Economic Perspectives

Evergrande conundrum

Print edition : October 22, 2021

A view of the halted Evergrande Cultural Tourism City, a residential-retail-entertainment development, in Suzhou city in China’s eastern Jiangsu province, on September 17, 2021. Photo: Vivian Lin/AFP

Worried investors outside the Evergrande headquarters in Shenzhen on September 15, 2021, after the Chinese property giant said it was facing “unprecedented difficulties”. Photo: Noel Celis/AFP

A Chinese behemoth’s missing of an interest payment triggers local and global fears of its impending collapse, but the government is in no hurry to bail it out, indicating that it seeks to control soaring property prices and curtail the wealth and power of corporates.

China’s Evergrande group, identified as the world’s most indebted property developer with accumulated liabilities in excess of $300 billion, missed an interest payment instalment due on September 23, 2021, on bonds borrowed through U.S. dollar bond markets. Although the company enjoys a 30-day grace period to pay up and avoid being in default, the absence, as yet, of any clarification on the missed instalment has increased uncertainty. The markets seem to be sceptical that the firm would meet in full the $129 million of interest payments on its bond issues due this month and the $850 million due by the year-end. Evergrande’s share prices have collapsed by more than 85 per cent over the last year.

As an Evergrande default and possible bankruptcy can have repercussions in China and all over the world, the global media has been obsessed with this company for weeks now. The domestic fallout would be influenced by the fact that Evergrande’s sheer size makes it a crucial component of China’s real estate sector, which is estimated to contribute more than a quarter of the country’s gross domestic product (GDP).

Growth and web of debt

Property sector investment accounts for a large share of the more than 40 per cent of the GDP devoted to fixed capital formation, and drives China’s growth. Debt has been a core element of this growth trajectory. Property developers borrow heavily to buy and accumulate land for construction of offices and houses that are acquired by buyers; their purchases are more often than not financed with debt, easy access to which has fuelled a speculative bubble reflected in soaring property prices in multiple urban locations.

Local governments sold land to developers since they needed revenues to service debt totalling more than $8 trillion taken on by special-purpose local government financing vehicles (LGFVs). The LGFVs were the financing route that provincial governments used to implement huge “prestige projects” that were launched to build and shore up the reputations of provincial party and government leaders. China’s growth rode on this web of debt.

The failure of a property giant like Evergrande can tear this web apart. But that would not be the only damage. A collapse in construction would curtail demand for everything needed in construction, from cement and steel to glass and fittings, adversely affecting those providing these inputs. Banks and other financial intermediaries that lent to property developers would lose heavily in the event of a default.

Individual property buyers who have paid advance instalments, but have still to be given possession of their property, and retail investors who bought into the wealth management products sold by the property developers, will take a hit owing to Evergrande’s failure. Some 80,000 people in China, including employees of Evergrande, reportedly hold around 40 billion yuan ($6.2 billion) worth of the company’s wealth management products. Many of them have been protesting outside Evergrande’s offices asking for their money back. Many investors’ savings are tied up with the company and if they suffer losses owing to the company’s default, their consumption and investment spending will decline, depressing demand even more.

And Evergrande is not the only property company that can fail. China Fortune Land Development defaulted in February 2021, and other construction firms are in line to follow. All told, the end of the property bubble can cut short the revival of growth in China after a longish slowdown that followed the high growth years of the 2000s and earlier.

The adverse effects of a property market bust would not be restricted to China’s economy. To start with, demand from China has been an important driver of global growth. So, any recession in China will have repercussions for economic performance in the rest of the world. Moreover, foreign financial firms and investors, who have been plied with cheap credit by central banks pursuing easy money policies to revive depressed economies, have been diverting a chunk of that money to the Chinese market.
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A consequence has been significant foreign exposure to China’s financial system, with property developers alone, including Evergrande, having raised more than $220 billion in debt from the U.S. dollar bond market. Any shock to the Chinese economy and financial system will reverberate in global markets, with analysts seeing the Evergrande saga as contributing to volatility in stock markets worldwide. Given this fallout, global players have been surprised by the absence as of now of any concerted effort on the part of the Chinese government to intervene and bail out Evergrande, which is seen by many as being “too big to fail”. In fact, Evergrande’s troubles are being seen as China’s ‘Lehman moment’, referring to the mayhem that followed the bankruptcy of Lehman Brothers in 2008. There are similarities and differences.

Riding on debt, China’s property development expanded at a pace that resulted in oversupply relative to the actual needs of the population. But this did not appear to be a problem as investors, looking to benefit from appreciation in property prices and enjoying access to credit, acquired multiple properties with no intention to stay in them. Evergrande’s own difficulties arose not only because it was overleveraged or had accumulated too much debt. It was also because the government decided to rein in the debt- financed speculative bubble in China’s property markets.

Govt curbs on developers

To that end, the government implemented its “three red lines” policy in 2020, under which the liabilities-to-assets ratio of property companies had to be kept below 70 per cent, the net debt-to-equity ratio below 100 per cent and the cash-to-short-term debt ratio above 100 per cent. The intention was to limit the leverage of property developers.

Simultaneously, lending for property purchases has been curtailed, and property buyers are finding it increasingly difficult to access mortgage finance. A combination of uncertainty among buyers about the viability of developers over the long term, during which they build the assets for which advance payments are made, and the brakes that are being applied on increases in mortgage lending, has slowed sales in property markets. With cash inflows to developers squeezed, and non-bank lenders holding back, servicing debt has become a problem for the likes of Evergrande, precipitating a situation of near default.

As has been the case in the past, many analysts see in the troubles in China’s property and financial sectors the beginning of the end of the country’s growth story driven by credit-financed speculation by local governments and the private sector. However, the Chinese government is not faced with a problem that it finds difficult to address. Rather, by clamping down on excess borrowing, the government has created the crisis in the property sector.

Moreover, the government, as of now, shows no signs of pulling back from its policy of reining in the speculative surge in property markets, nor is it rushing to bail out Evergrande believing that the company is “too big to fail”. This reticence is visible even though there is a real possibility that if the property bubble suddenly bursts, the fall in prices could wipe out the wealth of many ordinary Chinese people who bought properties when prices were high, or who have invested in financial products property companies sold with the promise of high returns.
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Although observers expect the government to finally relent and intervene, the delay in its intervention has resulted in palpable uncertainty in markets within and outside China. Will the government relent, that is the Evergrande conundrum.

The thinking behind the Chinese government’s actions, or lack of them, is not all too clear, except for the fact that it has clearly decided to deflate the speculative bubble. One explanation for the government’s stance is that it perceives inequality as having reached levels where it threatens its legitimacy and that of the Chinese Communist Party, with the ordinary citizen’s inability to afford housing being part of that problem. This is in keeping with the recent official emphasis on the pursuit of “common prosperity” rather than just growth and wealth creation.

Another explanation could be the government’s need to rein in wealth accumulation by private sector barons, China’s version of the Russian oligarchs, who might seek to extend their power and influence to the political arena. Even as President Xi Jinping consolidates control over state and party to ensure a long innings in power, it is probably not enough to keep party insiders under control. The increasingly powerful billionaires in the business world need to be reined in and the accumulation of excess wealth that gives them power curbed. Moves against a range of tech giants such as the Ant Group and Didi Chuxing suggest that this is high on Xi’s agenda. It could also be one motivation for new policies in the property sector.

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