Letter from Asia: Evergrande is no Lehman
For more than two decades, Evergrande’s journey to become one of China’s largest developer has come at a huge cost: ever rising indebtedness. At US$300 billion, the world’s most indebted property developer is now facing judgement day. Already falling behind on payments to banks, suppliers and holders of onshore wealth management products, interest payments on two Evergrande notes due on September 23 will provide a key test if the developer can meet its obligations to bondholders. The two Evergrande payments include: US$83.5 million on a 8.25% 5-year USD note and US$35.9 million coupon on an onshore bond. Investors are pricing in a high risk of default, with the notes trading at less than 30% of face value. In total, Evergrande has US$669 million in coupon payments coming due by the end of this year, of which US$615 million is in dollar bonds. Shareholders are in angst too: the stock price of Evergrande has fallen by around 85% this year.
The escalating liquidity crisis at Evergrande over the past few months – the hiring of financial and restructuring advisors, weaker contracted residential sales and lack of asset disposals – has pointed to a near-unavoidable credit event. Already, the deteriorating ability of the company to generate sufficient cash flow in the near term has led Agricultural Bank of China, the country's No.3 lender by assets, to make some loan loss provisions for part of its exposure to Evergrande. China Minsheng Banking Corp, another lender, while prepared to roll over some near-term debt obligations, has cut its loan exposure to Evergrande to 30 billion yuan from 40 billion yuan over the past 12 months, and also stopped offering new loans to Evergrande in recent months.
On the ground, the dire situation is spiraling: buyers are hesitant to acquire residential projects from Evergrande on delivery fears and suppliers have stopped work on payment fears – a vicious cycle leading to inability to deliver cash flow. It is reported that the company is giving units to suppliers in lieu of cash while some creditors have gone to the courts for recourse.
Still too big to fail? Yes and maybe no
While the Chinese authorities have so far intervened administratively by asking banks to allow for payment extensions and providing short term cash injections to try and ensure market functioning remains orderly – the People's Bank of China (PBOC) injected US$14 billion of short-term cash into the financial system last Friday in order to calm the markets – it remains to be seen if an outright bailout of Evergrande is likely. Thus far, the PBOC has requested all main Evergrande lenders to review their loan exposure and assess relevant financial risks on a monthly basis but has not provided any indication to Chinese lenders of a possible bailout. To note, Chinese regulators have increasingly tried to rein in domestic banks' unbridled lending to property companies, reiterated the need to curb property speculation, and emphasized the importance of deleveraging in the property sector.
There are a number of possible outcomes for Evergrande:
- The company, in effect, has lost access to all funding channels and, without government intervention, it would not take long before it defaults on its debt. In the “worst” case scenario, the government may step in to manage an orderly liquidation of Evergrande, but before doing so, it would have to undertake related risk evaluation among the financial institutions before letting that happen. A messy default on loans could stoke fears of widespread contagion, something the government will be keen to avoid even as it tightens financing restrictions on overstretched developers and discourages government bailouts.
- A corporate restructuring and partial bailout: a likely scenario is the segregation of project companies from the onshore holding company (Hengda) to ensure asset values are materialised and the cash flow is used for project construction only. Given that, project delivery will be most important from a social stability point of view and hence, home buyers and suppliers are most important among the stakeholders. A debt restructuring of the main onshore holding company would then take place, with a significant haircut to bondholders similar to HNA and Anbang.
- In the “best” case scenario, the government bails Evergrande out completely, similar to what they have done with Huarong Asset Management in a $7.7 billion bailout by Citic Group and other state-owned enterprises – a clear case of a company that is “too big to fail”.
Can history provide a guide? Still follow the policy?
Historically, Chinese state-owned enterprises and economically important private firms have accepted a certain level of moral hazard. Overleveraged, risky investments were okay, as it was assumed that the government would step in with a bailout in times of distress. Domestic and foreign investors have generally factored this into their risk models as a given. However, bondholders’ were negatively surprised when Beijing allowed Yongcheng Coal, Huachen Automotive, and Tsinghua Unigroup – all state-owned enterprises – to default over the past year. The government has made it clear that it will now allow “debt bombs” to detonate and only step in to save economically important firms.
Since then, investors have been given another opportunity to ponder on the question of which firms are economically important enough for a bailout. Huarong Asset Management, one of China’s big four state-owned asset managers and distressed debt collectors, serves as a prime example. In April 2021, the firm announced that it would be delaying its annual financial statements, which triggered a collapse in bond prices. After a four-month delay, the statements were released, revealing a 90 percent year-over-year profit drop during the pandemic. Effectively, the firm was on the chopping block for default and Beijing had a Lehman-sized issue on its hands. Given that the company was responsible for mopping up non-performing and deteriorating loans in the traditional banking sector, Huarong’s failure had the potential to send shock waves through the entire economy. So, after months of back-and-forth, a $7.7 billion bailout was arranged in which Citic Group and other state-owned investors injected the company with liquidity. Since the onset of China’s wave of defaults in 2020, this has been the first clear case of a company that was “too big to fail.”
Is Evergrande economically important enough to warrant help?
Historically, Chinese firms have been granted relatively easy access to credit, and non-financial corporate debt growth has ballooned at an unsustainable pace. Since 2015, Beijing has embarked on a targeted deleveraging campaign, particularly on over-indebtedness in the real estate industry. Last year, the Chinese government instituted a lending limit that applies to property developers known as the “three red lines.” The new policy seeks to ensure sustainable growth within the industry by setting caps on the amount of debt that can be held relative to cash on-hand. The “three red lines” specifically refers to debt-to-equity, debt-to-cash and debt-to-assets, of which the policy limits their annual growth at no higher than 15 percent.
That said, the sheer scale of Evergrande’s debt burden points to a likelihood of a partial bailout or a managed restructuring to mitigate systemic contagion to the broader economy and financial system. Standing in excess of $300 billion, Evergrande’s liabilities exceed Huarong’s total liabilities of $238 billion. If bond prices and ratings agencies are anything to go by, it seems that default is all but imminent for Evergrande, but Chinese regulators will struggle to look the other way in the event that the firm defaults, especially in a shorter-than-expected time frame. In bailing out its most bloated property developer right now, Beijing may be shooting itself in one foot to save the other: the $300 billion bailout would transfer the liability to the government and worsen the government’s pre-existing debt hangover. But up to 1.2 million people could be waiting to move into their new homes – homes that might never be finished. Upstream suppliers contributing materials or other resources to the projects are also awaiting payment. A near-term default for Evergrande could then mean temporary homelessness for many buyers and empty hands for Evergrande’s suppliers. The risk of not doing anything is just too high.
Ripple effect, contagion…
Yes, to ripple effect: An Evergrande collapse, even a managed one, would reverberate through the Chinese economy given the company’s liabilities is equal to 2% of the country's GDP. Pessimistically, a full-blown collapse would send ripples through the Chinese economy. Currently, more than three-quarters of household wealth in China is tied up in real estate, and Beijing has a strong incentive to make sure that such wealth doesn’t go down in an exploding bubble. A collapse of Evergrande would be detrimental to property values, which would deal a blow to consumer wealth and in turn lead to a slowdown in consumption and investment, in addition to other consequences. The firm is so big that this ripple effect is highly likely. Already, signs of a ripple effect are surfacing, though unrelated to Evergrande. The share price of Ping An, China’s largest insurer, fell sharply this year after it was revealed that the company took a $3.2 billion hit in the first half of the year after the default of China Fortune Land Development, a developer that specialises in industrial parks in the northern Hebei province. Ping An has Rmb63.1 billion ($9.8 billion) of exposure to the country’s real estate stocks across its Rmb3.8 trillion of insurance funds.
So far this year, mainland developers have had trouble issuing new offshore papers and most likely, would continue to face higher financing rates and reduced access to the offshore bond markets. The downside implication for smaller developers is more severe: residential sales and prices are falling across many Chinese cities and, with tighter property financing measures, will lead to falling contract sales and in turn, cash collection and flows concerns. Evergrande’s bond issuance makes up around 16% of China’s high yield market and a default will lead to a decline in confidence and reaffirm the view among investors that developers will face increasingly challenging financing conditions. In any event, it is also difficult to refinance through the bond market and more defaults are likely especially among the smaller players.
Limited contagion: It is likely that a corporate restructuring for Evergrande will take place, similar to the likes of HNA and Anbang. In the last few years, regulators have already gained some expertise in winding down unwieldy debt-fueled conglomerates. The restructurings of Anbang Group Holdings Co. and HNA Group Co., while painfully slow, were largely orderly and did not prompt a Lehman-like moment. Chinese policymakers would not allow those companies to threaten the financial and the broader economic system. Similarly, Evergrande is likely to be taken over, broken up, and liquidated as it is too big to fail. The current situation is not systemic: it is estimated that Evergrande’s loans and bonds account for about 20 basis points of total banking system loans and, even in the event of a default, would increase nonperforming loans (NPLs) by just 14% from the existing ratio of 1.8% (as of June 2021). At its peak, the NPL ratio in China reached 12.4% in March 2005 before falling to a record low of 0.9% in September 2011. So far, corporate borrowers have signaled that banks are still willing to lend and costs have stayed relatively stable. And because the government has focused its attention on de-risking the property sector in recent years and other developers have done good jobs of reducing their debt burdens so far, a full-blown banking system crisis is unlikely.
… But not a Lehman event
The collapse of Lehman Brothers, tied to global imbalances, excessive risk taking and lending, derivatives linked to mortgage-backed securities and cross collateralised debt obligations, ultimately led to a near-credit freeze in the global banking system that fueled the global financial crisis in 2008. Evergrande’s woes, though severe, are nowhere near as catastrophic. Throughout previous episodes, the Chinese government has shown that it has the means and the political willpower to manage through a crisis. Through its ownership of the four largest state-owned banks, the Chinese government is technically the world’s largest lender, and by alignment with the PBOC, has shown to be effective in managing through macroprudential risks. This time is no different. There is ample liquidity in the domestic banking system and banks are generally healthy and well capitalised. Yes, there will be a hit to bondholders. The outlook for the residential sector, already reeling from policy measures, may become more uncertain which, in turn, impacts mortgage values and banking profitability. Some banks, such as China Minsheng Banking Corp, will take a harder hit. Shareholders and buyers of Evergrande will face an uncertain road ahead. The broader Chinese economy may face near-term headwinds from the hit to sentiment. And in the case of a sharper property correction, both fiscal and monetary policies are likely to be eased further towards the end of 2021, with adjustments in property policies as well. Evergrande will be a warning and education to the market, help is on the way but no, there will not be an explosion of the “debt bomb” in this case.