Chinese Evergrande has long been an icon. It is not just a real estate developer, but a conglomerate that has embarked on many different businesses, including the production of electric vehicles.
Unfortunately, reaching such a huge size has come at the cost of enormous leverage. Leverage is the use of debt in order to undertake an investment or a project. At the same time, the leverage will also multiply the potential downside risk in case the investment does not materialize. Evergrande was “highly indebted” which means she has more debt than equity.
This didn’t seem to worry anyone until mid-2017, when President Xi created a high-level commission to deleverage Chinese companies. The reality, however, is that corporate leverage continued unabated until the Covid-19 pandemic hit the economy, including in the real estate sector and, of course, in Evergrande.
Chinese real estate sector
The Chinese real estate sector has long been too big and too risky. It is not a coincidence. It was a central part of the Chinese leadership’s plan to revive the economy after the 2008 global financial crisis. Increasing the supply of housing, as well as commercial real estate, was an easy way. to earn money because local governments were keen on job creation and growth.
Common prosperity is Xi Jinping’s new economic mantra to stress the importance of better income distribution and greater equality of opportunity.
As a result, the Chinese economy clearly overheated in 2010 due in large part to the construction boom. This has led regulators to limit bank lending to the already over-leveraged real estate sector. Developers have found other ways to address funding constraints, by aggressively pushing pre-sales and engaging in large bond issues. As the domestic bond market needed the regulatory green light, many moved overseas to the USD bond market.
The demand for housing in China has been secure as it has become the most important asset for investors to place their savings under the still draconian controls on capital outflows. Investing in housing has been an eldorado for Chinese households, as prices have been rising steadily until recently.
In 2021, house prices suddenly slowed. This has several reasons.
First, the sudden regulatory push to control the overburdened balance sheets of real estate developers led to the restructuring of some large real estate companies, such as China Fortune Land – before Evergrande even got into trouble. In other words, Chinese households – even if they are inundated by a still rosy image of the Chinese real estate sector and economy in the local media – are increasingly reluctant to invest in real estate.
The second reason is that the tighter controls do not only affect developers, but also real estate buyers who face huge down payments as well as the fear of a nationwide property tax, which has been around for some time.
Evergrande is heavily exposed to foreign investors, whether through the Hong Kong Stock Exchange or bonds issued in the Hong Kong offshore market.
Finally, Chinese households are bearing the brunt of an economy that has been slowing rapidly for several years, driven by its own overcapacity but also by the trade and technology war led by the United States as well as, more recently, the pandemic. In fact, the Chinese government’s crackdown on the real estate sector, through the introduction of the so-called “three red lines” to limit their leverage, dependence on pre-sales and short-term financing, has taken hold. set against the background of China’s rapidly changing long-term economic goal of growth to common prosperity.
Common prosperity is Xi Jinping’s new economic mantra to stress the importance of better income distribution and greater equality of opportunity. Excessively high – and rising – house prices are arguably the most important source of income inequality in China. Access to housing – or lack of it – is a key factor in explaining income disparities.
In this context, Evergrande has been a prime target of government repression for a number of reasons.
First, it is quite simply the biggest real estate developer.
Second, it is the most efficient developer and does not respond to any of the aforementioned three red lines.
Third, Evergrande is highly exposed to foreign investors, whether through the Hong Kong Stock Exchange or bonds issued in the Hong Kong offshore market. These, which represent nearly $ 20 billion, mostly denominated in USD, were mainly bought by foreign private banks and asset managers for their high net worth clients.
It seems clear, after the failure to pay a bond coupon in USD last Thursday, that Evergrande’s offshore debt will undergo restructuring. Following the example of China Fortune Land, which is completing its own restructuring, it will not necessarily be a nominal discount but an extension of the maturity and a reduction in interest due. Foreign investors are likely to be relieved if such a restructuring is announced, as they now have no clarity on the future of their investment in Evergrande.
In short, economic success is no longer the objective and financial excesses will be penalized.
Yet the bulk of Evergrande’s debt ($ 300 billion in total) is domestic and will need to be repaid, especially the equivalent of the $ 200 billion Evergrande received in pre-sales from Chinese households. Nearly 1.5 million Chinese households are waiting for Evergrande to complete their homes. This will certainly happen because other real estate developers are relying heavily on pre-sales, so if Evergrande doesn’t deliver on its promises, pre-sales for homes in China would dry up, pushing most real estate developers to the brink.
Moreover, common prosperity is not really about blaming the losses on households. As such, the Chinese government has already given clear signs that local governments will deal with unfinished projects.
China’s new economic policy
There are two things to remember about the future of the Chinese economy.
First, the Chinese real estate sector is not doomed to the collapse of the demise of Evergrande, as public money will be used to resolve its systemic consequences in China. This does not mean, however, that everyone, especially foreign investors, will be fully bailed out. Evergrande should serve as a warning signal of the cost of excessive leverage.
The second and final point to remember is that China’s growth will suffer. Not only will the real estate sector, which is a key contributor to China’s investment, jobs and growth, slow down after the demise of Evergrande, but investors in general will increasingly be wary of the radical change in China’s priorities.
In short, economic success is no longer the objective and financial excesses will be penalized. Contributing to common prosperity is now the key objective, even at the cost of disgruntled private investors and hence potential stagnation of the economy.