Chinese property giant Evergrande's debt woes have sent jitters across equity markets around the world over the past few days. The company, which owes more than $300 bn in debt, faces interest payments on key bonds over the next few days. On Wednesday, there was some relief for battered markets. Reports say a key arm of the Evergrande Group, the Hengda Real Estate Group, would be making a coupon payment on an onshore bond on Thursday. Also due on Thursday, however, is an interest payment of $83.5 million on a 5-year, US-dollar denominated bond. Default in this instance will likely have ripple effects on the Chinese economy and global markets.
Evergrande's current crisis can be traced back to Chinese policy changes in the aftermath of the GFC in 2008. Responding to the global economic downturn back then, the Chinese government turned toward investment as a driver of growth, launching a stimulus package of $586 billion. Supply-side expansion fuelled growth, as enterprises binged on easily available debt. For instance, China's debt to GDP ratio rose sharply from just under 140% in 2008 to nearly 260% in 2019. While this seemingly was plateauing in 2019, there was a sharp increase following the stimulus package that was announced in May 2020 in response to the COVID-19 pandemic.
The property sector had been particularly notorious in this regard. Over the years, credit expansion has closely been linked to property speculation. This has made housing expensive for the ordinary Chinese, but it has also fuelled economic growth. For instance, estimates inform that China's property sector accounts for anywhere between 20% to 25% of the country's GDP. At the same time, real estate also accounts for a significant chunk of Chinese household savings. These factors have, over the years, made property sector reform particularly challenging for China's regulators.
However, the tide did seemingly begin to turn around late 2016. This is when Xi Jinping first spoke about houses needing to serve the purpose of living rather than speculation. This was a mantra that he reiterated at the 19th Party Congress. This was followed by a move to term the management of financial risks as one of the three critical battles that the Party must address. The leadership was clearly suggesting that while growth mattered, there was a need to bring order and market discipline. This was not just critical to address risks but also to direct capital to benefit the real economy. These moves also indicated a greater willingness to address the moral hazard that underpins China's financial system, i.e., the implicit guarantee of the Chinese government against insolvency with the objective of containing financial, social and political stability challenges.
While it appeared that the pandemic had led to the leadership to ease the deleveraging campaign, the bankruptcy of Baoshang Bank and restructuring of giants like Anbang, HNA Group and China Huarong Asset Management suggested otherwise. In August 2020, the government outlined new "red lines" for property developers, limiting their credit-raising ability. These consisted of hard limits on a company's debt-to-asset ratio, its debt-to-equity ratio, and its cash-to-short-term-debt ratio. If developers failed to meet these red lines, it would restrict their access to lending. A leaked letter of support from Evergrande to the Guangdong provincial government in September 2020 underscored how challenging the situation had become for the real estate giant.
However, Evergrande was not alone in facing this stress. A January 2021 UBS note explains that as of earlier this year, S&P estimated that only 6.3% of their rated developers in China could fully comply with all of the three red lines. This indicated sector-wide weakness. This was evident in China's top banking regulator Guo Shuqing's warning of "bubbles" in the sector in March, as it was in data on defaults in the first half of 2021, with the real estate sector leading the pack, and data on declining sales of new homes.
It is in this context that one must examine the Evergrande case. In other words, the crisis is in part the creation of the Chinese government's policies to address deep-rooted systemic problems. However, doing so will lead to systemic instabilities, particularly when it comes to an entity as large as Evergrande. The group reportedly owns more than 1,300 projects in over 280 cities across China; it employs over 200,000 people and generates more than 3.8 million jobs each year. Its total liability is believed to be at 1.97 trillion yuan, accounting for about 2 percent of China's GDP. In addition, more than 128 banks and 121 non-banking institutions are believed to be exposed to Evergrande liabilities.
Considering the above, a collapse will have a systemic impact. Already, there is evidence of deep pain, with employees, contractors, and homeowners struggling for payouts. A complete collapse will also hurt banks that have deep exposure. Despite this, a comparison between Evergrande and the Lehman crisis is misplaced. This is for three reasons.
First, First, Evergrande's large landholdings are a source of strength. These can be leveraged to potentially infuse cash flow.
Second, the Chinese government enjoys tremendous control over the banking system in the country. The greatest challenge in the aftermath of the collapse of Lehman Brothers was the breakdown of systemic trust and modalities for valuing risk. The challenge for lenders was the lack of surety about the health of other institutions. In China, by contrast, the government's looming presence over the banking system means that the threat of a credit crisis akin to 2008 is a low probability.
Finally, as mentioned above, the Evergrande crisis is a product of changes in the government's policies to address leverage risks. There is plenty of room for Chinese regulators to address Evergrande's cash flow concerns and intervene in the markets through cash infusion. Of course, the challenge is that doing so will be politically uncomfortable, particularly when Xi Jinping has been pushing a "common prosperity" agenda, and it will also adversely impact the move towards addressing the moral hazard that underpins the system.
The author is Fellow-China Studies at Takshashila Institution
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