The private sector in China faces many challenges, from lackluster global demand to government regulatory interventions.
Of the many recent events, from Ant Group to the collapse of online tutoring industry, the default of China Evergrande Group is the most noteworthy given the high potential impact to the Chinese economy.
What makes Evergrande so important? First, real estate is one of China’s primary industries, accounting for roughly 29% of the Chinese economy, with new commercial housing sales exceeding 17 trillion RMB ($2.73 trillion) in 2020. For Chinese consumers, real estate is where they invest the bulk of their capital, which has alleviated the impact of China’s capital control policy on investment. Secondly, the real estate market is a lynchpin for local government financing, with land sales and bidding serving as the main source of capital for municipalities, who bear the spending mandates for most public services.
China Evergrande Group was the largest property developer by sales in 2020, with an annual revenue of 507 billion RMB ($79 billion) and total assets worth 2.3 trillion RMB ($358 billion) in 2020. It boasts of creating and sustaining 3.8 million jobs a year and hosts over 200,000 employees, with more than 1,300 projects across 280 cities. Evergrande was also known as one of the most indebted real estate developers in China, boasting over $300 billion in liabilities. In the summer of 2021, the company ran into liquidity issues leading to credit downgrades and a default on December 7, with shares declining nearly 90% in value since December of 2020.
It is important to note that the boom and collapse of the real estate sector was precipitated by Chinese government policies.
The current Evergrande liquidity crisis is an indication of a wider and a more prevalent problem in the real estate sector. Most developers have been comfortable using credit to expand their business. Among the top 50 developers, over half have asset-liability ratios higher than 70%. These highly leveraged real estate companies are going to struggle to withstand significant market turmoil. Already, there are at least six real estate developers – the China Evergrande Group, Kaisa, Fantansia, Sunshine City Group, Shimao Property Holdings Ltd., and China AoyuanGroup Limited – that have either defaulted or are in loan repayment negotiations with their investors.
The total liabilities of Evergrande alone are estimated at 2 trillion RMB ($314 billion), equivalent of 2 percent of China’s GDP. Beyond the potential effect on the real estate sector, the challenges facing Evergrande and other real estate developers have a spillover effect on numerous other sectors both upstream and downstream of real estate. For instance, suppliers across the construction, furnishings, landscaping, and advertisements industries are already suffering, with late or missing payments affecting smaller enterprises across China.
Evergrande is estimated to owe more than 200 billion RMB ($32 billion) to suppliers and contractors in the form of commercial papers or IOUs. This is a common practice in the Chinese real estate sector to increase liquidity (by borrowing) and to avoid regulations: commercial papers or IOUs are not accounted as interest-bearing debt. Because of this, it is hard to estimate accurately Evergrande’s liabilities: other estimates put the outstanding loans at almost 1 trillion RMB.
When Evergrande made payments to suppliers in IOUs, some suppliers use these notes to pay their own suppliers. Companies may also have sold the notes for 80-85% of the face value to raise needed cash. Now, these IOUs are untradeable and barely worth money, leading to protests outside the Evergrande headquarters by supplies and homeowners.
A wave of defaults would also have significant, negative effects on buyers, property owners, and consumers within the Chinese economy. Due to the current “pre-sale” system in China, and the significant lack of mortgaging and credit available for property, most of a property’s value must be paid by the buyer upfront, as evidenced by the central government in Beijing requiring an 80% minimum down payment starting in 2017. Such high requirements undercut the rights and interests of property buyers, both homeowners and investors, and force them to bear most of the risk. They will feel the effects of a general contraction of the Chinese real estate market the most, alongside those in industries directly servicing real estate and the developers themselves.
Ultimately, investors will be forced to accept extensions, while home buyers are facing unpredictability about housing and investment. Regulators and the central government in China are currently auditing the Evergrande ledgers, but there is no clear indication that a bailout will happen. Indeed, some predict the government will not rescue these developers to avoid incentivizing such practices in the future, despite the potential economic fallout.
Given these conditions, the current Evergrande crisis could lead to a cascade across the real estate sector in China, as other real estate developers may potentially default on domestic and foreign bonds in a negative feedback loop. While it is unclear if this outcome is certain, the economic hardships endured by small and medium sized enterprises catering to Evergrande across China and the centrality of the real estate sector to government financing and economic growth indicate that a full collapse of the real estate sector in China would almost certainly lead to an economic recession, potentially of global proportions.
One possible outcome is that the government will work with Evergrande to follow the HNA playbook (debt restructuring plan led by government-appointed task force and executed based on market rules) to let Evergrande declare bankruptcy and assist in making the situation more controllable and manageable.
It is important to note that the boom and collapse of the real estate sector was precipitated by government policies. Beijing relied on developers to drive up land and property prices in order to boost economic growth numbers.
In China it is challenging to get into the land business without political connections. It is even harder to secure credit from banks. In a highly regulated environment, the state allowed a handful of huge developers to expand recklessly. When times are good, the central government takes credit for managing and growing the economy. In a crisis, the developers shoulder the blame for mismanagement. After Huarong (a state-owned assesst management firm) and HNA (a conglomerate held by businesspeople closed to political elites), Evergrande is simply another poster child of the ironic lack of institutional control in a Party-controlled state.