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China’s moment of reckoning: The Evergrande crisis

China's opaque financial system has been a cause of concern for its financial stability and is now keeping overseas investors on edge as its fragile property sector slid deeper into economic angst. 

Fitch Ratings said that two Chinese real estate giants, China Evergrande Group and Kaisa Group Holdings Ltd., have defaulted on US$1.6 billion worth of bonds owed to global creditors. Evergrande is the world's most indebted real estate developer, with a staggering load of more than $300 billion in liabilities. This includes $19.2 billion of dollar debt. "With an illiquid portfolio of property projects financed by $300 billion of liabilities, 80% of them short-term, Evergrande has a huge liquidity mismatch," as per a recent article in The Economist. 

Last month it missed its first foreign bond repayment, and despite a 30-day grace period, it didn’t make good with its creditors. Kaisa, a smaller property company, had defaulted on a $400 million bond payment that was due in the first week of December.  

Fitch has since downgraded Evergrande and Kaisa to a "restricted default" rating over their failure to meet their financial obligations. 

Coming less than a week after China Evergrande Group and Kaisa Group Holdings Ltd. were officially labeled defaulters, there was a sudden drop in Shimao Group Holdings Ltd.'s bonds and shares. Shimao is China's 13th biggest developer by contracted sales. 

The fallout in China's property sector is showing no signs of abating, as more developers face the threat of default. "There is extreme stress in the market with about half the developers in the country in deep financial distress and pricing in high default risk," observed Jenny Zeng, co-head of Asia Pacific fixed income at AllianceBernstein. 

According to Moody's estimates, real estate and related industries account for about a quarter of China's GDP. Most property companies built their empires on borrowed money, primarily from bondholders, banks and construction contractors.

For more than a decade, Evergrande rode China's epic property boom that urbanized large areas of the country for its rapid economic growth, the likes of which the world had never seen. They minted money and expanded aggressively into new areas to become one of China's biggest companies, but imprudently, ended up with more debt than they could pay off - they borrowed more than $300 billion. The People's Bank of China (PBC), China's central bank, has blamed Evergrande's "own poor management" and "reckless expansion" for the problems it faces. 


Why are the real estate developers in trouble?

First, in the summer of 2020, the Chinese regulators imposed curbs on excessive borrowing in the real-estate industry to bring financial discipline, avoid enormous debt build-ups that threaten financial stability, and rein in rampant speculative buying. The property industry was squeezed by the tightening credit conditions forced by the government authorities to limit reliance on debt. 

Second, by July 2020 there was a fall in the housing sales, and the advent of Q3 2021 brought about a significant contraction in the Chinese property and construction business. The weak demand, declining sales and discounted prices (offered to homebuyers to keep the business afloat) contributed to an overall slowdown in China's economic growth, exacerbated the real estate crisis and added to the deteriorating cash flows of developers. Companies that accrued exorbitant debt to expand began struggling to complete housing projects and meet domestic and foreign repayments. 


Will Evergrande escape calamity? 

Is Evergrande too big to fail? Will it be allowed to fail, sold off to other Chinese companies, or offered a bail out? Will it become China's Lehman moment? These questions loomed over Evergrande and the global financial system and its key stakeholders for months. And now the Chinese government has made it clear that the real estate behemoth is headed for one of China's largest-ever debt restructurings. 

In recent times, Beijing has shown greater proclivity to let companies stand on their own or fail to control China's debt problem. This massive restructuring exercise will entail Evergrande's overhaul of its balance sheet without a government bailout - a process that will represent a serious risk to the Chinese economy. 

According to a recent article in Bloomberg, the government is now taking a more hands-on role at Evergrande. A seven-member "risk management committee" to restructure Evergrande, including officials from state-owned enterprises, has been constituted at the behest of the authorities. Only two executives from the company are on the committee, including its founder, Hui Ka Yan. 

Two weeks ago, PBC released $188 billion (1.2 trillion yuan) of liquidity through a cut in the reserve requirement ratio for banks. This was done by China's central bank to limit the real estate crisis fall out and to extend financial support to the housing market. 

"An orderly restructuring, where the company can run its operations as normally as possible and refrain from distressed asset sales will substantially help contain further damage across the sector," commented Jim Veneau, head of Asian fixed income at AXA Investment Managers. 

Evergrande said in a brief exchange filing on December 3 that it plans to "actively engage" with offshore creditors on a restructuring plan. However, Evergrande's bondholders have said that they expect international investors to be near the bottom of the queue for repayment. 

"Evergrande is complex and has entities in companies both inside and outside the People's Republic of China," remarked Daniel Anderson, a partner at the law firm Ropes & Gray in Hong Kong. "There isn't a clean, single legal mechanism that can be implemented to restructure the group. As a result, it will have to be across jurisdictions, which will make it highly complex." 

What happens next is really in the hands of the Chinese government authorities - will it be bankruptcy, a sale, or some other option - that remains unknown. "We all expected that Evergrande was not going to be able to pull a rabbit out of their hat," noted Michel Lowy, chief executive of SC Lowy. "Now, the ball is in their court to come up with some form of restructuring proposal," he added.  Yi Gang, the central bank governor, has indicated that Evergrande is not likely to get a bailout. 


What will be the impact if Evergrande fails?

The real estate crisis has fueled fears of wider shock waves for the global financial system and spooked investors who fear contagion across China's property and banking sectors, including domestic consumption and international commodity markets. 

If embattled conglomerate Evergrande goes bust, it could affect global financial markets and make it difficult for other Chinese companies to continue to access finance for their business from foreign investors. These investors, unnerved by the troubled Chinese property giant, may pull their dollars out of China to safer quarters and won't return to it as an investor. 

A collapse can also compel the Chinese financial system dominated by banks to turn conservative and lend less. "A failure could result in a credit crunch for the entire economy as financial institutions become more risk averse," said Zhiwu Chen, a professor of economics at the University of Hong Kong (HKU). And a credit crunch in the world's second largest economy will affect global growth. It certainly could have consequences for many countries that are linked to China through trade. 

Many of the housing unit projects were bought and money paid for in advance by individual buyers. Chinese consumers who bought property from the beleaguered real estate company could lose that money if they collapse or go bust. "The Evergrande debacle has probably given homebuyers concerns about whether developers will honor presale commitments," observed Julian Evans-Pritchard, senior China economist at Capital Economics. Also, the construction contractors and suppliers who did business with Evergrande would be at risk of incurring major losses, which could force them into bankruptcy. Notwithstanding, the related loss of millions of jobs would severely impede China's economic activity. 

Foreign investors are owed $1.3 billion in U.S. bond payments in December, according to Bloomberg-compiled data. These investors are worried that the money they are owed may be difficult to recover, and if there are any bankruptcy proceedings, they would be low on the list of creditors to be repaid.

"For global bondholders, the Evergrande default is likely to start a prolonged battle for repayment. Chinese authorities have made it clear the company should put homebuyers, suppliers, and retail investors - who bought the firm's wealth management products - ahead of debtholders. Some 1.6 million homebuyers have put down deposits with Evergrande for properties that have yet to be completed," as has been reported by Bloomberg recently. Evergrande's offshore noteholders included Ashmore Group Plc, BlackRock Inc., Fidelity International Ltd, UBS Group AG, and Allianz SE, according to data compiled by Bloomberg. 

Most likely to be hurt are those holding the company's U.S. dollar-denominated debt, who will face a "haircut" - they will be forced to accept payments of less than they are owed by Evergrande. 

"No matter what the outcome, offshore bondholders are last in line for payment and are certainly going to have to accept haircuts, possibly significant ones," said Andrew Collier, managing director of Orient Capital Research in Hong Kong. 

"With Evergrande's dollar notes trading at about 20 cents on the dollar, the market is already pricing in a haircut of around 80%. The key for bondholders is whether the company can speed up home sales and unload assets to raise cash so it can start settling its liabilities,” stated Gary Ng, a senior economist at Natixis SA.

According to the Federal Reserve, China's real estate travails could spill over into the U.S. financial system. The Fed warned of direct risks to the U.S. in its latest financial stability report (November 2021), commenting, "Financial stresses in China could strain global financial markets through a deterioration of risk sentiment, pose risks to global economic growth, and affect the United States." 

“An Evergrande collapse will not come without suffering,” said Dr. Xin Sun, a senior lecturer in Chinese and East Asian Business at King's College London, in a recent article published in Insider.

"The people who suffer most will be the existing shareholders," Sun said. "Their equity will be wiped out. About 70% of the shares belong to the founder's family, and that will all be wiped out."

For the government, the biggest fear is the potential spillover effect that will hit the wider Chinese economy. If Evergrande were to collapse, it would cause a domino effect across the real estate sector, leading to the demise of more developers. UBS asset management estimates there are 10 developers with potentially risky positions with combined contract sales that is 2.7 times Evergrande’s size. In other words, Evergrande is only the tip of the iceberg.

Evergrande’s failure will also have major ramifications in other sectors it is involved with, including consumer electronics, building materials, furniture and electric cars. If Evergrande goes bankrupt, it will need to engage in the expensive task of protecting tens of millions of homeowners and avoiding social unrest.

Moody estimates that 70% of Chinese household wealth is tied to real estate. And Evergrande’s collapse would mean a significant drop in Chinese home prices. That would shrink the primary assets of the world’s largest middle class. And if that happens it will send ripples across the global economy. That will be a problem the world cannot ignore.

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