The crisis engulfing Evergrande, China’s second-biggest property company, is the greatest test yet of President Xi Jinping’s effort to reform the debt-ridden behemoths of the Chinese economy. It could also be the most significant test that China’s financial system has faced in many years.
As angry protesters occupied the headquarters of the troubled property developer in recent weeks, some analysts have described the Evergrande crisis as “China’s Lehman Brothers moment”. Only this time it’s a credit-fuelled housebuilder that suddenly can’t pay its $300bn debts, rather than a blue-chip investment bank that many assumed was too big to fail but was instead thrown to the wolves 13 years ago.
Although there may be some parallels, the more extreme prophecies of doom for China may be no more correct than the assumption that Beijing will simply step in and bail out Evergrande to make sure the fallout from the failure of a property giant does not spread to other areas of the Chinese economy.
“It seems that we may have already started the financial distress process. As the risk of insolvency increases, the behaviour of sales agents, homebuyers, suppliers and other stakeholders changes in ways that further undermine revenues and raise expenses,” said Michael Pettis, a professor of finance at Peking University. “Once that process begins, conditions can quickly spiral downwards unless someone like the government steps in to guarantee payments.”
As Evergrande’s turmoil continues to brew, the pressure on China’s real-estate sector is being felt far beyond a single developer. August data released on Wednesday suggested that national home sales by value had tumbled by 19.7% year-on-year, the largest drop since April 2020. Growth in home prices had slowed, too.
The question is how Beijing is to intervene – if it is going to do so at all. Some analysts think it will try to save part of Evergrande with a “politicised hierarchy” of creditors headed by the small investors and homebuyers
who marched on Evergrande offices this week to demand their money back. Such public protest is rare in China and Beijing cannot risk it escalating into a narrative about the elites enriching themselves at the expense of ordinary people.
Starting on Tuesday, when the firm founded by the former steel executive Xu Jiayin 24 years ago is widely expected to default on
two key bank repayments, big banks and financial institutions face the prospect of a drastic haircut of more than 75% as the price of saving the little guys.
But the key question is: will that work? The company shocked the market this week by admitting that it cannot offload its assets quickly enough to stop the bleeding. Its share price is collapsing and trade in its bonds has been suspended. It could get messy, analysts say.
“The nightmare scenario is a fire sale of Evergrande assets that transforms a healthy market correction into a rout,” said Gabriel Wildau, a China political risk specialist and a senior vice-president at the advisory firm Teneo.
The potential timebomb has been ticking for some years. China’s housing market has become hugely bloated by years of cheap credit and is reckoned by conservative estimates to account for 16% of GDP, although some estimates put that figure at 25% – far more than the proportion in western economies.
But the low-hanging fruit of debt-fuelled growth has long gone. In 2007-08, about 6.5tn yuan ($1tn) of new credit was needed to raise GDP by about 5tn yuan a year,
according to the IMF. In 2015-16, it took more than 20tn yuan in new credit for the same growth.
This means it is becoming much more expensive to repeat the trick, as more credit is pumped into the system for an ever-decreasing impact. In the end there has to be a reckoning and the crisis at Evergrande suggests that the cycle has finally caught up with the poster child of China’s property-market miracle.
“It is an intractable problem. As long as Beijing for political reasons selects GDP growth targets that exceed the underlying growth rate of the economy, it needs surging debt to achieve those targets, and this surging debt requires implicit guarantees, or moral hazard,” said Pettis. “They can’t really get one without the other.”
This is perhaps the biggest headache for Beijing when it tries to make a reformed economic model work. Shortly after he came to power in 2013, Xi said that China needed to “shift the focus to improving the quality and returns of economic growth … to pursuing genuine rather than inflated GDP growth.”
Since Xi’s speech, a slew of regulations were introduced for various sectors of the Chinese economy, for example the so-called
“three red lines” for selected developers in 2020 which severely limited their capacity to borrow.
Experts agree that this was where the rot finally set in for Evergrande because, as property prices began to cool in the wake of the regulatory crackdown, the company could no longer borrow so much to cover losses. Some say that the way Xi handles the implosion at Evergrande will be the “most serious test” of his determination to see through his reforms.
James Shi and Simon Lee of the Hong Kong data analytics firm Reorg said Beijing’s priority would be to keep Evergrande in business – even if its in a zombified form – in order to finish the estimated 1.4m homes the company has pre-sold.
“This is the top priority for them and the government,” they said. “Nobody wants thousands of angry people demanding their money back.
“This means that other immediate creditors such as suppliers must expect that they won’t get paid straight away. There is also a lot of anecdotal evidence that Evergrande has offered flats as payment in kind to suppliers and contractors.”
They said bigger institutional creditors were a low priority and would most likely have to accept a
government-orchestrated restructure of the company. Foreign holders of Evergrande’s dollar-denominated bonds – which total around $20bn – wouldn’t have much say in what happened and would therefore face a wipeout, analysts say. They would probably pursue their money in international courts.
However, the big question hanging over this is how long such a process could keep a wide range of creditors at bay while the company continued to operate and meet its building obligations.
Damien Klassen, who manages millions of dollars at Nucleus Wealth in Melbourne, Australia, said Xi should be applauded for trying to make serious change to an unbalanced economy. The problem is that it could spiral out of control.
“Xi may be thinking that: ‘If I have to break a few eggs, I break a few eggs.’ I’m sure he would prefer if 25% of the economy was not devoted to the housing industry. Xi wants to change society, make property more affordable. That’s not a bad thing. But can he pull it off? He could end up with a debt crisis.
“The problem is that the banks have lent to every developer in the same way so you could see contagion across the whole sector. There will be uncertainty about who takes on the bad loans and then it will be the whole sector that won’t get any credit, not just Evergrande. No one knows what’s going on, so you don’t know which property companies will fall over next.”
Most observers agree that the state will be able to orchestrate a softer landing than western governments managed 13 years ago. Wildau points out that China’s banking system survived a stress test this month by regulators that factored in defaults on both home mortgages and developer loans in excess of the likely impact of an Evergrande collapse. Evergrande’s liabilities of $305bn are around half of Lehman’s and the west did not have the kind of regulatory control at Beijing’s disposal to defuse the situation.
However, whatever happens, and even if Evergrande lives to fight another day, the Reorg analysts say that the Chinese property market is already in a crisis as companies race to offload debt.
“The impact is already being felt in industry – it is deleveraging very rapidly. Companies are finding it much harder to raise money which is shown by very high yields for their bonds,” they said.
Capital Economics agrees that even if a soft landing is engineered, the property sector that has driven China’s growth for 25 years is entering a period of decline that could have a profound effect on the world’s second-biggest economy.
Even reversing the red lines would not make much difference, they argue, because sales of land and homes were already falling, partly because China’s slowing population growth is acting as a natural break on the housing market. There are fewer young adults than there were 10 years ago, something shown by a 31% drop in marriages from 2013 to 2019.
“Relaxation of regulatory controls on the sector wouldn’t change this fundamental constraint,” said Mark Williams, Capital’s chief Asia economist. “Construction, a key engine of China’s growth and commodity demand, will slow substantially over the next few years, whether or not the economy escapes the current crunch unscathed.”
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