09.22.2021: Evergrande, China’s largest property developer, missed interest payments to at least two of its largest bank creditors earlier this week, and appears to have averted defaulting on domestic bond payments due on Thursday (tomorrow). News of the troubled conglomerate, which has more than $300 billion of liabilities, rocked Chinese equities and sent shockwaves through global markets. With 1,300 real estate projects in 280 Chinese cities, the real estate giant represents about 6.5 per cent of the total debt in the Chinese property sector. Evergrande is saddled with massive liabilities, unfinished residential buildings and angry suppliers who have shut down construction sites. The firm has also faced protests by unhappy homebuyers, retail investors and even its own employees, forcing it to barricade the entrance at its Shenzhen headquarters.

Image, Market Update, 09.22.2021

In many respects, Evergrande rode a wave of Chinese public policy to unbridled success. Founded in 1996, Evergrande levitated China’s epic property boom, set off by President Jiang Zemin’s desire for China to enter the global supply chain. Fearing China’s aging population would create an unsupportable financial burden on its much smaller workforce, Beijing pursued a “growth at any cost” policy, creating building and infrastructure projects while handing shovels to the million-plus rural workers migrating to urban China every month in search of a better life. Meanwhile, Evergrande offered an opportunity for private homeownership to individuals with modest incomes. Without a social safety net, Chinese savers have been encouraged to purchase homes, whose prices have trended higher. Graph 1, Market Update, 09.22.2021

Fast forward to 2020: Evergrande and its founder, Hui Ka Yan, suddenly found themselves on the wrong side of Chinese public policy. Though his “common prosperity” initiative, China’s President Xi vowed to narrow the gap that divides the haves from the have-nots. Xi ordered state regulators to clamp down on speculation in the housing market and excessive borrowing, two characteristics that exemplify Evergrande. Last year, the Chinese government sought to limit property developers’ borrowing, fearing the perpetuation of a housing bubble. Making matters worse, over the last decade, Evergrande paid out billions in dividends, financed by debt, with roughly $5.4 billion flowing to Mr. Hui himself, making him one of China’s richest men.

Graph 2, Market Update, 09.22.2021

Now, jittery investors are wringing their hands wondering whether Evergrande will be bailed out, restructured or allowed to go bust. Allowing Evergrande to collapse would seriously impair Chinese homeowners, suppliers and domestic investors and would cause ripple effects throughout the domestic economy. The signals are mixed. Beijing has moved to shore up large companies that have gotten into financial trouble in the past, lessening the possibility of a Lehman-like scenario. Recent trends, however, argue against a bailout, as Chinese lawmakers have increasingly showed a willingness to allow troubled companies to fail, particularly those that operate counter to President Xi’s “common prosperity” values.  Authorities in Guangdong have already rejected at least one bailout request from the firm’s founder, according to Bloomberg. Authorities met with Evergrande officials last month to direct them to get their debt in order. At the same time, the People’s Bank of China (PBoC) moved to insulate the country’s banking system by directing banks to reduce their exposure to troubled property developers.

How Chinese policymakers address the challenges will have meaningful effects on the Chinese economy and the broader credit and equity markets. We believe the risk of China’s problem spilling into global financial markets is limited. Foreign banks have little exposure to Evergrande debt. Foreign funds hold the conglomerate’s roughly $24 billion of foreign dollar debt, which are spread among a broad shareholder base. The company owes $7.4 billion in bond payments over the coming year to foreign holders. Bond giant Blackrock holds nearly $400 million of Evergrande debt among its funds and strategies. Those bonds have plunged to about 27 cents on the dollar since June.

Graph 3, Market Update, 09.22.2021

Evergrande’s failure has the potential to tighten China’s credit conditions if lenders and financial institutions become more risk averse. The company’s fate threatens China’s broader property sector and, potentially, its financial system, testing policymakers’ desire to clean up the country’s corporate culture. According to The Wall Street Journal, authorities in Beijing have indicated they no longer are willing to bail out foreign and domestic bondholders, placing them instead on a long list of creditors vying for company assets. That said, the PBoC has already injected 90 billion yuan ($14 billion) into the country’s banking system to avoid a liquidity crisis, according to Bloomberg. Evergrande concerns, when added to China’s broader regulatory crackdown, represent significant headwinds to economic growth in the world’s second-largest economy and will likely keep a lid on its stock market. Debt recovery efforts by creditors would put additional downward pressure on property prices and crimp profit margins across the supply chain.

Allowing Evergrande to fail, however, would send shockwaves throughout China, leading to financial turmoil and civil unrest, two things that Beijing strives to avoid. Leaders are in no mood to allow a collapse. We expect policymakers to restructure Evergrande’s bonds, inflicting pain on shareholders and bondholders but protecting the millions of customers who have paid for unfinished apartments. The Wall Street Journal reported that Evergrande presold more than 1.4 million apartments valued at $200 billion that remain unfinished. Maintaining social order is a top priority for the Communist Party, and it should also be noted that real estate currently accounts for 40 per cent of household assets in China. Even a 10 per cent property price correction would inflict serious financial harm on a large swath of Chinese households.

The PBoC can probably engineer an Evergrande restructuring while avoiding a full-blown credit crisis. China’s central bank probably can’t prevent a property market downturn that would weigh on China’s economic growth. Dollar bonds will likely be restructured, but most of that debt is widely distributed among hundreds of funds and strategies. In fact, court-led restructurings have become common in recent years, with more than 700 completed in 2020, according to Bloomberg.  Eventually, Evergrande’s tangible assets will be sold off. The Chinese government and PBoC would likely stand ready to intervene to limit the social and economic damage, and have the wherewithal to cushion the financial blow from the Evergrande bubble. That said, President Xi’s “common prosperity” philosophy will weigh on growth for several years to come.