China Evergrande
The End of China's Field of Dreams?
I am not the first person to compare China’s economic growth strategy to the film Field of Dreams: “If you build it, they will come”. But the comparison does seem apt, if not original. Looking back on recent Chinese economic history, China did build it and they did come. And they did so in size. Whatever one thinks of the Chinese system, the sheer magnitude of capital investment and the pace of economic development over the past several decades has been nothing short of extraordinary. And China’s capital investment has fueled the growth of not just the domestic economy, but the global economy as well.
China was the only major economy to grow at all during the covid-ravaged 2020 and it is forecast to grow at a rate of 6.5-8% in 2021, substantially faster than any other major economy including the US. China now accounts for more than 15% of global GDP—the US is at 22% or so—and China has for many years accounted for a much higher share of the growth in global GDP. From 2013-2018, China accounted for 28% of global GDP growth, over twice the share of the US, which had and still has a much larger economy. (US GDP this year will likely exceed $22tn, compared to $15th or so in China, higher if we use PPP to convert currency values.) It used to be said that “when the US economy sneezes, the rest of the world catches cold”, but I think we can now safely substitute China for the US in this statement. When the Chinese economy contracts, or more precisely when its growth rate slows, the rest of the world economy contracts as well, sometimes violently.
China has financed its economic growth with substantial amounts of debt, backstopped by high domestic savings rates. Total national debt in China today is likely approaching 300% of GDP, compared to about 250% in the US. (Both numbers are up substantially in 2021 and I could not find current figures.) But the composition of the debt is quite different, with a much larger share of Chinese total debt having been incurred by the private sector, as opposed to government borrowings. (In the US, the federal debt is now over 100% of GDP, about double the share in China). Most Chinese private debt has been funded domestically through state-owned banks, which has allowed the Chinese government to exercise a large degree of control over lending (and borrowing) activity in China, but Chinese private companies have also incurred a substantial amount of foreign-currency “offshore” debt, primarily in USD.
Keep in mind, however, that in China the bulk of total debt has gone to fund capital investment, contrasted with the US where a larger share of our growing debt has been incurred to fund private consumption and government transfer payments. This differential in capital investment is reflected in the divergent economic growth rates of the two economies, 2% or so in the US and multiples of that in China. But capital investment contributes to growth even when the returns on investment are low (or negative), and it is not unreasonable to ask whether this has been the case in China.
How sound is the Chinese economy today? And more specifically, how good are all those Chinese private borrowings? What are the implications for the domestic and global economy if it turns out that the realized return on capital investment in China has for years been quite low, possibly even negative, and we are looking at trillions of dollars of of dud capital investment projects all financed with debt embedded in the Chinese financial system?
Global stock markets fell about 2% on Monday (more earlier in the day), purportedly on the back of renewed and growing fears of debt defaults by the world’s largest property developer, China Evergrande. It is always difficult to say with confidence why the stock market does what it does—a former colleague of mine used to say “more sellers than buyers (or vice versa)”—and stock market moves often seem to be overstated, swinging too far one way and then too far another. But the financial press seems to think Monday’s market reaction was due in large part to growing Evergrande debt concerns. I am skeptical, as usual, so let’s look at the numbers.
The total market cap of the world stock markets is something on the order of $100tn or so, with most major markets up 15-20% in 2021. So a 2% stock market correction implies a value reduction of $2tn or so. But the total liabilities of China Evergrande are only about USD 300bn, of which financial debt is only $88bn, and even if these obligations are completely worthless (which seems highly unlikely), that explains only a small part of the total drop in global stock market value. Which leaves us with some questions to answer.
Something bigger than Evergrande’s own imminent debt default seems to be troubling the stock market, but what it is? Is Evergrande the proverbial canary in the Chinese coal mine, warning us of much larger problems in the Chinese property market or more broadly in the Chinese economy? Could the failure of Evergrande turn into China’s own Lehman moment?
I’m not sure, but I do have some thoughts and I think we should all pay attention to this developing story. And in the meantime perhaps we can learn a bit more about Evergrande and the Chinese property market. To this end, I encourage you all to read this article from the WSJ, “Pop Goes the Chinese Property Market”.
Cutting to the chase, I think it is fair to say that the global stock market is concerned not just with Evergrande but rather with the overall state of the Chinese property market (a huge part of the domestic economy) and the implications for the banking system and for Chinese economic growth. We have all been following the recent actions of the Chinese Communist Party to flex its muscles with respect to various large businesses and industries. The technology industry has recently been a primary focus as has the financial services industry. The domestic property market is absolutely critical to the health of the Chinese economy, and private developers like Evergrande play a critical role in the property market. And Evergrande itself is not only large but also highly leveraged, with liabilities that total 2% of Chinese GDP. Hence the stock market concern over China Evergrande. Evergrande may be just a canary in the coal mine, but the Chinese economy consumes a lot of coal and Evergrande is a very large canary.
The Chinese government is transparently attempting to cool down a hot property market, in part by restricting the amount of leverage used to finance property development, and it has taken to regularly reminding citizens that “homes are for living in, not for speculation”. (A good lesson for us all!) And these efforts seem to be having an effect. New home sales fell 19% in August, with residential construction starts down 3% from January to August. According to Goldman Sachs, the median gross profit margin of Chinese property developers in the first half of this year fell by 4.6 percentage points, a reduction of close to 20%. Moody’s forecasts that property sales could fall another 5% next year, further pressuring property developers’ ability to service their large and growing debts. And this contraction in the property market is already reverberating through the banking system. At China’s biggest commercial bank (by value), Industrial and Commercial Bank of China (ICBC), 4.3% of property loans were non-performing at the end of June, up from 2.3% six-months earlier, and it would not be unreasonable to assume that this number has increased since June. The market price of junk bonds issued by Chinese property developers has collapsed, including the debt of Evergrande affiliates. But can the Chinese government control the fallout from this perhaps overdue cooling off of the property market, limiting the collateral damage to the broader economy?
Of course the Chinese government is well aware of these concerns and has many tools at its disposal to contain the damage, more so than was the case in the US during the run-up to our last financial crisis. (It is a fair question to ask whether the US government lacked the tools, or just the will, to manage the fallout from the US housing bubble, but I digress.) The specific actions taken recently by the Chinese government include a new cap on the amount of mortgage debt and credit extended by banks to property developers, which is to be reduced to 40% of banks’ loan books. Yes, that’s right, 40%! This number alone should give us a sense for the magnitude of the property-related debt problem in China and the implications for its banking system. No wonder the stock market is concerned.
Now back to China Evergrande. Evergrande’s Hong-Kong listed shares have lost 90% of their value since July and 20% over the past five days, so investors are clearly concerned about the solvency of the company. Of Evergrande’s total liabilities of USD 300bn, it appears that only about $88bn is in the form of financial debt, ie loans and bonds, both domestic (Yuan denominated) and offshore (USD). Most of the balance (over $200bn) appears to consist of trade liabilities of various sorts, the biggest component of which is contract liabilities, essentially the cash that customers have deposited as down payments on 1.4mm unfinished homes. Evergrande also owes money to its suppliers and to investors who have purchased various asset management products from the Company. All of these obligations are trading at large discounts, and press reports indicate that Evergrande is settling some of its debts with non-cash assets, including the transfer of raw land and interests in unfinished developments. This sort of behavior is generally not an indication of financial solvency and adequate liquidity.
And while Evergrande is not the only Chinese property developer in financial difficulty, it is the largest. As noted, its own liabilities exceed USD 300bn, equal to about 2% of Chinese GDP. Evergrande has ongoing projects in over 200 cities across China, and it employs 3mm people directly (and likely multiples of this indirectly). Evergrande owes money to something like 170 domestic banks and 120 non-bank financial firms, and its bank debt alone represents 0.5% of the total Chinese bank loan debt outstanding. With this much money owed to so many institutions and individuals, it is no surprise that Evergrande has been besieged with protestors over the past weeks.
If you have been following the financial news in China, you will know that Evergrande is only one of several large companies which has recently faced imminent default with massive amounts of outstanding debt. Another is Huarong, a state-fun financial conglomerate which began life as a “bad bank”. It was set up in 1999 to restructure bad loans from the banking system but it has continued to take on more bad debt and has also morphed into somewhat of a debt-financed financial conglomerate. Together, the two companies (Huarong and Evergrande) owe their creditors more than $500bn, equivalent to 3% of Chinese GDP and 4% of total Chinese non-bank debt outstanding.
The Chinese government has already agreed a plan to restructure the debt of Huarong, but as of now it is unclear what will happen to Evergrande. Evergrande has two big interest payments due this week, an onshore payment which appears to have been settled (see link below) and a USD offshore payment due on Thursday (with a 30-day grace period). It may be that the government lets Evergrande default on its $21bn of foreign-currency financial debt, but this is only a small part of Evergrande’s total financial obligations. The government is expected to come up with some sort of solution that avoids a messy default on the balance of the Company’s debt and other liabilities, structured in a way that is palatable to the Company’s domestic lenders and its millions of individual creditors. How this will work is not yet clear, but it will likely be consistent with the Chinese government’s traditional approach to debt management, “extend and pretend”. It is anyone’s guess how long the Chinese government can continue kicking this debt default can down the road, but kick it they almost certainly will. And if they do, the stock market will probably breathe a huge collective sigh of relief, for now at least.
But could this situation turn out quite differently, with a much worse outcome for China and the global economy? Somewhat provocatively perhaps, the US financial press is asking this question: Could Evergrande turn into China’s Lehman moment? I think this is highly unlikely and the stock market seems to agree with me, today at least. My reasoning is twofold: (1) because of the much greater control which the Chinese government has over the domestic banking system, and (2) because of the one-party structure of the Chinese political system. Think back to the disjointed fiasco that was the US government’s initial response to the collapse of the US housing bubble in 2007-8 and compare that to how the Chinese government sorted out similar problems in its own banking system in 2015. The Chinese government controls the domestic banking system and it governs the industry with a view to supporting the domestic economy and achieving governmental objectives, rather than generating financial returns for its owners (including the state). Chinese banks are much better capitalized now than they were in 2015, and the current capitalization of the Chinese banking system bears no comparison to the woeful state of US banks in 2008. (US banks were grossly undercapitalized going into the financial crisis and investment banks like Lehman quickly blew through what little capital they did have.) And of course the CCP does not need to deal publicly with the sort of internecine political warfare that we witnessed in the US Congress back in 2008 and 2009 (and again over the past two years, as the US attempted to deal with covid). I am not suggesting that the CCP does not need to manage internal dissent, but this is largely done behind closed doors which mitigates much of the capital markets impact. Many of us enjoy eating sausage, but none of us want to see how it is made.
But even if this will not likely be China’s Lehman moment, the Evergrande story is far over and we should all continue to follow it. The capital markets certainly will.
Links:
China Evergrande’s Flagship Unit Resolves Onshore Bond Payment, WSJ 9.22.2021
Why Evergrande is not China’s ‘Lehman Moment’, CNBC, 9.22.2021
China’s Regulatory Storm Risks Triggering Wider Economic Damage, WSJ 9.21.2021
Evergrande is China’s Economy in a Nutshell, WSJ 9.21.2021
What China Must Do to Contain Evergrande Fallout, WSJ 9.21.2021
Protestors in China Besiege China Evergrande, The Economist, 9.18.2021
Pop Goes the Chinese Property Market, WSJ, 9.16.2021
China’s Dodgy-Debt Double Act, The Economist, 9.4.2021
Three Chinese Giants Pose a Big Risk for Banks, The Economist, 6.24.2021
Is China’s Biggest Property Developer Too Big to Fail? The Economist, 10.3.2020
I really enjoyed this post Professor. Because of how you broke down the reasons for Evergrande's potential default (ie. New home sales fell 19% in August, ICBC, median gross profit margin of Chinese property developers, total liabilities of CE = $300B, etc.).
It so interesting to hear your mental process of diagnosing and researching companies, especially when you break it down into steps. Keep up the good work! This newsletter continues to fuel my interest in finance, financial history, and the global economy!
Interesting and perceptive analysis. I agree with your observations - “.. a lot of coal… very large canary”. Clearly there is more in play here than a single company’s excessive leverage. That being said, I think the prospects for a China Lehman are very small indeed. A government with highly centralized power and vast financial resources has the ability to manage outcomes - for better or worse - and China’s current leadership has demonstrated their competence and willingness to do so (sometimes ruthlessly). My expectation is that they will use Evergrande and similar cos to teach painful lessons to lenders - probably more so for international lenders and less for domestic - but spare the other creditors (trade liabilities, including especially customer down payments). At the end of the day Chinese leadership values domestic stability above all other objectives, as it is that which could threaten the CCP. Their decisions on Evergrande, as with most other issues, will be assessed through that prism.