Does Evergrande’s bankruptcy threaten China’s economy?

How did Evergrande reach its collapse point?

Evergrande Group was founded in 1996 as a private real estate development company. At the time, China was rapidly urbanizing and the government was dismantling the state-provided housing system by privatizing urban housing. The company’s core business is real estate development, but it has also diversified into other industries such as electric vehicles, finance, healthcare, and tourism. Evergrande debuted as a Fortune Global 500 company in 2016, just 20 years after its founding, and managed to remain on the list until 2022. In 2018, it was ranked the world’s most valuable real estate brand, but was downgraded to “restricted default.” ” US rating agency Fitch gave the rating in December 2021 after the company defaulted on interest payments on dollar-denominated bonds twice. In August 2023, Evergrande filed for Chapter 15 bankruptcy protection with the U.S. Bankruptcy Court for the Southern District of New York as a necessary step to reorganize its foreign debt.

Evergrande’s rapid growth has been made possible through aggressive borrowing and unconventional financing. Its aggressive use of leverage has made it the world’s most indebted real estate developer. In 2022, the company’s total debt exceeded $335 billion*, which is more than 10 times its total revenue and approximately 1.8% of China’s gross domestic product (GDP) in the same year. Of the debt, $25.4 billion was owed to foreign creditors.

Evergrande’s debt-fueled expansion quickly became unsustainable. Starting in August 2020, Chinese regulators will restrict real estate developers’ debt-to-cash, debt-to-assets, and debt-to-equity ratios through a series of restrictive guidelines called “regulations,” making the real estate sector more affordable. An attempt was made to curb excessive borrowing. 3 red lines [link in Chinese]. These restrictions backfired, exacerbating market stress and jeopardizing the real estate industry by hurting developers’ balance sheets. Evergrande recorded a combined net loss of $81 billion in 2021 and 2022.

What is driving China’s real estate boom?

From the early 2000s to the mid-2010s, housing prices skyrocketed across China, with “first-tier” cities such as Beijing, Guangzhou, Shanghai, and Shenzhen leading the charge. From 2003 to 2014, home prices in China rose by more than 10% per year, even after adjusting for inflation. China’s home price rise is much larger than the US housing bubble.

This boom was driven by two major housing reforms over the past four decades that transformed China’s socialist housing towards privatization and marketization. 1988 [PDF] Urban housing reform encouraged households living in employer-provided rental public housing to purchase housing at below-market prices. In 1998, additional reforms introduced market-based housing and abolished the old system linking housing allocation to employment.

The privatization and marketization of housing has contributed to a rapid increase in homeownership rates, leading to significant increases in housing and non-housing consumption, but its unintended consequences have been to increase housing costs, land prices, and vacancies. There has been a sustained increase in rates.

Furthermore, as a result of the Chinese government’s long-term financial repression policies, including persistently low real deposit interest rates and capital controls, households have limited alternative investment options, accelerating speculative investment in the housing market.

Could Evergrande’s bankruptcy have broader ramifications, or could it represent a sustained threat to China’s growth?

Evergrande’s bankruptcy is not the result of China’s Lehman shock. The collapse is unlikely to immediately spread throughout China’s financial system. The collapse of US investment bank Lehman Brothers in 2008 was the largest corporate bankruptcy in US history at the time, and had a negative impact on the US financial system. The company’s failure was due to aggressive lending fueled by excessive use of novel, risky, and opaque financial engineering products and excessive risk-taking without adequate risk management. Unlike Lehman, Evergrande’s bankruptcy was due to excessive borrowing and aggressive use of leverage, not excessive securitization. Furthermore, Evergrande’s financing was only 0.2%. [link in Chinese] China’s corporate bonds accounted for only 0.04% of China’s domestic bond market.

But Evergrande’s creditors also include Chinese home buyers and companies along the real estate development supply chain, such as construction companies, home appliance manufacturers and home decor companies. Evergrande’s bankruptcy has exacerbated the problem of weak investor and consumer confidence in China’s economy. This will cause a further negative confidence shock to Chinese households, and will deter many potential homebuyers from making a purchase. It will take time to regain your confidence. Meanwhile, declining confidence has slowed demand growth in the housing market, weighing down the entire real estate sector, which accounts for nearly 30% of China’s economy.

Disruptions in the real estate market also bode poorly for local governments and households, as they lead to increased leverage and reduced consumption, making it more difficult to expand aggregate domestic demand.

In other words, it is unlikely that Evergrande’s failure will cause a wave of contagion and lead to a large-scale bank failure. However, the negative shock to the real estate sector and the Chinese economy, as well as the damage to Evergrande’s corporate creditors, further increases the obstacles facing China’s economic recovery.

How could it change the way global investors view China?

China’s central bank and financial regulators have lifted some restrictions on the real estate sector and encouraged and expressed willingness for banks to provide reasonable liquidity support to real estate developers. [link in Chinese] Work with local governments to resolve hidden debt issues. However, the Chinese government’s lack of willingness to support households amid counter-espionage efforts and weak ties with the West have increased policy uncertainty and risk premiums in China. The Chinese government is trying to encourage foreign direct investment (FDI), including 24 concrete reform measures. [link in Chinese]new FDI to China will decrease in 2023 [link in Chinese] For the first time in over ten years. Even without the Great Collapse, global investors need to recognize that the structural problems of China’s economy remain unresolved and cannot be easily resolved through China’s fiscal and monetary policies. .

If foreign bond holders are not repaid during the forced liquidation process, it will be a further blow to investor confidence in the Chinese economy. China’s economy is already in decline and is struggling to recover amid growing regulatory uncertainty and geopolitical tensions in China.

A slowdown in the Chinese economy, particularly in the real estate market, could push down commodity prices due to reduced demand for primary products such as oil and steel, which would ease inflationary pressure on the global economy. However, weak domestic demand could increase the likelihood that China will export surplus supplies such as electric vehicles to global markets, increasing the risk of trade tensions between China and the United States and its allies.

*2.4 trillion RMB