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There are two types of scary borrowers in China. The first kind has good-looking assets but it’s unclear how much debt they have hidden away. Think Evergrande. The second has a lot of debt but no assets to shore up their ability to repay, but they have the political connections some hope will help bail out the first kind.

To avoid hurting the broader economy, China is considering easing rules to let its distressed real-estate developers sell off assets to avoid defaults. The so-called “three red lines" on leverage ratios—formulated in August 2020—were so tight that there were no buyers for developers’ property holdings even if the likes of Evergrande were willing to offload projects at fire-sale prices. Going forward, regulators might let white-knight developers take over assets without having the projects’ debt affect their own leverage ratios and risk crossing the three red lines. That would be a relief. But will anyone take the bait? Even the richest real estate magnates might have second thoughts because of the hazards lurking underneath.

In the fast-churn, high-leverage world of Chinese builders, every step is a chance to squeeze in hidden debt. To buy land, developers often borrow from trust companies. To secure deals, they ask their own senior management and employees to buy into these trust products.

Even after buying land, developers are unlikely to get enough bank loans to cover construction costs. Big lenders are already dangerously near the regulatory cap of 40%. As a result, developers start owing their suppliers money, often in the form of commercial paper. They also do pre-sales, which require consumers to pay the full price of a home long before it’s ready for possession.

In short, developers end up borrowing from everyone.

So, when a new corporate buyer goes shopping for a development project, many creditors already have claims on it. Sometimes, the financing is so complex even the seller does not know how much money it owes. One solution has been for corporate rescuers to jointly develop projects with distressed developers who then have to absorb all liabilities. Once projects are done, they can sell all the apartments and the troubled builder can repay debt. Or so goes the idea.

Unfortunately, this doesn’t work well in practice. When sellers fail, white knights can’t quite disentangle themselves.

For instance, in January 2020, Shimao Group Holdings Ltd, China’s 10th largest builder by sales last year, came to the rescue of struggling Fujian Fusheng Group, promising a joint venture to develop its projects. That came at a steep cost. This month, as sell-offs spread to the better-known names, traders dumped Shimao’s bonds, worrying that it’s on the hook for private debt issued by Fusheng. Last week, Shimao lost its investment-grade S&P rating. In this environment, a white knight would have to be extra cautious. One bad move, and the saviour itself would need to be saved.

Traders love to dream about state-owned white knights riding to the rescue. But are they really big enough to save their private peers? China’s top ten builders are mostly private enterprises. And the government hasn’t exactly been willing to rescue its own firms. Beijing has let state-owned firms default as far back as 2015. Even state-owned enterprises must watch their wallets.

Financially and politically, there has been another option: bailouts from provinces and municipalities. These routinely set up shell companies to build roads and re-purpose farmland to residential use to stimulate the local economy. They are the debtors of the second type. Few of these so-called local government financing vehicles (LGFVs) are profitable or have assets that can make money, but investors don’t look at their cash flow. They focus instead on how much political support these vehicles can get to remain viable. So, unlike developers, LGFVs have no trouble tapping onto the onshore bond market. With about $1.7 trillion of bonds outstanding, they are the single largest group of debt issuers in China itself.

For example, the Guangzhou-based developer China Aoyuan Group was offered 2 billion yuan in loans from a local LGFV: the collateral was the developer’s headquarters, guaranteed by the chairman, according to a report by Redd. In addition to owning toll rights of roads to nowhere, LGFVs can provide creditors empty apartment blocks, too. LGFVs are a crisis waiting to happen.

Desperate times demand desperate measures. Beijing has vowed not to bail out Evergrande, currently the world’s most indebted developer. But market conditions have worsened since it made that promise in mid-October. Why, even investment-grade builders like Country Garden Holdings have seen their bonds tumble, a sign that contagion risk is real.

China has to find a workable solution to fix its crisis of developer debt. And time is running out.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets.

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