Global investors are watching nervously as one of China’s biggest property developers struggles to avoid defaulting on massive debts worth tens of billions of euros, fueling fears of possible wider shock waves for the world's financial system.
China Evergrande Group owes over €250 billion. With interest payments of more than €110 million due this month alone, the company faces a major test.
Economists expect Beijing to intervene if Evergrande and lenders can’t agree on how to handle its debts. But any official resolution is expected to involve losses for banks and bondholders.
Could Evergrande spark a global financial crisis in the same way the collapse of US bank Lehman Brothers did in 2008? Here's an explanation of how we got here.
What is Evergrande?
Let's start with the basics. Evergrande Group, founded in 1996, is one of China’s biggest builders of apartments, office towers, and shopping centres, and one of its biggest private-sector conglomerates.
The company says it has more than 200,000 employees and supports 3.8 million jobs in construction and other industries. Evergrande says it has 1,300 projects in 280 cities and assets worth 2.3 trillion yuan (€303 billion).
Evergrande’s founder, Xu Jiayin, was China’s richest entrepreneur in 2017 with a net worth of €36 billion, according to the Hurun Report, a Chinese equivalent of the Forbes rich list.
He tumbled down the list as tech billionaires like Alibaba's Jack Ma and Tencent's Ma Huateng overtook him, but still ranked as China’s richest property developer last year. He also topped Hurun’s 2020 list of philanthropists, giving away an estimated 2.8 billion yuan (€327 million).
Evergrande's property empire has also branched out into electric vehicles, theme park development, health clinics, mineral water, and other businesses.
Xu built Evergrande on borrowed money, possibly even more so than rivals in an industry that depends on debt. As of June 30, Evergrande reported 2 trillion yuan (€263 billion) of outstanding debts to bondholders, banks, construction contractors, and other creditors.
Of that debt, 240 billion yuan (€31.6 billion) was due within a year, down 28.5 per cent from the end of 2020 but nearly triple Evergrande's 86.8 billion yuan (€11.4 billion) in cash holdings, according to a company financial report.
In early 2021, Evergrande forecast its total annual transaction volume would surpass 2 trillion yuan ($310 billion). It reported a $1.4 billion first-half profit but says sales are weakening because news of its cash crunch is making would-be buyers nervous.
Fears over the company's ability to service its massive debts have impacted its share price. Evergrande’s Hong Kong-traded shares have fallen 85 per cent since early 2021. Its bonds are trading at an equally deep discount.
Evergrande was caught out by new limits regulators imposed on property-related borrowing as part of the Communist Party's marathon campaign to reduce reliance on debt.
Economists have been warning China’s rising debt is a potential threat for more than a decade. The ruling party has made reducing such financial risks a priority since 2018.
But total corporate, government and household borrowing rose to nearly 300 per cent of economic output last year from 270 per cent in 2018. That's unusually high for a middle-income country.
News reports indicate Evergrande borrowed everywhere it could, including by requiring employees of its construction contractors to buy its debt.
In 2017, state-owned China Citic Bank in Shenzhen agreed to lend 40 billion yuan (€5.2 billion) for an Evergrande project only after its executives agreed to invest at least 3 million yuan (€395,000) each, according to the Chinese business news magazine Caixin.
What's the government's position?
The Communist Party has cracked down on debt as it tries to nurture self-sustaining economic growth based on domestic consumption instead of trade and debt-supported investment.
It allowed China's first corporate debt default since the 1949 revolution in 2014 as part of efforts to force borrowers and lenders to be more disciplined. Until then, the government had intervened to bail out insolvent borrowers to avoid spooking financial markets. Beijing has gradually allowed more defaults, but none by a debtor as big as Evergrande.
What about other property developers?
Other major developers such as Vanke Co., state-owned Poly Group and Wanda Group have not reported similar problems. But hundreds of smaller developers have shut down since regulators in 2017 started tightening control over fundraising tactics such as selling apartments before construction begins.
Chinese residential property is regarded as posing little risk to the financial system, however, because most apartments are paid for with cash, not mortgages. That makes a wave of defaults like those in the United States after the 2008 crisis unlikely and easier for banks to manage.
"Given how bloated China’s property developers are, there could be a whole wave of defaults around the corner," but Beijing has resources "to prevent a full-blown Chinese credit crunch," Simon MacAdam of Capital Economics said in a report.
"For all its flaws, this is one advantage of having a tightly controlled financial system versus a more free-market system".
China’s 'Lehman moment'
Some commentators suggest Evergrande might become China’s "Lehman moment," referring to the failure of Wall Street bank Lehman Brothers, a forerunner to the 2008 crisis.
But economists say the risk of wider financial market contagion is low.
"A managed default or even messy collapse of Evergrande would have little global impact beyond some market turbulence," said MacAdam of Capital Economics.
Evergrande has $18 billion of outstanding foreign-currency bonds, but much of that is held by Chinese banks and other institutions. Unlike Lehman, whose assets were financial instruments whose prices can swing wildly, Evergrande has 1.4 trillion yuan (€184 billion) of land and partially completed projects with relatively stable prices.
In the unlikely event of outright default, China’s banking system has an annual profit of 1.9 trillion yuan and reserves of 5.4 trillion yuan against bad loans, "which could easily absorb the loss," Larry Hu and Xinyu Ji of Macquarie Group said in a report.
Investors are waiting to see what Chinese regulators might do, but analysts say they appear to be focused on protecting home buyers by ensuring apartments already paid for are completed.
The government has injected money into other insolvent Chinese companies, but economists say Beijing appears determined to avoid doing that with Evergrande.
In August, Huarong Asset Management Co Ltd, the biggest of a group of companies created to help resolve bad loans held by state banks, was bailed out by a capital injection from state-owned companies after it lost 102.9 billion yuan (€13.4 billion) last year.
In a letter Tuesday to employees, Xu expressed confidence the company will survive.
"Evergrande will surely get out of the darkest moment as soon as possible," Xu said in the letter marking the traditional Mid-Autumn Festival.