An analysis of what went wrong with the Evergrande real estate group in China
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- What is Evergrande: It is China’s second largest property developer, founded in Guangzhou 1996. It is running more than 1300 projects in over 280 cities, and its huge success with real estate prompted diversification into many other businesses (often unrelated). The main focus is on real estate, though.
- Debt-fuelled growth: Evergrande is laden with huge liabilities, a lot of debt totalling $310 billion. The company is going through hard times with insolvency issues, and underperformance in terms of revenue. When the Chinese government put a list of companies that could pose a threat to the market and lead to its collapse, Evergrande was on it. This has crushed its credit rating, share prices and reputation among a once-adoring public.
- The debt problem: Of the $310 b debt pile, about $85 b comes from bonds and loans from banks. These are the liabilities Evergrande actually pays interest on. A sum of $67 b comes from shadow banking systems; money from shady sources. The rest of the $158 b is the amount of accounts payable. It means that they owe the suppliers (for their projects) money for their goods and services supplied.
- Collapse was coming: Analysts predicted the death of Evergrande for years. Its chairman, Xu Jiayin, who founded the company in 1996, put up $1bn of his own cash in 2018 to meet a shortfall in demand for an Evergrande bond with a 13% coupon. The company relied on ever-increasing short-term debts, often at higher and higher costs, to fund a business model that relies on borrowing money to develop properties and selling them years before they are completed to generate cash from buyers’ deposits.
- This crisis was a long time coming. Evergrande has increasingly relied on short-term debt in its business model, which uses borrowed money to build property that is sold before it is built. Since August ’20, the Chinese government has been cracking down on developers’ ability to accrue debt, limiting both liability-to-asset and debt-to-equity ratios and requiring companies to hold cash equivalent to their short-term debt.
- Such rules have changed the nature of China’s property sector, which accounts for 20-25% of GDP. Expect the turmoil to stretch far beyond Evergrande.
- China’s Real Estate Market: It is the biggest in the world, and accounts for 10% of China’s entire economy. But Evergrande is just 4% of the total market. So the fear of complete collapse causing devastating repercussions to not only the Chinese economy, but also the stability of the CCP itselg, and the global economy as well, may not be true.
- Xi Jinping's crackdown: When central-government regulators stepped up their campaign against "leverage" in August 2020, major cracks began appearing in its business. Authorities constricted developers’ capacity to continue accumulating debt, doing three things - (i) limiting liability-to-asset ratios to less than 70%, (ii) net debt-to-equity ratios to less than 100% and (iii) mandating levels of cash that are at least equivalent to short-term debt.
- Everything changed: The policy changed the nature of the business. Unable to continue perpetually expanding their debts, Evergrande and several other weak companies have slashed home prices and halted projects in order to preserve cash. Evergrande is said to be offloading housing projects in an attempt to generate just enough cash to make payments to suppliers. It is also selling off its land at a 70% discount. There are ten other Chinese property groups with 1.86trn yuan ($290bn) in contracted sales that are in similar risky positions.
- Orderly collapse: China's authorities want the “marketised default”—or an orderly market exit and well-managed restructuring for troubled companies. The term has surfaced in government documents and local media as of late, as regulators become adept at managing larger, more frequent and highly complex defaults. They have had some successes. But far from being a well-managed process, Evergrande’s distress has been roiling markets around the globe and dragging down other weak developers. Major indices in Europe and America fell on September 20th as Evergrande’s situation appeared to worsen. Yields on the bonds of a number of struggling Chinese developers soared.
- Reshaping China: The crackdown on developer debt is one of the several campaigns Xi Jinping, China’s president, is using to remould the country. A sweeping clampdown on internet-technology companies has wiped out more than $1trn in shareholder value since early 2021. A number of New York-listed Chinese companies have seen their entire business models destroyed. These changes, along with the goal of improving housing affordability and ridding the property market of speculation, have been encapsulated by Mr Xi in the phrase “common prosperity”. A regime shift is occurring without necessarily the markets fully comprehending the enormous underlying change to the structure of the economy.
- Market Crash: Many financial institutions and suppliers rely heavily on Evergrande, and a lot of companies could go bankrupt if they’re not paid in time. This will be like a domino effect of the entire Chinese market, with Evergrande at the center of it. The company has over 1,23,000 employees, and that doesn’t include the number of construction workers who are hired for each of their projects.
- Bailout: While the liability amounts to $310 b, the interest they actually need to pay imminently, amounts to $669 m, much more manageable. So while Evergrande is having a hard time with insolvency, if the government were to help out, they can be back in the game soon. With investors gathering in front of the Evergrande buildings and the probability of a political risk increasing, $669 m might be a small sacrifice for the stability of the regime!
- China’s intervention: The Global Times, a media that directly reflects the stance, position, and opinion of the Chinese government, said that Evergrande was “not too big to fail”. China’s central bank injected $14 b in cash on Sep. 17, and another $15 b later through Open Market Operations (OMO). Since the liquidity they provided was the most they’ve done in the past 8 months, it’s safe to say that they had Evergrande in mind.
- Three Red Lines: Chinese government had issued "the 3 red lines", which are the debt related restrictions, since 2020. The government wants to deleverage the real estate market. The Chinese government will provide liquidity in the market, but won’t directly intervene and solve the problem for Evergrande. So Evergrande’s bankruptcy may be inevitable.
- Evergrande’s Stock and Bond Prices: Evergrande’s stock fell close to 90% from its all time high levels, and over 80% since the beginning of this year. The company’s dollar bond’s price has also dropped over 70%. The bonds of Evergrande’s real estate counterparts are also dropping sharply, and signaling a potential crash.
- Future of Chinese economy: As China’s property sector accounts for 20-25% of its economy, an extended campaign against developer debt could significantly lower China’s growth prospects. That will lead to much greater economic and financial turmoil further down the road. Regulators may eventually be forced to bail out the property industry along with the financial one. That will lead to questions on Xi Jinping's entire approach.
- EXAM QUESTIONS: (1) Explain how the giant Evergrande group fell into a financial crisis. (2) What is a financial contagion? Can the Chinese economy now experience it, and spread it to the regional economies too? (3) Why is Xi Jinping reshaping China so rapidly? What is the key motive?
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