September 24, 2021
Evergrande’s debt distress: Withdrawal symptoms of China’s debt-fueled growth model
China’s giant property developer Evergrande Group seems to have missed an interest payment of US$ 83.5 million on an 8.25% 2022 US$ note due September 23, 2021. The Group has therefore entered a 30-day grace period before being declared in default. However, whether in formal default or not — the Chinese authorities have reportedly instructed the Group to avoid a “near-term default on dollar bonds” — Evergrande will need to restructure its debt. The Group has almost RMB 2 trillion (US$309 billion) of liabilities. Of this, RMB 572 billion (US$ 88 billion, reduced from US$ 110 billion at the end of 2020) is classified as debt with maturities longer than one year, with US$ 669 million of interest payments due by the end of the year. The remaining liabilities consist of commercial bills, supplier and trade payables, and obligations to homeowners. Clearly, Evergrande will be the largest corporate debt restructuring event in China to date and already has significant financial implications in and outside of China.
A policy-triggered debt crisis
Evergrande’s troubles started when its debt-fueled business model became unsustainable thanks to China’s attempts to rein in significant growth of debt in the property sector. Since August 2020, China’s authorities have implemented a “three red lines” policy, according to which a property company cannot borrow new debt unless it satisfies three leverage ratios: liability to asset less than 70%, net debt to shareholders’ equity less than 100%, and cash to short-term debt not less than 100%. Having failed to meet these required ratios, Evergrande and multiple other Chinese developers could not borrow new debt to refinance old debt and continue normal operations. They have until 2023 to fix the non-compliance problem. As a consequence, the Group has failed to finish many projects, estimated to involve 1.5 million units (leading to protests by buyers who had already paid for units). It has also not been able to start new projects so as to sell units and generate the cashflow needed to sustain its business. A liquidity crisis quickly morphed into a solvency problem, with Evergrande reportedly failing to sell some of its non-core assets (including its electric vehicles and property services units — even at discounted prices) to raise cash to meet debt servicing obligations.
Evergrande is the second biggest property developer in China, with assets around US$355 billion over 1,300 developments, 200,000 employees and hiring up to 3.8 million workers every year for project construction and development. Evergrande’s share price has tumbled by more than 75% year to date. Its failure will directly hurt its employees, contractors, and suppliers (most of whom have not been paid), as well as customers (who will not receive paid-for units), creditors, and investors. It has already negatively impacted other property developers in China and Hong Kong, as well as banks and other financial institutions (in China and overseas) holding Evergrande’s debt. The real estate sector accounts, directly and indirectly, for about 29% of China’s GDP. The sector’s problems compound the impacts of the Delta variant by slowing economic activity. Many analysts have cut China’s 2021 growth estimates by 30-50 basis points, and by almost a percentage point in 2022. In particular, emerging markets (EM) have been hurt by the combination of China’s slowdown and the Fed’s indications that it will taper its bond purchases soon. So far, commodity prices, such as prices of iron ore and copper used in construction, have declined. With capital flows to EMs falling, EM financial markets are significantly underperforming their mature market counterparts, exemplified when Evergrande’s distress drove equity selloffs across the world on September 20.
Judging by how Chinese authorities have managed previous corporate default situations, it is clear they will not bail out Evergrande with public funds. Doing so would undermine their policy to restrain the growth of debt in the property sector. Nor will China allow the uncontrolled collapse of Evergrande to threaten financial and social stability. This is clearly not China’s Lehman moment, as suggested by some analysts. Recent developments indicate that the authorities will likely guide the workout of Evergrande’s liabilities, preferably in pre-default restructurings, to buy time for the losses to be absorbed in an orderly fashion. This strategy is intended to limit contagious impacts on financial markets and the wider economy, following a seniority waterfall reflecting Beijing’s political priorities.
Debt workout according to China’s seniority waterfall
Beijing’s first priority is to conserve available cash at Evergrande and use it to pay workers, suppliers, and contractors to finish the projects under construction, and to deliver units to buyers who have paid. The authorities may even encourage healthy developers and other companies to take over and finish some of Evergrande’s projects. Frustrated homebuyers demonstrated at Evergrande headquarters and could spark further social unrest, something Beijing clearly wants to avoid.
Chinese banks, both private and state-owned, account for RMB 227 billion (US$ 35 billion), or 40% of Evergrande’s debt. Reportedly, some banks have not received interest payments and tried to reach agreements with Evergrande to reschedule debt and stretch out payments. It is likely that the banks will be encouraged to keep providing liquidity to Evergrande to keep its essential operations going. In any event, China’s banking system is well capitalized, with the average capital adequacy ratio currently at 14.7%. It is quite able to absorb potential losses on the scale of Evergrande and more. A recent stress test by the PBOC shows that even with a sharp rise in the bad loan ratio for property development loans by 15 percentage points ,and for mortgages by 10 percentage points, the average capital adequacy ratio would fall to 12.3%. This represents a big hit, but still leaving banks above the minimum required ratio of 9.5%.
Evergrande has pressured its employees as early as April to lend to the Group through investments in its wealth management products (WMPs — which means losing their performance and bonus payments). These employees and investors have joined others — totaling 80,000 holding RMB 40 billion of WMPs — to demonstrate and demand their money back. Reportedly, Evergrande has offered to repay those investors with discounted property units. However, this may not be a viable solution as the Group faces strong demands to delivers units to homebuyers who already paid for units.
Evergrande will try to negotiate some form of debt rescheduling with holders of RMB 53.5 billion onshore bonds. The proposal will be similar to the “off clearing house” resolution deal it reached on September 22 with holders of the RMB 4 billion, 5.8% 2025 onshore bond. It is essentially a pre-default restructuring, likely involving some forms of extension, partial payments, or coupon reduction. The challenge is that the process of onshore debt negotiation and restructuring lacks any transparency. As a result, the terms of the restructured deal are not publicly known.
This approach in dealing with Evergrande’s troubles leaves holders of the US$ 19.2 billion offshore bonds at the bottom of the seniority waterfall, probably facing difficult restructuring negotiations with Evergrande. The 8.25% 2022 bond issue has been trading in Hong Kong at around 25-30 cents on the dollar, reflecting investor expectation of a deep haircut in the restructuring process. This has already negatively impacted Asian offshore US$ bond markets, where Chinese property developers have issued US$ 221 billion of bonds.
In the meantime, the People’s Bank of China (PBOC) has repeatedly injected net new liquidity to the banking system to ease financing pressures. This is expected to continue, likely on a scale commensurate with any money market pressures that might develop.
In short, the Chinese authorities will use all means at their disposal to engineer a restructuring of Evergrande’s debt with manageable contagion to the financial system and the economy.
Concluding observations
More broadly, Evergrande’s debt restructuring has accelerated the pace of corporate debt default in China. In the first half of 2021, there was about RMB 116 billion (US$ 18 billion) of corporate debt default — mostly on onshore bonds — compared with RMB 187 billion (US$ 29 billion) for the whole of 2020, previously a record high. With a non-financial corporate debt to GDP ratio of 157.6% (the highest in the world but declining from 163% over the past year, according to the Institute of International Finance), China’s attempts to control the debt growth in the property sector and other sectors will likely generate more debt distress in the future among both private companies and state owned enterprises. While the process will likely be managed to avoid triggering serious financial instability, it will nevertheless slow China’s growth in the foreseeable future.
This expected slowdown highlights the key contradiction in China’s policy goals at present. On one hand, China wants to implement a dual circulation strategy to make its economic growth more domestically and less externally driven given the intensifying strategic contention with the US and the West. On the other, China also wants to reduce the leveraging of its economy, especially in the property sector, to reduce risks of financial crises, as well as reining in its big high-tech and platform companies for political and social reasons. However, these policies will slow growth in the interim period until a new growth paradigm can be found, making its dual circulation strategic goal more difficult to achieve. It is not clear how President Xi Jinping plans to resolve this fundamental contradiction, or if he even can.
Hung Tran is a nonresident senior fellow at the Atlantic Council, a former executive managing director at the Institute of International Finance and former deputy director at the International Monetary Fund.
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