Markets are concerned about effect of crisis on other countries
The story so far: Chinese real estate conglomerate Evergrande Group has been in the news recently over its inability to pay interest on its huge debt obligations. The company recently defaulted on interest payment and is set to miss more deadlines. Many fear that the company is insolvent, and its share price has dropped over 80% in the last one year and hit a 10-year low.
What is the trouble at Evergrande?
The Evergrande Group is China’s second-largest real estate company in terms of total sales and employs over 200,000 employees. Its core business deals with buying large amounts of land, developing them into houses, restaurants and so on and selling them to interested buyers. The company uses large amounts of debt from banks and investors as well as short-term loans extended by suppliers and property buyers to fund its business.
It has total liabilities worth over $300 billion and has to pay around $37 billion in interest and maturing debt over the next one year. The company’s bonds have been downgraded by rating agencies such as Fitch and S&P and have traded well below 50 cents on the Dollar, given the company’s precarious financial position.
The company has also taken money in advance from over 1.5 million property buyers, promising to deliver developed properties to them in the future and is yet to pay many suppliers. The company’s wealth management team has collected over $6 billion from its own employees promising high returns. It has defaulted on these products and has offered to give away parking spaces and other real estate in lieu of these loans, leading to public outcry.
Why is the company in trouble?
The most immediate trigger of the current crisis, analysts believe, is the Chinese government’s new rules for property developers. In August 2020, the Chinese government came up with rules (also called the ‘three red lines’) stating how much a property developer can borrow given its financial position as measured by three debt metrics. The new rules practically cut off Evergrande from taking on any more debt on its balance sheet. This was a big hit to Evergrande’s business as it engaged in heavy borrowing to run its business. The company was thus forced to sell its land and other properties at steep discounts to meet its debt obligations. This fire sale of assets, it is said, eventually led to Evergrande’s insolvency.
Some see the Chinese government’s new rules as a bid to puncture the country’s property bubble and bring about a ‘soft landing’ of the economy. Chinese authorities have traditionally encouraged businesses to take on huge amounts of debt through the heavily state-controlled financial sector to develop new properties. This led to the indiscriminate development of properties, so much so that almost a third of the Chinese GDP is made up of the property sector. Millions of properties with very little demand from buyers have been seen in Chinese ‘ghost cities’.
Over the years, Chinese authorities have also tacitly supported the property bubble by bailing out troubled developers. A letter leaked last year by Bloomberg showed Evergrande’s executives seeking financial assistance from the Chinese government by admitting their inability to meet their debt obligations to banks. It is said that the Chinese authorities now want the country’s resources to be allocated towards other sectors such as technology and have thus decided to withdraw their support for property developers. It should be noted that the Chinese government has in recent years let various business entities with exposure to the property sector go bust instead of bailing them out of trouble. The restrictions on property developers are seen by some also as an example of the Chinese government taking on influential private businessmen under the guise of the ‘common prosperity’ programme to fight income inequality.
Other analysts, however, believe that the current crisis was a long time coming. They argue that the company’s business model has been unsustainable for a long time. In 2012, Andrew Left of Citron Research argued that Evergrande was insolvent and that the company was engaged in aggressive accounting practices to cover up its troubles. It was said that the company held properties that it could not sell on its balance sheet as inventory, thus avoiding the booking of losses. The company was also accused of running a ponzi scheme as it relied on the constant inflow of funds to prop up a business model that is fundamentally unsustainable. Interestingly, Evergrande has over the years consistently reported strong profits and has showcased a strong balance sheet with sufficient liquid assets.
What lies ahead?
China’s financial system lacks transparency, so one can only guess how banks and other financiers will be affected by a default at Evergrande. Many have called the Evergrande crisis China’s own ‘Lehman moment’, alluding to the failure of U.S. bank Lehman Brothers, which precipitated the 2008 financial crisis. Some even believe that, apart from the roughly $300 billion in debt on its balance sheet, the company may have additional debt in the form of various off-balance sheet obligations. Other analysts, however, argue that this is not a cause for worry since the Chinese financial system is state-owned and does not operate to maximise profits. The Chinese state, they believe, will always be ready to bail out entities if necessary. Any such bailout, however, analysts point out, will have costs as it will require the creation of a fresh supply of money, which in turn will debase the value of the Chinese currency.
Markets are concerned about the effect the crisis in China’s property sector will have on other countries. On the one hand, foreign investors with direct exposure to Evergrande or to companies that are financially linked to Evergrande may experience losses. On the other hand, any slowdown in the Chinese economy as the country tries to rebalance its economy away from the property sector will have effects on the global supply chain. Metal stocks in India, for instance, have witnessed a sharp correction, and the move was attributed to fears of a slump in Chinese demand. Some analysts, in fact, believe that Chinese growth could drop to as low 1-2% as the country massively rebalances its economy.
Other critics of China, such as U.S. billionaire investor George Soros, have warned investors to refrain from investing in China, pointing to the absence of the rule of law. The Chinese government’s crackdown on the ed-tech sector and businessmen such as Alibaba founder Jack Ma has not gone well with foreign investors. The exposure of foreign equity investors to assets in China and Hong Kong, which has witnessed a steady uptrend over the years, has dropped this year. Investors increasingly believe that the policies of the Chinese government have become unpredictable under the rule of President Xi Jinping.