What is happening to the China Evergrande Group, and why does it matter to the rest of the world?
Evergrande, as it is known, was founded 25 years ago just as China began to allow home ownership. It builds and sells homes, apartments, and other real estate, and has recently expanded into theme parks, health-care services, mineral water production, and electric-vehicle manufacturing.
Evergrande is mammoth, with about 800 projects in progress, spread across more than 200 cities. In 2018, it had projects totaling 33,000 acres of floor space under development, quadruple the level from just four years earlier.
From the start, people queued up for hours for the chance to buy an Evergrande apartment, and many are still buying homes prospectively that will not be built for several years, largely because home values have perpetually gone up, and thus for the Chinese, owning more homes has been viewed as the primary means of wealth acquisition, even if those homes sit empty, or don’t actually exist yet.
Along the way, Evergrande amassed the equivalent of more than $300 billion in debt and other liabilities, which is likely greater than the realistic value of its assets. As it piled on this debt, Evergrande paid out billions in dividends to stockholders, with much of that cash going to Hui Ka Yan, the company’s founder and largest shareholder, and the wealthiest man in China as recently as 2017.
Now, to put it bluntly, Evergrande is perhaps the most grotesquely overleveraged company in the world, and we are witnessing its unraveling. It is struggling to pay its creditors. It has suspended work on some of its real estate projects after it delayed payments to suppliers and contractors. It is running out of cash, its share price has plunged more than 80 percent, and some of its bonds are trading at dimes on the dollar. It has recently hired financial advisers to guide it through this morass.
But the problem is not merely that Evergrande is facing the prospect of its own collapse. We are all facing the specter of the possible spread by “contagion” of Evergrande’s problems to other companies in China, to the region, and to the world. What happens in China matters immensely, since it is now the second largest economy in the world and has been the primary source of global growth for over a decade.
In the past few days, Evergrande has missed a key payment deadline and is now likely to miss more. Its electric vehicle subsidiary has also just announced a “serious shortage of funds.” So far stock markets in the U.S. and China have been unaffected.
Nevertheless, Evergrande has been in a highly indebted state for years, so it is worth understanding why it is coming undone now, and what the long-term impact to China and the global economy might be.
To really understand the Evergrande situation, we need to step back and understand debt, and how it works. Growth in private-sector debt makes an economy grow, because loans are used to build houses and factories and buy homes and cars. It follows that rapid private debt growth makes an economy grow rapidly. If everything had to be paid upfront with on-hand cash, and even forms of debt such as store and vendor credit did not exist, all economies would be a fraction of their current size and any financial growth would be a challenge. And indeed, rapid private debt growth has been at the core of China’s economic strategy for at least ten years and longer, dating back to the days when Deng Xiaoping opened up China’s economy, and with that strategy it has assumed a leading role globally. (I use the phrase “private-sector debt” for all non-central government debt, even though in a communist country like China it is something of a misnomer.)
Since 2008, private-sector debt in China, the debt of its businesses and households, has doubled in ratio to GDP, skyrocketing from 112 percent to 224 percent in 2020. In the United States, by contrast, that ratio has actually dipped slightly, from 168 percent to 160 percent in the same period. I have written about the perils of rapid private debt growth for years, and written previously in these pages about its role in financial calamities in China, the U.S. and elsewhere.
The story of China has become a story of massive dependence on debt for growth.
But if rapid debt growth goes on for too long, that economic growth produces too many empty houses and buildings. This part of the story should sound familiar. We’ve seen it in the United States in 2008, Japan in the 1990s, and at many other moments in history. And it’s been happening for a few years in China, which now has enough empty property to house more than 90 million people.
When it is happening, that scale of overbuilding—though obvious from even the most cursory analysis—appears to be creating so much wealth that it provokes celebration rather than consternation at every step of the way. Before it brings difficulty, debt-fueled construction creates a burst of jobs and wealth, and not just in the construction industry, but in the production of steel, cement, and other supplies, and in the sales of luxury items to the newly wealthy. And it looks good in the economic data, at least initially, since the building of houses and other structures gets counted as “GDP growth” even if they all don’t get sold.
In China, unfinished buildings that have stayed empty for years and blight the landscape are now commonplace. And in this respect, Evergrande is merely symptomatic of a much bigger problem: China’s sprawling real-estate sector, which contributes as much as 30 percent of the country’s gross domestic product, has been the prime driver of its economic growth, but now may become the prime drag on that growth.
As overbuilding and overcapacity reach extraordinary levels, as they have in China, its economic decision-makers can choose one of two paths. First, they can slow growth and let demand catch up. But that decision has the political and economic consequence of slower growth and fewer jobs. No one looks good when growth is decelerating. Alternatively, decision-makers can keep fueling growth with even more private debt that results in even more empty houses and buildings and postpones the inevitable reckoning for some future date.
In any of the other largest economies in the world, the kind of private debt and overcapacity accumulation seen in China would have long since created a banking crisis, as it did in Japan in 1998 and the United States in 2008. But China is different in one key respect: It owns or controls all of the major components of its economy. If it chooses to allow banks to continue to lend to an already overleveraged company, then it can more readily do just that. Therefore, it can juggle debt, overcapacity, and other elements of economic crisis far longer than Japan or the United States.
The crazy overleveraged situation with Evergrande has been going on for a while, but it is deteriorating into a crisis for the company only now because the government and its regulators in Beijing have clearly decided to rein in the leverage of corporate borrowers, and especially property developers. It has decided to take on this issue in part because the COVID-19 pandemic more clearly exposed the precarious situation of developers like Evergrande, and in part because the real-estate mania has now driven home prices above levels that most of its citizens can afford.
This instinct toward restraint is not a new one for Beijing, which has warned for years about high private debt levels. But it is not without an inherent conflict: The government wants the country to grow, it wants to provide more and better jobs, and it wants to surpass the U.S. economy in size. But to do all of this requires debt growth, and so Beijing has always eventually backed off of restrictions on private-sector debt growth.
This time seems different, because Beijing’s action has been much more specific. It has articulated a “three red lines” policy for property developers. This policy mandates a liability-to-asset ratio of less than 70 percent, a net debt to equity ratio of less than 100 percent, and a cash-to-short-term debt ratio of more than 100 percent. These lines are not overly harsh but they are much more conservative than the current practices of many in the industry.
If a company violates all three red lines, it is not allowed to grow its debt. That limits its ability to borrow more money to make payments on older debts—the oldest trick in the real estate developer’s playbook. Evergrande crossed all three red lines—its debt to equity ratio is close to 500 percent—and it was therefore forbidden from raising additional debt. This triggered the crisis we’re hearing about today.
For some time now, Evergrande has been going to extraordinary lengths to get new cash in the door—preselling houses, apartments, and buildings years before they are built, selling wealth management products to ordinary citizens that are, unbeknownst to these purchasers, unsecured, last-in-line debt (what some might pejoratively call “sucker debt”), and selling off non-core businesses, unencumbered land, and other assets.
Since it has so little cash, it has also been scrambling to pay its creditors with non-cash items. Evergrande has paid suppliers with IOUs and creditors by giving them land or unfinished apartments in lieu of cash.
Anyone and everyone paying any attention has seen Evergrande’s unraveling for a long time. Not only are its debt ratios terrible, but it has had negative cash flow for three of the past five years. Even so, suppliers have had little choice but to play along: They either had to trust Evergrande or lay off thousands of their own employees. Meanwhile, remarkably, even some sophisticated institutions have increased their investments in Evergrande. Thus far in 2021, BlackRock has increased its position in Evergrande’s debt in its $1.7 billion Asian High Yield Bond Fund. HSBC and UBS have reportedly done something similar. These institutions are presumably betting on—indeed, counting on—Beijing to step in yet again to save Evergrande, however unwise this bet may be.
The Chinese government is not oblivious. It knows the issue well, has been wrestling with it for years, and developed significant experience with overleveraged behemoths in its last major debt crisis in 1999.
China became a capitalist economy after Deng Xiaoping took power in 1978, and quickly learned to use debt to build up a surprisingly robust economy. But it built too much, too fast, and its major 1999 crisis followed the 1997 credit and currency crisis that beset other Asian economies.
Dealing with this crisis was very painful, but Beijing resolved it by infusing its banks with new capital and allowing its four biggest banks to transfer bad debt on very favorable terms to four “asset management companies,” created for this very purpose—to magically remove those banks’ bad debt. More recently, Beijing organized the bailout of one of those asset management companies—the China Huarong Asset Management Co.—and began bankruptcy proceedings on the conglomerate HNA Group Co.
Not only did Beijing learn a lesson about the management of bad debt in the earlier crisis, but it also has ample financial capacity to deal with any problem of this sort, no matter the magnitude. It has monetary sovereignty, and thus has the same debt issuance and money creation capability as the United States or Japan.
So, all of this leaves the government with three options on Evergrande.
The first option would be to ease back and return to a more accommodating credit posture—allowing exceptions to the three red lines policy and “kicking the can down the road.” After all, China has ample resources to prop up or clean up Evergrande’s problems.
A second option would be to follow the three red lines policy, but work carefully to monitor the restructuring of Evergrande and contain its economic impact on other businesses and households. While doing this, it could provide support to overall markets in ways that counterbalance its new red lines policy; for example, easing credit curbs in smaller cities.
A third option would be to follow the three red lines policy, do nothing proactively, and just let the chips fall where they may.
China may yet decide on a version of option one, but my opinion is that they will elect to follow option two, managing the situation and maintaining control of its impact on the economy. It is highly unlikely that it would ever consider option three.
I believe this for a few reasons. Many analysts think Beijing is intent on making an example out of Evergrande—and likely other highly leveraged companies beyond Evergrande. That would likely mean letting stockholders and large bondholders take losses—and it will most certainly mean a change in Evergrande management, perhaps even with harsh consequences for the current management. It could mean letting a restructured Evergrande continue to operate under new management, but will more likely mean that the company is broken apart and divided up, and sold or conveyed on a “region-by-region basis” to other development companies or regional governments.
The more difficult question for Beijing will be whether to help those 80,000 individuals who now hold the equivalent of more than $6 billion in Evergrande wealth certificates—that is, unsecured debt—which they bought because they were enticed by 7.5 percent returns. The equally difficult question will be whether to help those individuals who have prepaid for 1.4 million apartments, valued at $200 billion in total, that Evergrande has yet to finish. Beijing’s actions on these will be setting a resounding precedent for future, similar failures.
Even very recently I would have guessed that China’s government would intervene to help those with wealth certificates or unfinished apartments. To not do so would stir civil unrest, and Evergrande’s potential victims have already begun to protest at its offices. Contrary to my expectations, Beijing is now expressing reluctance to bail out the country’s most heavily indebted property developer or help these individuals, and is asking local officials across the country to prepare for a “possible storm.” Beijing wants both, to send a limited but powerful message about overleverage, and control any broader impact on its economy.
This is the biggest wild card in the entire scenario: If Beijing does not step in to help these citizens, it will send a profound signal indeed.
There is a risk to the scenario of making an example out of Evergrande and allowing for a “storm.” China’s financial system sits on the bedrock belief that China’s government will intervene to prop up major companies and banks. The assumption of a government guarantee is the key reason that companies with such high levels of leverage have had no problem raising capital and obtaining debt funding.
If doubt about that support enters the equation, even if it is simply doubt about how far Beijing is willing to let this go, it could precipitate other collapses that would necessitate an intervention by Beijing at some key point to reassure markets, and thus undo the very example it is trying to set.
As this article goes to press, Evergrande has just missed a key bond payment deadline, which could precipitate just such a test, though as mentioned markets at the moment are steady and confidence in Beijing’s management of the situation remains intact.
The task for Beijing will be to let enough air out of this balloon to keep it from popping, yet keep it aloft.
Given that Beijing’s direction with Evergrande and its reluctance to aid these individuals would bring economic pain to so many, we might wonder how President Xi Jinping and Beijing plan to emerge with their popularity intact.
Xi is probably counting on support based on ideologies of egalitarianism and nationalism. The three red lines policy is consistent with China’s recent, more assertive posture toward its business community generally, including its crackdown on data and gaming companies. It is also part of an overall campaign against the extremes of wealth inequality that so starkly flout the egalitarian ideals of China’s Communist Party. In recent years, housing prices have risen to levels out of reach for most, and stabilizing the market has become a priority for leader Xi, using the mantra: “Homes are for living in, not for speculation.”
So Xi presumably believes that his strengthened power base will help him get through the any fallout from Evergrande. He has to believe that the overt and ardent nationalism and the fervor it has created will help him counter the “possible storm.”
Evergrande is not the only highly leveraged developer in China. Beijing may already be working pre-emptively on the same debt issue, and with similar tactics, with a number of other developers including Sinic Holdings, Sunac China Holdings, Greentown China, Guangzhou R&F Properties, and Sino-Ocean Holdings.
Unless China’s regulators seriously mismanage the situation, a systemic crisis in the country’s financial sector is not likely to happen. However, home sales in China’s major cities are down dramatically, and since those sales play a central role in its economy, China is in for a least a short-term slowdown in growth, with commensurate employment issues.
A significant impact will also be felt by local governments, which for decades have financed themselves in large part through land sales to companies like Evergrande. That revenue will now decline sharply, compromising their economic development efforts along with their ability to service their own debt.
In the 2000s, China’s GDP grew by an average of more than 10 percent, in the 2010s growth slid to a still strong 7.7 percent. A number of analysts are now calling for growth of 4 percent or lower in the coming years.
If that prediction holds true, then we will be looking at a very different China.
Finally, Evergrande, if its damage to China’s economy is not largely contained, could have an impact on other economies in the region and the world—this is the so-called “contagion” effect of China’s credit woes. Since China is determined to remain in control of its overall economy, this likelihood of contagion is remote, but what if significant problems did arise?
First, any countries that export to China could feel a slowdown, especially other Asian countries. Western countries have been much less dependent on sales to China, with the notable exception of Germany, which depends significantly on wealthy Chinese to buy its automobiles. But this impact will mostly constitute a “slowdown,” and not a crisis.
There could also be an impact on foreign investors who have made loans to or invested in China’s property developers and other companies. However, there has been comparatively less cross-border lending and investment in China’s companies than there was from other countries in the United States in 2008, so I would expect the losses to overseas investors and lenders to be unpleasant, but manageable.
That brings us to credit contagion, the idea that loan problems in one country can precipitate loan problems in other countries. Credit contagion is not so powerful a force that it can topple countries that have had conservative credit growth and lending practices. For example, the rampant over-lending in the United States and Western Europe in 2008 had only a modest impact on China. Its stock market corrected, but its GDP growth barreled ahead and its lenders were fine, because China at that time had not been over-lending.
But the force of contagion can affect countries that have been on their own lending binges over the last decade, because Evergrande’s plight could act like a red flag for the credit habits and policies of lenders there.
This danger does not apply to the United States, since its lending trends over this past decade have been benign, aside from some smaller categories such as margin debt and private placement debt. Nor does an “over-lending binge” describe most other Western countries, including Germany and Spain. France, surprisingly, has been on a real estate lending binge, and could feel the Evergrande contagion impact more significantly.
Even in Asia, most lending trends have been reasonable over the last decade, with three notable exceptions: South Korea, Vietnam, and Australia (which I include in Asia because of its significant dependence on Asian markets).
As regards global stock markets, an Evergrande failure poorly contained could bring a correction. But a stock market crash is different, and much less damaging, than a banking crisis.
So a major reversal in China may impact everyone to at least some small degree, and if not contained it would likely most acutely impact South Korea, Vietnam, and Australia, because of their own high debt growth; and perhaps a few non-Asian countries like France, for the same reason, and Germany, because of its export concentration.
Looking forward, the Evergrande episode underscores the longer-term challenges for China. It can no longer rely as heavily on real estate for economic growth. The wealth gained by rising house prices has been at least partly an illusion all along, since it is the rapid increase in lending that creates the demand that causes the prices to rise. If lending slows, prices stop going up and may even fall.
China’s population growth is decelerating, and may begin to see an absolute decline. Its growth may slow to levels reminiscent of Japan after its 1998 travails.
Even with the Evergrande debacle, China’s corporate debt growth had been abating, but now its household debt—encompassing mortgages, credit cards, and more—is growing at a problematic pace.
China has long said it will be more disciplined in debt growth but also maintain high growth rates. That’s a contradictory, or at least paradoxical, statement. Growth requires debt. You have to pick one or the other—restrained debt growth and moderate GDP growth, or rapid debt growth to bring high GDP growth.
There is a possible silver lining in Evergrande. If Beijing handles this deftly, then it will have shown evidence of its crackdown on the excesses of capitalism, it will have emerged from this episode having purged some of its excess debt, and it will have a lowered risk profile and the opportunity to focus more on the industries that it wants to drive its future growth: artificial intelligence, supercomputing, genetic engineering, 5G and 6G communications networks, electric vehicles, virtual reality, and more. The Evergrande crisis can be part of its transition, albeit a painful one, from what some have called its “build, build, build” strategy, to an “invent, invent, invent” strategy that centers instead on the industries of the future.
Beijing has shown that it can handle challenges of this sort in the past, and in every likelihood they will handle Evergrande, too.
But, the wheels could yet come off.