China’s Evergrande (Real Estate) Debt crisis-Cause & Effects
Who is Evergrande?
Evergrande is 2nd China's largest real estate developer, part of the Global 500 and one of the world's biggest businesses by revenue & operates only in China
Incorporated in the Cayman Islands in 1996 during a period of mass urbanization in China
Listed in Hong Kong and based in the southern Chinese city of Shenzhen, it directly employs about 200,000 people & indirectly helps sustain more than 3.8 million jobs.
Founder: Xu Jiayin (Hui Ka Yan, 63, grew up poor) was once Asia's richest person and, despite seeing his wealth plummet in recent months, has a personal fortune of $11.5 bn (peaked at $36.2 billion in 2019). $8 billion is from cash dividends paid to Hui since Evergrande’s 2009 IPO. His Fortune was still at $27.7 billion as of March 5, making him the 53rd-richest person in the world. Value of his shares has since crashed to $3.5 billion, but even if it goes to zero, his dividends alone would still make him one of the 100 richest people in China. He has 77% stake in Evergrande.
Evergrande’s total liabilities have increased every year since it went public but it has paid out a dividend every year except 2016.
Exchange Rate: $1=6.46 Yuan (RMB)
Revenue: $109 B
Total equity: $22 B
World’s most indebted property firm with $306.3 billion (2% of GDP) in liabilities including payables & has been criticised for tapping the shadow banking market (Off Balance Sheet), including trusts, wealth management products and commercial paper. Evergrande reportedly owes money to around 171 domestic banks and 121 other financial firms
Analysts and short-sellers have been predicting the death of Evergrande for years.
Investors became worried in September, 2020 after a leaked letter purportedly from the company showed Evergrande had pleaded for government support to approve a (now-dropped) backdoor listing plan as they were facing Cash crunch ($13 billion).
Concerns intensified after Evergrande admitted in June as it did not pay some commercial paper on time, and in July a Chinese court froze a $20 million bank deposit held by the firm on the request of Guangfa Bank.
Some 80,000 people in China who hold about RMB 40 bn in the company’s wealth management products are waiting nervously to see whether Evergrande will honour payment obligations. Company is offering Apartment in lieu of Investments in Wealth Management portfolio
Evergrande is offering its properties at major discounts (30-52%) to ensure money was coming in to keep the business afloat.
Liability mismatch: The Company has relied on ever-increasing short-term debts, often at higher and higher cost, to fund a business model that depends on borrowing money to develop properties and selling it years before they are completed to generate cash from buyers’ deposits.
Businesses: Real Estate-1,300 projects in more than 280 cities across China (Housing only), Wealth Management, making Electric Cars, Mineral water, Dairy, Grain & Oil, Pig farms ,Drink manufacturing, owns one of country's biggest football teams & Stadium, 2 major theme parks, football tutoring school, Sponsor of the Women's Volleyball Club, Health and wellness park, Retirement community, International Hospital, Music Festival Tour Concert , Internet based Entertainment Networks, Life Insurance, Shengjing Bank (50% stake),
Why would it matter if Evergrande collapses? Too big to fail?
There are several reasons why Evergrande's problems are serious:
1. Many people bought property from Evergrande even before building work began. They have paid deposits and could potentially lose that money if it goes bust. The developer still owes an estimated 1.6 million unfinished apartments to buyers who have already made down payments.
2. There are also the companies (Suppliers) that do business with Evergrande, which could force them into bankruptcy.
3. Potential impact on China's financial system: If Evergrande defaults, banks and other lenders may be forced to lend less, leading to credit crunch. A credit crunch would be very bad news for the world's 2nd largest economy, because companies that can't borrow find it difficult to grow, and in some cases are unable to continue operating. This may also unnerve foreign investors, who could see China as a less attractive place to put their money. Offshore bondholders are bracing for a default, perhaps as early as Thursday, with one bond due to pay interest trading at about 30 %of its face value.
4. China’s Debt Crisis
PBoC reports that the combined domestic debt of corporations, households and the public sector increased last year to a level equivalent to 280 % of GDP ($ 42 trillion). China’s domestic debt, denominated in Yuan, consists of 3 components: corporate, household and government debt. Corporate debt includes borrowings by private sector and state-owned companies. Public debt is a combination of national and local government debt.
When China’s Foreign debt of 14.5% of GDP (June 2021) is included, Total debt rises to about 295 % of GDP.
China’s outstanding foreign debt, including US dollar debt reached US$2.4 trillion in 2020, whereas China’s Forex Reserve is $3.26 T which includes US Treasury of $1.06 T. Foreign investors, including wealth managers, mutual funds, family offices & hedge funds, hold RMB 3.62 trillion worth of Chinese bonds at the end of April 2021.
Household debt to GDP (according to NFID) is 62.2 % at the end of 2020. In China, over the last 5 years, households are at the forefront of leverage. Hence, the real estate crisis could weigh on HH sentiment more significantly.
The most obvious imbalance to tackle is China’s staggeringly high gross savings rate of 45.7 %. Reason for high savings is an imperfect social security net.
National debt (or government debt) of the PRC is the total amount of money owed by the central government, local governments, government branches and state organizations. As of 2020, China’s total government debt stands at approximately US$ 7.0 trillion, equivalent to about 45% of GDP. As per S&P ratings, Chinese local governments may have an additional $5.8 trillion in off-balance sheet debt. Furthermore, debt owed by state-owned industrial firms is another 74% of GDP according to IMF. The three government-owned banks (China Development Bank, Agricultural Development Bank of China and Exim Bank of China) owe a further 29% of GDP. The high debt level is a current economic issue facing China.
Corporate sector in China accounted for a large proportion of total debt at 160% of GDP
Many of the borrowings are not recorded in the books of borrowers and transparency is weak, China’s Shadow Banking market is worth $ 13 Trillion.
Real estate market in China
Top 10 (Revenues in Yuan Billion)
1. Country Garden Holdings-749.36
2. Evergrande Group-696.47
3. China Vanke-692.05
4. Sunac China Holdings-546.25
5. Poly Real Estate-457.6
6. China Overseas Land & Investment-345.26
7. Greenland Holding Group-338.87
8. Greentown China-289.22
9. China Resources Land Ltd.-242.8
10. Shimao Property-240.42
In the last 20 years, China’s real estate market has experienced its most prosperous development.
With nearly one hundred thousand real estate developers, China's real estate market is ranked among the world’s largest as of 2020, recruiting over 2.9 million employees, and generating revenue from real estate sales that has increased 10 fold since 2005.
Housing Prices jumped: China's real estate market has become a subject of debate for a long time, with housing prices doubling over the last decade, average real estate sale price per square meter in China skyrocketed from 3.8 thousand Yuan in 2008 to more than 9 thousand Yuan in 2019 (+237% jump). The housing price increased so rapidly, especially in larger cities, which the government had to take measures to restrict investment.
Land purchase has also become an important source of financial revenue for many local Govts. The Party (CCP) has eminent domain over the land of China; this means that they can take over any land in an emergency.
Demographic problem impacting demand:China’s population is barely growing. In 2020, only 12 million babies were born, down from 14.65 million a year earlier. That figure is predicted to drop below 10 million in the years ahead.
Around 20% of the apartments are estimated to have been unoccupied, which indicates the degree of speculation in real estate. China’s largest engine of growth is building properties for which there is no market. In the process, it is consuming capital and creating winners and losers in a real estate lottery.
Real estate contributes about 29 % of GDP is so overbuilt that unsold apartments could accommodate at least 90m people.
Impact on China’s Real Estate Market
Real estate sector is in a tailspin, with sales in 52 large cities down 16 %in the first half of September year on year, extending a 20 % decline in August
Debt unwinding: Evergrande is the 2nd largest Real Estate developer in China, but as is seen often with RE firms, is heavily leveraged (D/E has run up to as much as 10x, depending on how you calculate). In line with recent Chinese govt moves to dampen speculation, reduce prices and curb monopolies, Debt is a “crisis” issue but China funds all its sovereign debt, and most of its overall debt via local savings – China’s savings rate is 45% of GDP. Further, China runs the highest current account surplus in the world, being the largest exporter in the world. That affords policymakers monetary ammunition to depreciate currency, swap foreign reserves into local currency for stimulus or merely attract a chunk of foreign capital to plug capital holes in affected sectors like RE.
With the slowdown of China’s economic development and gradually saturated market, people are also afraid of the burst of the real estate bubble.
China Grapples With Epic Property Boom, the $52 Trillion Bubble
The total value of Chinese homes and developers’ inventory hit $52 trillion in 2019, twice the size of the U.S. residential market
Real-estate surge eclipses the one in U.S. housing in the 2000s; desperate buyers undeterred by Covid pandemic
At the peak of the U.S. property boom, about $900 billion a year was being invested in residential real estate. In the 12 months ended in June, about $1.4 trillion was invested in Chinese housing.
China’s property sector accounts for 28-29% of its economy.
Cause of the Problem for Real Estate Market in China
Evergrande’s woes are merely the symptom of a much bigger problem. Evergrande is not as the root cause of the troubles in China’s property sector but it is a symptom of the government’s efforts to reshape the market. Other property groups also appear at risk.
Overall, China’s Evergrande problems are fallout of the PBoC’s liquidity and regulatory tightening to rein in excessive debt-taking. The pace of ramp-up, level of debt and China’s demography have striking parallels with Japan of late 1980s.
Japan's "Lost Decade" was a period that lasted from about 1991 to 2001 that saw a great slowdown in Japan's previously bustling economy. The main causes of this economic slowdown were raising interest rates that set a liquidity trap at the same time that a credit crunch was unfolding.
As part of Mr. Xi’s slogan of “common prosperity”, the measures include making housing more affordable and ridding the property market of speculation.
Oversupply has been a problem for several years. What changed is that last year China decided the issue had become so chronic that it needed to firmly address it. President Xi Jinping had also run out of patience with the excesses of the property sector, say observers, and Beijing formulated “three red lines” to reduce debt levels in the sector. Evergrande is proving to be the first big victim.
Beijing desperately wants to move its growth model from property to high technology manufacturing and the deployment of green technologies.
Evergrande has failed all 3 red lines. Those lines are the ratio of liabilities to assets, of net debt to equity, and cash to short-term debt.
1. Limiting liability-to-asset ratios to less than 70%,
2. Net debt-to-equity ratios to less than 100% and
3. Mandating levels of cash that are at least equivalent to short-term debt.
Domino effect
Start with banks, the main area of regulatory concern. China’s banks have lent heavily to developers.
A recent central-bank stress test on banks’ exposure to the property sector concluded that an extreme scenario, in which loans to developers suffered a 15% rise in their NPAs, would eat up 2.1 % of banks’ overall capital-adequacy ratios, reducing the industry average to 12.3%. Such a drop in the banks’ capital buffers, evenly spread across the banking sector, would be a tolerable depletion of protection.
But such a crisis would not hit banks evenly; weaker banks would see a much larger reduction (according to analysts at S& P Global, a ratings agency).
Ping An Bank and Minsheng Bank, both hit by sell-offs in recent days, had big shares of their total loan books extended to property groups in the first half of the year Shengjing Bank, which is majority-owned by Evergrande, is thought to have lent heavily to the property company. Hong Kong-traded shares in one large Shanghai-based group, Sinic Holdings, collapsed by nearly 90% on September 20th on fears that it would fail to repay a bond due in October.
A banking crisis is not the base case for many investors watching the situation. Several financial institutions with high exposure to the property sector have suffered steep declines in their market value.
But “the situation would change very quickly” if a bank of Minsheng’s scale proved vulnerable. Central authorities would probably step in swiftly at the first sign of distress at a major bank.
Of more immediate concern are Evergrande’s links to China’s shadow-banking system.
According to The Economist, quoting UBS, 10 other Chinese property groups with 1.86 trillion RMB ($290 billion) in contracted sales are in similarly risky positions.
Property represented two thirds of China’s household assets in 2019
About 45% of its interest-bearing liabilities in the first half of 2020 were from trusts and other shadow lenders, which are opaque and typically charge higher rates, compared with just 25% for bank loans.
Panic in the offshore bond market is another worry.
Chinese developers are the largest issuers of dollar-denominated bonds traded in Hong Kong, and among them Evergrande is the single largest issuer. The company’s bonds have traded at less than 30 cents to the dollar over the past week.
This dwindling ability of local governments to raise finance to spend on infrastructure has the potential to depress Chinese growth considerably. Fixed asset investment, which last year totaled Rmb51.9tn ($8tn), constitutes 43 %of GDP.
An even more consequential trend for China’s political economy is the collapse in land sales by local governments, which fell 90 % year on year in the first 12 days of September. Such land sales generate about one-third of local government revenues, which in turn are used to help pay the principal and interest on some $8.4tn in debt issued by several thousand local government financing vehicles.
Metals are beginning to react to the writing on the wall. Iron ore had already been in decline due to restrictions on steel production. Hence, demand for the steelmaking raw material has fallen, bringing the price below $100 per ton. That is half the level it reached earlier this year. Thus, China’s property market, for so long the engine of global metal demand, could end the current metals boom
Many other developers’ yields have shot up above 30%.
Chinese Economy Impact:
In the decade from 2000 to 2009, China’s GDP growth averaged 10.4% a year. Meanwhile, during the decade from 2010 to 2019, annual GDP still grew by an average of 7.68%. Growth this decade will struggle to exceed 4%. It could average just 1-2% in the second half of this decade. If such projections prove correct, the Chinese growth “miracle” is in peril.
An extended campaign against developers’ debt could significantly lower China’s growth prospects as such a strategy could lead to much greater economic and financial turmoil farther down the road.
Policy-induced liquidity tightening has hit the House Hold debt pocket, which could impact the construction sector (28-29% of GDP, larger than Spain and US at their peak) and the knock-on effect on consumer spending and global industrial activity.
China, from net export boom to debt binge, a la Japan: Evolution of China’s growth model over the last 20 years resembles that of Japan in 1980s. What followed in both countries was a sustained debt binge (particularly in real estate). BoJ’s tightening in late 80s pricked the debt bubble, causing a plunge in land prices, and consumer spending. Currently, China’s resolve to rein in debt through liquidity/regulatory tightening is testing the solvency of its property sector.
China’s financial system is largely state-owned/controlled, and capital account is not as open; hence a global financial contagion (a la GFC of 2008) is unlikely.
Authorities may be reluctant to fuel another debt binge, unproductive investment and moral hazard in the system and hence growth risks are real.
Evergrande will reduce their properties prices (30-50%) to pay back loans and hence there will be an impact in the housing market locally, employment & hence consumption. Credit off take at the banks may also slow down leading to slow domestic growth. Growth slowing down in China may affect commodities. If the government in any sense comes out to bail, Yuan will depreciate.
In 2007, China’s then premier Wen Jiabao called the Chinese economy “unstable, unbalanced, uncoordinated and unsustainable”.
Political & Social Impact
Worried by protests: The property sector is becoming a threat to financial, economic and social stability as it has already sparked protests in several cities
The biggest danger may not be economic at all. Xi Jinping, China’s ruler presides over a regime in which honest debate is clearly receding as the trappings of a personality cult proliferate. If sycophantic zealotry is allowed to crowd out reason, and hubris to eclipse calls for restraint, then Beijing could undermine the credibility that will be crucial to the success of any transition. Xi is working in a very different environment from previous generations of revolutionary leaders. If mishandled attempts to fix the property bubble lead to slower future growth, Beijing risks not just investor flight, but losing the support of its population.
Evergrande’s wealth-management products (about 1.4m) is expected to be forced by Chinese Government to broker a partial bail-out for assets most connected with social stability
The biggest contagion risk flaring up in the market is Mr. Xi’s unyielding crackdown on leverage as Xi Jinping has said ‘houses are for living in, not for speculation’
The assault on China’s vibrant tech sector suggests Mr. Xi will see the deleveraging campaign through and its implications are bigger than the current market rout.
Investors are waiting for a signal from Beijing. So far the absence of any strong sign of support has shown that regulators do not want to step in.
China’s ‘Common Prosperity’: The Maoism of Xi Jinping
Ø It is Xi Jinping's effort to return to socialism
Ø Is CCP using “common prosperity” to centralize power and neutralize dissent?
Ø Is China Braces for Social Unrest after Evergrande Collapse?
“Common prosperity” promises to the Chinese an egalitarian development and a fair share of wealth, which parallels other ambitious goals from Xi Jinping: “the rejuvenation of China” serving a rich state and a strong army, “The Belt and Road Initiative” (BRI) mostly targeting the developing countries, “New Type Relationship of Great Powers” defining Sino-U.S. relations, “Human Community with a Common Destiny” intending for a tianxia [under heaven] world order led by China.
The biggest problem of this tactical use of new talk is that it has lost its freshness, because from Jiang Zemin to Hu Jintao and finally to Xi ̶ namely the 3rd, 4th, & 5th generation of leadership ̶ all grandiose slogans have been cooked by the same author ̶ Wang Huning, who is currently ranked No. 5 in the Standing Committee of the CPC Politburo. But this may not work as:
Ø The mounting new challenges have become more complex,
Ø The opposition elite has emerged and become more creative, and
Ø The global environment has become more inclement for the survival of the CPC because COVID-19 poisoned the whole world.
Ø After the Wuhan Virus pandemic, the CCP has already lost its credibility before the world community.
Ø Cases of Human Rights violations in Xinjiang (East Turkestan), Hong Kong, and in Tibet are coming to the light. The CCP has always tried to suppress the oppressed voices but due to the smart phones and presence of social media, it is failing in doing so.
Ø Demographic time bomb ticking: Again, the Party has the solution: 3 child policy for all! Will Chinese change from 1 child to 3 child new norm?
Ø Wealth disparity:
China’s richest 20% earn more than 10 times the poorest 20%, a wider gap than in the U.S. Germany, France. Though the number of people living in extreme poverty has dropped dramatically over the past decade, more than 600 million people -- about half of China’s population -- live on an annual income of 12,000 Yuan ($1,858) or less.
At the other end of the spectrum, rapid economic growth and market-based reforms created tremendous wealth: China has 81 billionaires on Bloomberg’s ranking of the world’s 500 richest people, more than any other country after the U.S., and there are thousands more billionaires and multimillionaires who don’t crack the top 500.
Impact on India
Commodity exporting companies from India, mainly steel and iron ore, would be the major loser if China witnesses an economic slowdown. If China depreciates the Yuan, then Indian companies in sectors like textile, tyres, chemicals (where India and China both compete for the international market) will face intense competition from Chinese companies.
Global Impact
China is the largest buyer of most of the products coming out of emerging markets. It buys energy from Russia, semi chips from Taiwan, food from Brazil, capital goods from Korea, shipping services through Singapore, iron ore from India. When China sneezes, EM catches a cold. Not only emerging markets but approx. 50% of revenues for the European luxury goods sector have been coming from China.
Comparing Lehman? Superficial, not real, not even close
Ø The issue with Lehman (a Bank) was “leverage on leverage”. Lehman packaged RE loans in nice packets called CDO (Collateralised Debt Obligations).
Ø Evergrande is not a bank. Its loans are on Chinese bank balance sheets (with adequate capital cover) or with investors as Wealth Management Products (all equity financed, so no major leverage on top). Banks and WMP-holders will take haircuts, but the impact is largely mitigated at the first level due to lack of leverage on leverage.
Ø China is confronting excesses in real estate and associated debt, but not in its equity market.
China is asking local governments to prepare for possible "economic and social fallout" should Evergrande Group—the world's most heavily indebted property developer—become bankrupt in the coming weeks, according to the The Wall Street Journal, signaling a reluctance to bailout the debt-saddled company as the actions are being ordered as "getting ready for the possible storm". Local governments have been tasked with preventing unrest and mitigating the ripple effect on home buyers and the broader economy.