Evergrande: The Chinese “Lehman Moment”
By Joshua Ong
The Chinese economy has faced a significant slowdown in the past few years. In this article, we explore the causes and implications of the slowdown. The cause of the property crisis can be traced back to August 2020, when Chinese regulators introduced the “three red lines” to limit the borrowing of real estate firms, as part of the 2020-2021 reforms by Xi Jinping’s administration. These “three red lines” rule that developers must keep: 1) a debt-to-asset ratio of 70%, 2) a 100% cap on net debt to equity, and 3) enough cash on hand to satisfy short-term borrowing, debts, and liabilities. These new regulations greatly affected the China Evergrande Group, which had leveraged itself heavily in the preceding years.
What happened?
Some background on Evergrande:
Is a massive private-sector Chinese property developer and home builder
Earned $78 billion in revenue in 2020 and has almost 800 projects in more than 200 Chinese cities
Owes billions of dollars in debt, as it borrowed money and presold apartments to aggressively amass land and develop projects
The new regulations from Beijing prevented Evergrande from taking on new debt, and Evergrande found itself cash-strapped, missing several crucial repayment deadlines. As of June 2021, Evergrande’s total debt burden had been the most of any publicly traded real-estate management company globally. On 6 December 2021, Evergrande finally defaulted on offshore bond payments and formally entered the restructuring process, and on January 26 this year, Evergrande released a statement saying that it aimed to produce a preliminary restructuring proposal within six months to reassure creditors.
Why is Evergrande important?
Evergrande is deeply embedded in China’s financial system and economy, which relies heavily on the property sector for jobs and growth, with around 29% of China’s total GDP coming from the real estate sector. As of 2020, Evergrande had 200,000 staff, hiring about 3.8 million people a year for projects. Evergrande has accumulated liabilities of about RMB $2T, equivalent to 2% of China’s gross domestic product. The collapse of Evergrande would mean thousands would lose jobs, in a chain reaction that implicates many more parties involved.
These regulations imposed by Xi Jinping’s administration have caused developers to use special off-balance sheet financial instruments used to bypass the new debt limits. The country’s largest developers issued “commercial paper” worth RMB $336B in 2020, up 40% year-on-year. Commercial paper is an alternative form of payment that Chinese developers use instead of cash, legally using its own assets as collateral. The problem is compounded when other companies “endorse” the commercial paper transaction, being legally liable as well. Commercial paper is often endorsed many times before the final holder, meaning that Evergrande’s failure to repay commercial paper would cause many other companies who endorsed its commercial paper to be sued or potentially have their assets frozen. Evergrande accounted for over 60% of commercial paper issuance by the 20 largest real estate developers, with a combined worth of 3.5% of China’s GDP. Thus, Evergrande’s overdue commercial paper payments caused a chain reaction, affecting many local Chinese construction companies and suppliers.
What is the international impact?
Figure 1: Fall in prices of shares of Chinese developers (in %) [Source: Capital IQ]
Before Evergrande officially defaulted, strategists said that if the liquidity crisis was not properly contained by the Chinese government, there would be a massive chain reaction affecting markets globally. The mountain of debt is owed to both local creditors like China’s largest construction companies as well as banks and international investors, including Blackrock and UBS, with the latter holding about USD $283M in debt exposure across multiple portfolios. Declining property sales and slow progress in asset disposals have made it even more difficult for Evergrande to resolve its debt troubles. In addition, negative news coverage and weak market sentiment caused Evergrande’s stock price to fall 85% by September from the start of the year. Investors have been wondering if Evergrande would turn out to be China’s “Lehman moment” and spark a global financial crisis, given Evergrande’s large size and potential international impact.
The “Lehman” Moment?
The original “Lehman” moment refers to the bankruptcy of the Lehman Brothers investment bank in September 2008, symbolic of the entire subprime mortgage saga. Lehman was often thought of as “too big to fail”, as it was widely believed that the government would bail them out through the usage of federal reserves. When Lehman declared chapter 11 bankruptcy, the US stock market plunged and markets across the globe felt the aftershocks.
The difference between these crises lies in the early warning signs of default from China’s largest property developers. Evergrande’s slow and predictable demise came as a surprise to no one, with investors and creditors well aware of its financial troubles, and thus did not have the same global impact as the 2008 global financial crisis. As of now, there does not seem to have been any massive spillover effects, apart from the huge haircuts for international investors.
How is the Chinese government responding?
China’s communist party has been in the spotlight throughout this crisis, with investors watching Beijing’s response closely as they wait for government intervention to alleviate the debt crisis. However, the Chinese government has maintained that it would be handling the crisis in a “market-oriented way”, with no bailout in sight. Although Beijing has made it a priority to protect the affected construction workers, suppliers, and thousands of Chinese citizens who bought unfinished apartments, global bondholders are not as high of a priority to Beijing. They would have to wait out the lengthy restructuring process, which depends on negotiations with the company and the Chinese government.
To support the Chinese economy through the property market downturn, the Chinese government has rolled out several measures:
The People’s Bank of China cut the reserve requirement ratio for banks in December 2021
The Guangdong province summoned the Chairman of the Evergrande group and sent a working group to Evergrande to oversee risk management, strengthen internal controls, and maintain normal operations
Evergrande’s new risk committee includes officials from China Cinda Asset Management, Guangdong Holdings, Guangzhou Yuexiu Holding, and Guosen Securities, entities either owned or backed by the state
With the property market slowing and large property developers having to adjust to new debt constraints, the Chinese property sector has been increasingly strained, with ripple effects becoming clearer. Several other property developers like Kaisa and Shimao, have also defaulted on their payments, and the total number of firms that were “consistently overdue” increased by 26% in December 2021, compared to the month before. The surge in defaults on commercial paper in 2021 also reflects the liquidity stress in the real estate sector despite the measures taken by Beijing. In spite of the increasing number of struggling property developers, the Chinese government has stood by its decision to clamp down on developer debt, claiming that Evergrande’s own “poor management and blind expansion” caused its downfall, inferring that frugal companies would be just fine.
The increased defaults in this troubled sector are testing foreign investors’ long-held assumptions that Beijing would step in and bail out its largest companies. Now, China seems to be increasingly willing to let these large companies go bankrupt, with the recent bankruptcy of HNA Group being a prime example. The shift in Beijing’s attitude stems from its debt problem, as China’s companies have increasingly struggled to pay back the bills they racked up during the Chinese economy’s rapid expansion in the 2010s. Chinese companies owe hundreds of billions of dollars in debt to lenders and investors around the globe, and the increased willingness to allow companies to go insolvent displays the tough stance that Beijing is taking to rein in its companies’ lending habits and let the property sector cool off. In recent years, aside from HNA, Anbang was brought under state control and restructured, while Baoshang was a huge bank that was allowed to go bankrupt.
Outlook
The Chinese government has a history of leaving foreign investors with little to nothing. Just days before 2022, Evergrande pledged to start paying its workers again and to deliver more homes. However, with little information on the source of the money or paying its international creditors, investors have again been left to question the credibility of Evergrande’s promises. Given the complicated structure of Evergrande and its entities, the restructuring process will be highly complex and span several jurisdictions, and past instances such as the Asia Aluminum crisis suggest that the Chinese government has shifted away from pleasing foreign investors.
Instead, this could demonstrate the government’s renewed focus on the containment of systemic contagion risk within strategic sectors in the economy, such as the property sector, leading to questions surrounding the credibility of Evergrande’s promises to arise. It is likely that with influence from the Chinese government, the domestic creditors would be preferenced second after Chinese families, leaving foreign bondholders and shareholders last with the sharpest haircut.
More broadly, the sector has been collectively affected by Evergrande’s liquidity crisis, with investors dumping bonds from financially weaker developers and groups without state backing. For instance, Shimao Group Holdings and Country Garden Holdings saw large dips in their bond prices recently.
The collective market value of Chinese developers has also dropped in the span of a year, as shown in Figure 2.
Figure 2: Market Value of Chinese developers from February 2021 to February 2022 [Source: The Wall Street Journal]
Rating agency Fitch has downgraded China Evergrande Group and its subsidiaries, Hengda Real Estate Group and Tianji Holding Limited to a “Restricted Default”. This was followed by a report by Coller Capital that estimated that almost a third of groups with exposure to China would decrease their investments in China’s real estate sector in the next three years, deterred by liquidity problems of large developers and further potential defaults.
It is likely that more developers feel the unintended consequences of Beijing’s “three red lines”, given the recent trends in missed bond payments. Even if Evergrande successfully restructures and distributes its assets, the wider problem of the new deleveraging policies still weighs down on many other property developers, and China’s real estate sector may face troubles still.
With nearly a third of its GDP from this sector and given China’s global influence (accounting for 14% of global GDP in 2018), the implications of a slowdown in the Chinese real estate sector would translate into slowing global economic growth.
In closing, Evergrande’s crisis is a symptom of a bigger issue - repairing the Chinese growth model. Xi Jinping’s political agenda and policies
seem to lean towards communist ideals, establishing tighter control over the market economy and decreasing China’s income and wealth disparities. Beijing’s crackdown on tech giants, its revised anti-monopoly stance, and its ban on cryptocurrency have taken their toll on the Chinese index, with the CSI 300 lagging far behind the S&P. Xi Jinping’s administration seems set on persisting with the deleveraging camp
aign to encourage market discipline, willing to face waning growth and financial market volatility in exchange for “common prosperity”.
Figure 3: CSI300 against the S&P500 and MSCI World Index. [Source: Capital IQ]
*This article was written in February 2022. Since then, a group of bondholders, including Saba Capital, Redwood Capital Management, and Ashmore began legal analysis on deciding legal action against Evergrande, after Evergrande made a disclosure that “mystery lenders” claimed more than $2bn in cash, angering investors and potentially sparking a legal battle.