What are the systemic risks of an Evergrande collapse?

CHINA’S FINANCIAL authorities are honing a new skill: the “marketised default”—or an orderly market exit and well-managed restructuring for troubled companies. The term has surfaced in government documents as regulators manage larger, more frequent and highly complex defaults. They have had some successes. Evergrande, a massive Chinese property developer on the brink of collapse, is proving to be anything but.

The company, the world’s most indebted property firm with $300bn in liabilities, said on September 22nd that it had come to an agreement with bondholders on a coupon payment on an onshore bond due this week, easing some fears of an imminent collapse. Analysts had been expecting the company to default on both yuan- and dollar-denominated interest payments. The fate of the dollar-bond payments, due as The Economist went to press, was unclear. On September 23rd The People’s Bank of China, the central bank, injected more short-term liquidity into the financial markets than it has since late-January, in a sign it was attempting to soothe market concerns about an Evergrande default.

Far from being a well-managed process, Evergrande’s distress has been roiling markets around the world. Major indices in Europe and America fell on September 20th as Evergrande’s situation appeared to worsen. Yields on the dollar bonds of some Chinese borrowers outside the property sector have risen.

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. R&F Properties, another highly indebted group, has said it will raise up to $2.5bn by borrowing cash from company executives and selling a property project. Several financial institutions with high exposure to the property sector have suffered steep declines in their market value. The price of iron ore fell below $100 per tonne on September 20th for the first time in a year amid speculation that Chinese homebuilders will construct fewer properties.

The crackdown on developer debt is not an isolated event, but one of several campaigns Xi Jinping, China’s president, is using to remould the country, including a clampdown on internet companies. As part of Mr Xi’s slogan of “common prosperity”, the measures include making housing more affordable and ridding the property market of speculation. “A regime shift is occurring without necessarily the markets fully comprehending the enormous underlying change to the structure of the economy,” said Sean Darby of Jefferies, an investment bank.

Analysts and short-sellers have been predicting the death of Evergrande for years. Its chairman, Xu Jiayin, who founded the company in 1996, put up $1bn of his own cash in 2018 to meet a shortfall in demand for an Evergrande bond with a 13% coupon. 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 them years before they are completed to generate cash from buyers’ deposits.

When central-government regulators stepped up their campaign against leverage last August, the first major cracks began appearing in its business. Authorities have constricted developers’ capacity to continue accumulating debt, limiting liability-to-asset ratios to less than 70%, net debt-to-equity ratios to less than 100% and mandating levels of cash that are at least equivalent to short-term debt. The policy has changed the nature of the business. Unable to continue perpetually expanding their debts, Evergrande and several other weak companies have slashed home prices and halted projects in order to preserve cash. Evergrande is said to be offloading housing projects in an attempt to generate just enough cash to make payments to suppliers. It is also selling off its land at a 70% discount, says one investor. UBS, a Swiss bank, has identified ten other Chinese property groups with 1.86trn yuan ($290bn) in contracted sales that are in similar risky positions.

How far will the turmoil spread? The volatility leading up to the expected default on September 23rd has already given investors a taste of the risks emanating from China’s deleveraging campaign. However, many analysts still believe severe contagion can be ring-fenced to groups with known connections to Evergrande and other weak property developers.

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-percentage-point rise in their non-performing ratios, would eat up 2.1 percentage points 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 (see chart). Minsheng has tight links to Evergrande. Shengjing Bank, which is majority-owned by Evergrande, is thought to have lent heavily to the property company. A banking crisis is not the base case for many investors watching the situation. But “the situation would change very quickly” if a bank of Minsheng’s scale proved vulnerable, says a China-based executive at an asset manager. Central authorities would probably step in swiftly at the first sign of distress at a major bank, the investor adds.

Of more immediate concern are Evergrande’s links to China’s shadow-banking system. 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, according to Gavekal, a research firm.

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. Many other developers’ yields have shot up above 30%. 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 as they did recently with Huarong, a state-owned investor in distressed debt that required a full bail-out in August. The treatment of Huarong, which is intricately connected to China’s financial system, suggests that Mr Xi is still intent on avoiding a generalised market meltdown.

If Evergrande does default, there is still the possibility that the government may step in to help individuals. The state, which is likely to be worried by protests in recent days by savers who have bought Evergrande’s wealth-management products, is expected to be forced to broker a partial bail-out for assets most connected with social stability. Such a process would be focused on the properties the company has already sold to ordinary people and which are not yet built. Capital Economics, a research firm, estimates there are about 1.4m of those. This could involve a number of companies carving up construction projects across the country and taking over assets in the provinces where they are based. By keeping these projects under development, suppliers and contractors would also in effect be bailed out.

One difficulty in organising such a bail-out will be finding buyers. The crackdown on leverage has left few developers with excess cash to make such purchases. That means local governments may need to step in to help out.

Perhaps the biggest contagion risk flaring up in the market is not that posed by Evergrande itself but by Mr Xi’s unyielding crackdown on leverage. Logan Wright of Rhodium Group, a research firm, sees Evergrande not as the root cause of the troubles in China’s property sector. Instead it is a symptom of the government’s efforts to reshape the market. Mr Wright says the assault on China’s vibrant tech sector suggests Mr Xi will see the deleveraging campaign through.

These implications are bigger than the current market rout. China’s property sector accounts for 20-25% of its economy. An extended campaign against developer debt could significantly lower China’s growth prospects, says Tommy Wu of Oxford Economics, a research firm. Such a strategy could lead to much greater economic and financial turmoil farther down the road. It would also raise further questions about where Mr Xi’s relentless and wide-reaching campaigns are leading China. ■

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