China Evergrande, Part 3

Your questions answered

Is China’s economic bubble about to burst?

I spent last weekend in New York at the wedding of the son of some very good friends. At the wedding I met several new people who, when they learned that I taught finance, asked me some version of this question: “What is China Evergrande and should we be concerned?” I told them briefly what I knew about the situation but when I mentioned my recent newsletter posts on this very topic, I watched as their eyes quickly glazed over and they made a quick exit for the bar. And in due course, so did I.

But I have now returned from the wedding (and the bar) and I again find myself thinking about China Evergrande and searching for answers to the many questions we all have. I can’t say that I have all the answers, but I thought I would take a stab at addressing some of questions, recognizing that this story is still unfolding and there is a lot we still don’t know (and may never know, this being China).

What is China Evergrande? Evergrande is the largest (or second largest) property developer in China, founded by Xu Jiayin as Hengda Group in 1996. The company went public in 2009 on the Hong Kong Stock Exchange, where it still trades today. Evergrande builds apartments mostly for a well-to-do clientele and is currently constructing approximately 1.4mm unfinished units in cities across China. It employees about 200,000 people directly and several million people indirectly. Evergrande also owns a number of non-real estate businesses, including an EV auto manufacturer, several theme parks, a football club and a bank. In 2020 Evergrande generated consolidated revenues of Yuan 500bn (USD 77bn) and net income of Yuan 8bn (USD 1.2bn). It reported year end assets of Yuan 2.3tn (USD 350bn) and equity of Yuan 350bn (USD 54bn). Evergrande’s share price has fallen over 90% this year and the market value of the Company’s equity is now around USD 4.5bn.

Why is Evergrande so much in the news? Evergrande is newsworthy because it is very large, systemically important to the Chinese economy, and failing. Property development accounts for something like 20-25% of the Chinese economy and Evergrande is one of the country’s largest property developers. Evergrande itself has over $300bn of liabilities, equal to about 2% of Chinese GDP. (Total financial debt in China, public and private, equals about 300% of GDP and only about one-third of Evergrande’s liabilities consist of financial debt.) The press has speculated that Evergrande may be China’s “Lehman moment”, which is unlikely to be true but is nevertheless good for generating viewer clicks and attracting ad dollars. Evergrande is also newsworthy because it offers us a rare glimpse into the workings of the Chinese financial system and its management by the Chinese government.

How much money does Evergrande owe, and to whom? Evergrande has total liabilities of around USD 300bn, of which two-thirds is owed to customers who put down deposits on homes to be constructed by Evergrande. Evergrande also owes money to trade suppliers, some of which it has been settling with non-cash assets (eg financial interests in uncompleted projects), as well as to banks, financial institutions and individuals who have purchased various asset management products sold by Evergrande and its affiliates. Evergrande’s indebtedness for borrowed money totals about $90bn, of which two-thirds ($60bn) is owed to domestic banks and another $16bn or so to bondholders (primarily offshore). Evergrande has a complex capital structure, with much of the debt owed by subsidiaries on both a secured (bank loans) and unsecured (bonds) basis. Most of the bond debt is denominated in USD and owed to foreign bondholders. The Company’s bonds trade at big discounts to par value, in some cases 70-80%.

Evergrande is expected to default, but why? Evergrande has both a solvency problem and a liquidity problem. The Company is highly levered on a book value basis (6.5x assets/equity), the market value of its assets appears to be well below their book value, and the Company’s shares trade at 10% of book value. The Company’s assets are mostly long-term (including land), while its liabilities are disproportionately short-term (perhaps as much as 80% of total liabilities). Non-financial companies can operate for an extended period of time with negative book equity and a depressed share price, but they go bust very quickly if they cannot settle their liabilities in cash when due. Evergrande is at this point today. For some time now it has been selling assets at big discounts to raise cash and it has been settling liability claims with non-cash assets. The Company missed an interest payment on some of its offshore bond debt last week and will likely miss another payment due this week. Evergrande’s offices have been deluged with irate customers and investors, whose protests have not gone unnoticed by the press or by the authorities. If Evergrande were a bank, the “run” would have started some time ago and the regulators would already have stepped in by now.

What will happen next? This is not clear, but we are all waiting to see when and how the Chinese government intervenes. The capital markets seem to expect some sort of managed restructuring of Evergrande, perhaps with uncompleted property projects transferred to new developers who can make good on customer and supplier obligations. Domestic bank lenders have some credit protection from loan collateral, although how much is unclear, and they have also received liquidity support from the PBOC. Bondholders (primarily foreigners) will almost certainly suffer big losses on default and should not expect much in the way of help from the Chinese government, which is primarily concerned with protecting domestic creditors, particularly individual property buyers, and with maintaining “social stability”.

Could this become China’s ‘Lehman moment’? I suppose it could, but it probably won’t. The Chinese banking system appears to be well capitalized (although this is never clear, even in countries more transparent than China) and the solvency of the banking system should not be threatened by even large defaults at Evergrande, absent a much broader contagion effect rippling across the economy. (This is not to say that individual banks will not suffer big losses, however, including some banks affiliated with Evergrande itself.) And the PBOC has made very clear that is prepared to support the banking system with copious amounts of liquidity. In contrast to the Lehman situation, the government in China appears to have not only the tools but also the will to resolve the Evergrande situation in a way that concentrates losses on foreign creditors (primarily bondholders) while protecting core domestic constituencies, including over a million Chinese homebuyers. It is still unclear how the Chinese government will resolve this situation, but resolve it they will, most likely with minimal disruption to the domestic economy and very little in the way of global impact.

What does Evergrande tell us about the bigger China story? This I think is the most interesting aspect of the Evergrande situation. The Economist recently ran an article on exactly this topic (see link below). The headline was “Evergrande’s crisis highlights China’s shortcomings” and it asked this question: “Can ‘common prosperity’ lead to financial stability in China?” [‘Common prosperity’ is a new government initiative to reduce income inequality, in part by scaling back excessive property speculation and leveraged financing. The imposition of these new policies has put substantial pressure on the business of highly leveraged property developers like Evergrande.] The article did not provide a clear answer to this question, but the overall tone was skeptical and I am inclined to agree. The Chinese financial system does seem “vast and opaque” and it may well “pose a threat to the domestic economy and [possibly] to the world”. Chinese national debt now likely exceeds 300% of GDP and much of this debt has been incurred by private companies like Evergrande. [China’s GDP exceeds $15tn and the total national debt is probably around $50tn.] This threat is particularly concerning if it turns out that much of China’s debt has been incurred to fund dud capital investment projects, in the property sector and elsewhere. Capital investment in China is currently running at 40% of GDP (about $6tn a year), a level which may have made economic sense several decades ago but may not today. Economic growth in China is slowing for many reasons, but most importantly perhaps because of China’s rapidly changing demographics, which no longer justify the same scale of capital investment as 20 years ago. These points were made by Paul Krugman in a recent NY Times op-ed piece (see link below), in which he suggested that while Evergrande might not be China’s “Lehman moment”, it could be their ‘Babaru moment’. [‘Babaru’ is a reference to the Japanese “bubble economy” of the late 1980s, which collapsed spectacularly and triggered several decades of economic contraction, the effects of which continue today]. As noted in my first Evergrande post, China now accounts for 15% of global GDP but in recent years has contributed almost 30% of global GDP growth. So if it turns out that China’s economic growth has been built on the back of dodgy debt-financed capital investment projects, which begin to fail in the coming years, the implications could be huge, for China and the world.

And that would be a “babaru” moment indeed.

Links:

“Evergrande’s crisis highlights China’s shortcomings”, The Economist, 9.25.21

“What are the systemic risks of an Evergrande collapse?” The Economist, 9.25.21

“This might be China’s Babaru moment”, Krugman, NY Times, 9.24.21