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China's Evergrande Debt Crisis: What Caused It, and How Might It Impact China and Beyond?

Editor, TRANSFIN.
Sep 20, 2021 7:40 AM 7 min read
Editorial

A $300bn crisis is knocking on the doors of China's massive real estate sector.

The Evergrande Group is the country's second-largest property developer by sales. It is also the world's most debt-burdened real estate company.

Since June, a series of news reports have confirmed what was rumoured for over a decade: Evergrande has been on a downward spiral and will most likely default on its mountain of debts. And in doing so, it could spark a damaging ripple effect throughout the Chinese economy - and maybe even beyond.

Unless, of course, the Chinese Communist Party (CCP) intervenes.

How did Evergrande get here? Simply put, by growing too vast too quickly. But first, let’s get down to brass tacks...

Back to Basics: What is Evergrande?

The company was founded in 1996 in Guangzhou province by Hui Ka Yan. At 62, Hui is still Evergrande's Chairman today.

The firm benefited greatly from Beijing's urbanisation push, which saw hundreds of millions of Chinese migrate from rural areas to cities, a shift that coincided - and fuelled - China's rapid economic development to become the world's second-largest economy. State-backed lenders liberally loosened their purse strings and Evergrande used this flood of capital to grow and expand rapidly across the country.

As of 2021, it controlled 778 projects in 223 cities and directly supported nearly 200,000 jobs (and indirectly created over 3 million). In 2009, the company raised $722m from its Hong Kong listing. It became one of the largest conglomerates on the planet and the nucleus of Chinese real estate, a sector that contributes 15-20% to the national GDP.

 

Jack of All Trades, Master of None

But even as Evergrande made big bang real estate bets, it stretched itself thin with countless side ventures. It always had an eye on diversification, but it seriously began pushing its boundaries from 2011, following its successful IPO.

The company dipped its feet into everything from amusement parks and health insurance to milk production and pig-breeding to bottled water and baby formula. An EV-focused subsidiary, Evergrande New Energy Vehicle, announced ambitions to develop 14 electric vehicle models and sell 5 million of them annually by 2025. Its media company, Hengten Networks, owns a streaming platform with 20.1 million paid subscribers, in addition to a film and TV production firm. It also bought Guangzhou FC, one of China's most popular football clubs.

China's Evergrande Debt Crisis, What Caused It, and How Might It Impact China and Beyond?This relentless diversification drive was fuelled both by easy loans from eager lenders and the tacit understanding in corporate China that, should things go south, the stability-crazy CCP will intervene. Easy money and moral hazard bred a dangerous complacency that, eventually, came home to roost.

 

Knock Knock, It’s Reality

Eventually, three main factors turned out to be Evergrande’s death knell.

One, China’s real estate sector began slowing down in the late 2010s. This hurt the margins of Evergrande's core businesses.

Two, starting 2015, regulators in Beijing began a mission to impose some fiscal discipline on China Inc. (more on this later). The days of overleveraged and risky investments were numbered. No more guaranteed state bailouts, no more accommodation for costly corporate adventurism.

Three, Evergrande’s many side-hustles failed spectacularly. In hindsight, it was probably ill-advised to dabble in sectors it had no expertise in - like EVs. Its football ventures alone saw it bleed $155-310m annually.

 

A Series of Unsurprising Events

Soon, reality began catching up with Evergrande.

Last year, a leaked company letter reportedly showed that it had pleaded for government support to approve a now-dropped backdoor listing plan (Evergrande said the letter was fake). In June, it admitted to not having paid a commercial paper on time. Next month, a Chinese court froze a $20m bank deposit on the request of Guangfa Bank.

Meanwhile, lawsuits from homebuyers, tired of waiting for their long-overdue projects to be completed, piled on. Lenders joined the line, demanding billions in outstanding bills. By August, the extent of Evergrande's mess was apparent to all.

China's Evergrande Debt Crisis, What Caused It, and How Might It Impact China and Beyond?How big is the mess, you ask? Over $300bn in liabilities. More than any other non-financial listed company in China, and more than any property company on the planet. A debt pile 56x bigger than a decade ago.

Which brings us to the chaotic events of last week...

 

The Ides of September

On Monday, Evergrande released a statement saying rumours of its bankruptcy were "completely untrue". But the very next day, it conceded that it was finding it difficult to find buyers for its assets and said the consummation of these sales was "uncertain". It added that the risk of it defaulting was very much real.

The same day, regulators reportedly enlisted international financial advisors to examine the company's finances. On Wednesday, a spokesperson for China's National Bureau of Statistics acknowledged the difficulties of "some large real estate companies". It was also reported that state officials had rejected Hui's request for a bailout.

The icing on the cake for Evergrande were the hundreds of investors and creditors who showed up outside company HQ in Shenzhen to demand an audience with management. They have been protesting loudly for days on end - and this is important to note, because the People’s Republic of China is not exactly known for tolerating protests of any kind.

FYI: That said, protests against Evergrande aren't new - they have a tardy record when it comes to corporate governance. There have also been instances in the past of the Army being called to pacify situations after workers surrounded the CEO's house to demand timely wage payments.

At this point, let’s look at what the two elephants in the room are thinking and doing about this crisis - Evergrande and the Chinese government.

 

What’s the Company Doing to Contain the Fallout?

Egged on by regulators and creditors alike, Evergrande resorted to a fire sale of its assets. This began years ago - but has failed to yield the turnover expected.

The sale of an 18,580-square-metre office tower in Hong Kong “has not been completed within the expected timetable”. The EV venture is still up for grabs (potential buyers are likely waiting for a default, which would bring with it an attractive discount). In the meantime, successive ratings downgrades and a stock market bloodbath further dimmed the company’s yard sale prospects.

 

What’s the CCP Doing to Contain the Fallout?

In mid-September 2008, Lehman Brothers infamously filed for bankruptcy protection, the culmination of the firm's role in the subprime mortgage crisis and one of the major events of the 2007-08 financial crisis. Coincidentally, Evergrande finds itself in a similar situation exactly 13 years later.

But how relevant is the Lehman parallel? Evergrande’s default could have a domino effect across the property and banking sectors and beyond. George Soros has even opined that it could cause China’s economy to crash. This is not unfathomable in a country where nearly three-quarters of household wealth is tied to housing.

Basically, it’s the “too big to fail” hypothesis. And this is where the Chinese government comes into the picture. In more ways than one, Evergrande’s growth has mirrored broader trends in the Chinese economy - trends fostered and driven by Beijing. The company grew thanks to the government’s encouragement of rapid urbanisation and tolerance of a get-rich-quick culture, even if it meant taking undue risks and putting your tentacles in too many places at once. (FYI: In 2020, Chinese companies’ debt was 160% of GDP, compared to just 85% and 115% in the US and Eurozone respectively.)

Evergrande’s fall from grace was also driven by regulators’ u-turn on deleveraging and de-risking (which the CCP has declared to be one of the five core government tasks of 2021). In fact, the ongoing regulatory backlash against big companies in the Middle Kingdom? Chinese real estate has been facing this onslaught since 2020, when the city of Beijing began reigning in property developers by forcing them to liquidate by selling properties discounted by almost 25%.

But will the CCP’s new-found willingness to let China Inc. Reap what it sows extend to Evergrande? That’s the $300bn question. And, frankly, there’s no straight answer.

In H12021, 25 Chinese businesses were “allowed” to default on about $10bn worth of bonds - something unimaginable only three-four years ago. However, at the same time, Beijing has been known to intervene when it feels the fallout could be too catastrophic. Take the case of Huarong Asset Management, one of the largest state-owned asset managers and distressed debt collectors, which fell into hard times over the past year. After months of back-and-forth, the government agreed to a $7.7bn bailout package which involved state-owned enterprises injecting liquidity.

Huarong was too big to fail. Will that be the verdict for Evergrande too?

The clock is ticking. The company has about $84bn in dollar-bond interest due September 23rd. Whatever the CCP decides, it could possibly be revealed in the coming days. 

FIN.
 

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