in excess of $320bn.  Baoshen, a regional lender, was allowed to fail last year after accumulating $32bn in debt, with $26bn in public funds used to rescue creditors who were repaid at the rate of 60 cents to the dollar owed.  Earlier this year, one of China’s biggest buyers of global assets, HNA, was taken over by state bankruptcy regulators and broken into four separate entities. And most recently Huarong, a state-owned asset manager with $15.9bn in losses, was bailed out by state-owned investor groups after its Chair, Lai Xiaomin, was executed for corruption.

If the above precedents are any guide, it is very likely that Evergrande’s assets will undergo an orderly distribution of its assets to an assortment of state and private buyers, with the result that those who made deposits will get their houses, creditors will get paid, and domestic bondholders will get away with minor haircuts, while the bigger losses are borne by international bondholders.

Although this solution would tackle the Evergrande problem, it could be just the beginning if the authorities persist with deleveraging the property and financial sectors.  With many other property companies in trouble, it would be difficult indeed to replicate such an orderly distribution of assets across the property sector for every company in trouble.

Accounting as it does for 29% of China’s GDP, a significant slowdown in the real estate sector will have ramifications for overall economic growth in China.  According to some analysts, a 20% fall in real estate activity could result in a 5-10% fall in GDP, leaving aside amplification from a banking crisis, or accounting for the significance of real estate as collateral. Regulatory crackdowns have already wiped over $1tn off the value of Chinese assets on domestic and foreign exchanges.

Then there are the global implications.  China accounted for 28% of all global growth between 2013 and 2018 – twice as much as the US.  A significant slowdown in the Chinese real estate market would spell slower global growth, with a particular impact on commodities that enter into construction.  In the not too distant past, it used to be said: ‘if the US sneezes, the world catches cold’.  Now the question is what happens when China sneezes?  Would the world catch cold?

Chinese developers have $5tn in debts, and few would be solvent under proper accounting standards. Bondholders on the $19bn offshore dollar market can kiss goodbye to $19bn.

As can be seen, the rest of the world has a profound interest in the unfolding saga in the Chinese property and finance sectors.  Declining business confidence in China consequent upon tightening regulations and a pivot towards the state is causing ripples across the Chinese private sector and foreign investors, who are trying to frighten the Chinese leadership by asserting falsely that the agenda of greater state intervention would translate into lower growth, less innovation, less efficiency, greater misallocation of resources and less income to distribute.  These assertions are made by people who place such blind faith in the market that they cannot see the elephant in the room, for what could be a greater misallocation of funds than that which results in a crisis of overproduction with its fearful consequences?

The truth is that, with the deepening market penetration of the Chinese economy, crises of overproduction will inevitably follow in its wake.  Today it is the construction sector, tomorrow it may be manufacturing.  Even if the Chinese authorities are able to get over the difficulties in this sector, crises elsewhere are bound to erupt.  China has become a workshop too big for the world.  There is only one real, and long-lasting, solution and that is to roll back the market and return to the type of planned economy that preceded the era of ‘reforms’.  It will be a tremendously difficult transition to effect, but there is no other way.