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A Chinese Black Swan that could spook markets

An upcoming Evergrande project in central China’s Henan province. The firm is currently the world’s most indebted real estate developer and has liabilities of around $300 billion (Photo: AFP)Premium
An upcoming Evergrande project in central China’s Henan province. The firm is currently the world’s most indebted real estate developer and has liabilities of around $300 billion (Photo: AFP)

  • China’s second-largest real estate firm is in a debt trap. Will the financial contagion spread to other Asian nations?
  • Given the firm’s sheer size and systemic role, officials in Beijing could step in to ensure an orderly restructuring. Such a move would also address rising fears of a financial contagion

MUMBAI : In the last decade and a half, the essayist and author Nassim Nicholas Taleb popularized the term black swan in reference to an event that comes as a big surprise, particularly for the economy and the financial system. While the term has become popular, what the world seems to see more of are gray rhinos. A gray rhino, a term coined by Michele Wucker, an American policy analyst, is a highly probable large threat that is likely to hit the world at large at a certain point of time.

One such gray rhino is the Chinese company Evergrande, the second largest real estate company in the country. It is the most highly indebted real estate company in the world and has liabilities of around $300 billion. The company is facing huge cash flow issues and might not be able to service its liabilities, starting this week.

A Bloomberg report dated 15 September points out that the ministry of housing and urban-rural development of China has told banks that the Evergrande Group will not be able to pay its debt obligations which stand due as of 20 September. In a filing with the Hong Kong stock exchange earlier this month, the company itself admitted to facing huge cash flow pressures.

The contract sales of properties sold by Evergrande have been coming down over the last three months, with sales falling from $10.75 billion in June to $5.71 billion in August ($1=0.15 Chinese yuan).

The month of September typically tends to be a good time for China’s real estate firms, but Evergrande expects the sales to continue declining during the month due to the negative media reports about the company. This decline in sales would “place tremendous pressure on the… cashflow and liquidity" of the company.

To cut a long story short, China’s second largest real estate company, which claims to have 1,300 real estate projects across more than 280 Chinese cities, and which dabbles in everything from football to electric vehicles and health to mineral water, is in trouble. Some western commentators have even equated this to China’s Lehman Brothers (2008 financial crisis) moment. Will it come to that? An even bigger question, however, is how did a company, which is run by a man who was once the richest person in China, get into this situation? And will there be financial contagion due to troubles at Evergrande?

Context to current crisis

The Evergrande Real Estate Group was founded by Xu Jiayin in 1996 in the city of Guangzhou, which is very close to Hong Kong.

In 1996, only 29% of the Chinese population lived in urban enclaves. By 2011, this had crossed 50%. In 2018, the urbanization rate was at 60%. In a May 2019 report, E-House, a company that offers real estate information services among other things, wrote: “During this period (1996 to 2008), an estimated 17 million people moved into the cities each year on average, fuelling demand for 8-10 million units of housing annually. Of those, an estimated four million units were first-time purchases."

Xu latched on to this opportunity. Given the fact that he was the new kid on the block with limited financial resources, he decided to concentrate on mass market housing. Operating on scale, by 2004, Evergrande had become one of the ten largest Chinese real estate developers in a market that had more than 24,000 players. In 2016, Evergrande became a Fortune 500 company. And in 2017, Xu became the richest man in China. He is now the tenth richest man in China.

Evergrande’s rise happened primarily because of what E-House calls the Evergrande model of “three highs and one low" (high debt, high leverage, high turnover and low cost). And it is this model of high debt and high leverage that has now landed Evergrande in trouble.

Over the years, the Chinese home prices have risen. There are three major reasons for this. The first as we saw is the rural to urban migration, which created huge demand.

The second is speculation. As Thomas Orik writes in China—The Bubble That Never Pops: “For mom-and-pop investors, real estate was the only show in town. Bank deposits, with their below-inflation returns, looked unattractive. The roller coaster stock market, lurching between huge gains and massive losses, was too volatile to act as a store of value."

The third major reason is the government. As Orik writes: “For China’s government, real estate is the ballast that keeps the economic ship afloat." In fact, an estimate made by economists Kenneth S. Rogoff and Yuanchen Yang in an August 2020 working paper published by National Bureau of Economic Research in the US suggests that the real estate sector contributes around 29% of the Chinese gross domestic product (GDP).

This has happened primarily because the Chinese government controls many important aspects of the country’s real estate market.

As the E-House report referred to earlier points out: “The Chinese government controls key levers, including urban land, capital, infrastructure, and the pace of rural-urban migration. It can easily relax some of these levers to stimulate the economy in the short run." This is something that the government has done whenever the economy is lurching towards a slowdown.

Over the years, this fallback option has led to real estate getting more and more important in the Chinese economy. It has also pushed up prices, especially in the tier-1 cities.

All this has come at a cost. Real estate developers have become overleveraged over the years. As Orik writes: “Total debt for real estate developers came in at about 48.9 trillion yuan at the end of 2016, up from 10.5 trillion in 2008." Other than overborrowing, the Chinese real estate developers have also overbuilt.

At the same time, household debt to GDP ratio jumped from 18% in 2008 to 62% in 2020. Outstanding home loans make up for over 70% of this.

Other than increasing the financial risk in the system, the rise in home prices has also increased the gap between the haves and the have-nots, something that Chinese President Xi Jinping has been concerned about. At a key Communist Party of China Congress in October 2017, Xi said that “houses are for people to live in, not for speculation".

The Chinese government, over the last few years, has been trying to control and put a lid on speculation in the real estate sector.

Red lines

As a part of this overall strategy, in August 2020, the government imposed a guidance policy based on three red lines. The red lines refer to three financial ratios. As a January 2021 UBS report points out: “If the developers fail to meet one, two, or all of the ‘three red lines’, regulators will then place limits on the extent to which they can grow debt." A developer who met all the three red lines was allowed to increase the company’s debt by 15% per year.

The idea behind this is to control the rise of home prices and land prices and to bring down the amount of loans that are given to the real estate sector, given how systematically important the sector had become.

Evergrande failed the three red lines test earlier this year, thus limiting the ability of the company to continue raising debt. A Reuters report points out that the company hopes to meet the requirement by the end of next year. This has gone against the company’s high debt and high leverage strategy and created a liquidity problem for it, where it is finding it difficult to pay off its debt and other liabilities. It’s running short on cash.

The Chinese real estate market, much like the Indian one, runs on pre-sales. This involves the prospective buyer paying the full price of the house, which involves making a down payment and securing a home loan, before the unit is built.

An estimate made by Capital Economics suggests that Evergrande owes $195 billion to buyers. The money is for 1.4 million individual homes that the company has promised to build. The question is where did this money go? On this, only speculations can be made. A part of it could have gone into buying land. In its 2020 annual report, the company said that it has land reserves amounting to a total gross floor area of 231 million square metres, with an original value of $73.5 billion. The company has also diversified into many other businesses.

Over and above this, the company has raised money by selling wealth management products to around 70,000 investors, including its employees and suppliers. In fact, in the filing with the Hong Kong stock exchange earlier this month, the company admitted to two subsidiaries failing to repay wealth management products issued by third parties for an amount of $140 million. As per the ratings agency Fitch, the company also owes around $100 billion as trade payables.

What’s the endgame?

According to Bloomberg estimates, the company has interest payments amounting to $669 million till the end of this year, a bulk of which is interest to be paid on dollar bonds issued by the firm.

In March and April next year, around $3.45 billion of its dollar bonds need to be repaid. These bonds are currently trading at 30 cents to a dollar, suggesting that the investors do not expect the company to repay a bulk of the money it had borrowed through these bonds. There is bound to be a haircut.

While the company can afford to default on its external liabilities, a similar situation cannot be allowed to play out domestically. As Julian Evans-Pritchard, senior China economist at Capital Economics, wrote in a research note in July: “China’s leadership is presumably reluctant to offer a bailout to Evergrande, given the desire to punish reckless behaviour by private entrepreneurs and discourage speculative property investment… But given the firm’s sheer size and systemic role, officials would step in to try to ensure an orderly restructuring in the event of a default."

One idea that is already being suggested is to use Evergrande’s massive land bank to settle liabilities. As the Capital Economics note points out: “The most likely endgame is now a managed restructuring in which other developers take over Evergrande’s uncompleted projects in exchange for a share of its land bank." The company is also looking to pay the investors in its wealth management projects by allowing them to bid for its property assets at steep discounts.

Hence, the aim is to ensure that the domestic liabilities are settled in an organized way. Also, while Evergrande is the second biggest Chinese real estate developer, the overall market continues to remain highly fragmented and as the ratings agency Fitch points out, the developer on its own had only 4% of the market share in 2020. Hence, “the risk of significant pressure on house prices in the event of a default would be low, unless the restructuring or liquidation of its assets become disorderly."

Further, while the Communist Party of China has been trying to control home prices, it also needs to make sure that prices don’t fall rapidly. In fact, Guo Shuqing, head of the China Banking and Insurance Regulatory Commission, had warned in March that if home prices fall, people might suffer losses, leading them to default on their home loans and this would create economic chaos. As a result of these domestic compulsions, all the talk about financial contagion spreading into other Asian financial markets seems unlikely as of now.

To conclude, the real estate-led growth model in China needs to unwind. Other than overbuilding, the demand for homes in the years to come is likely to shrink. As Rogoff and Chang write: “The age group of 20-50 (years), who comprise the majority of homebuyers, keeps shrinking. The abolition of one-child policy effective from January 2016 is unlikely to reverse the downward demographic trend." Also, “urbanization has reached the point where home ownership is (now) over 90% among the 276 million urban households."

If economists writing for the National Bureau of Economic Research understand this, so do the leaders of the Communist Party of China. It’s just that unravelling this and ensuring a smooth landing is going to be very difficult and take a lot of time. Having said that, the Communist Party of China needs to ensure that the gray rhino does not become a black swan that could potentially affect the financial stability of other Asian nations, including India.

The writer is the author of Bad Money.

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