The Chinese conglomerate Evergrande has long been a symbol of China. In addition to being a real estate developer, he’s a conglomerate with many different business areas, including electric vehicle manufacturing. The fact that Evergrande was able to become so big was also due to an enormous “leverage” through the borrowing of outside capital. Such loans are used to make investments or carry out projects. If these activities do not develop well, the potential risks multiply. Evergrande was very heavily “leveraged” in this sense, ie the debts were higher than the equity.
This didn’t seem to bother anyone until President Xi convened a commission of experts to reduce the debt of Chinese corporations in mid-2017. After that, however, the corporate debt continued unhindered until the economy – and thus also the real estate sector and, of course, Evergrande – was hit by the Covid-19 pandemic. The Chinese real estate sector has long been too big and too risky. This is no coincidence, but was at the heart of the Chinese leadership’s plan to rebuild the economy after the 2008 global financial crisis. Promoting real estate supply and related sectors has been an easy way of generating income for local governments looking to increase growth and employment.
The Chinese real estate sector has long been too big and too risky.
The Chinese economy showed clear signs of overheating as early as 2010, largely due to the construction boom. This prompted regulators to limit bank lending to the already over-indebted real estate sector. As a result, however, the developers found other ways to secure their financing: They issued large quantities of bonds and aggressively pushed ahead with pre-sales of apartments. And since they needed regulatory approval for the domestic bond market, many switched to the overseas dollar bond market.
The demand for housing in China was assured to the extent that real estate was the most important option for investors to invest their savings in the face of the still draconian capital outflow controls. Investing in real estate has been a bonanza for Chinese households as prices rose almost steadily until recently. In 2021, however, house prices suddenly fell. There were several reasons for this.
First and foremost, the sudden surge in regulation to control property developers’ overstretched balance sheets has resulted in some large real estate groups like China Fortune Land were restructured – even before Evergrande got into trouble. In other words, while Chinese households are still inundated with rosy images of the sector and the Chinese economy in the local media, they have become increasingly cautious about investing in real estate.
The second reason is that the tightened controls affect not only developers, but also property buyers, who have to pay large down payments and are afraid of the introduction of a nationwide property tax that has been rumored about for some time. Finally, Chinese households are feeling the strain of an economy that has been declining rapidly in recent years – not just due to its own overcapacity, but also from the US trade and technology war and the pandemic. The Chinese government is cracking down on the real estate sector by introducing what are known as the “three red lines” to reduce its debt and limit its reliance on upfront sales and short-term financing. This takes place against the background that the long-term Chinese economic goal is changing from growth to shared prosperity.
This shared prosperity is Xi Jinping’s new economic mantra to emphasize the importance of better income distribution and greater equality. Extremely high and rising house prices are probably the main source of income inequality in China. Access to or lack of housing is a key factor in explaining differences in prosperity.
Shared prosperity is Xi Jinping’s new economic mantra to emphasize the importance of better income distribution and greater equality.
In this environment, Evergrande was a prime target for the government’s crackdown for several reasons. First of all, the group is simply the largest real estate developer. Second, it’s also the most indebted, crossing all three of the red lines mentioned above. And thirdly, Evergrande is heavily dependent on foreign investors through its listing on the Hong Kong stock exchange and its bond issues on the foreign market there. The outstanding bonds, mostly quoted in dollars, totaling nearly 20 billion US dollars, were mainly bought by foreign private banks and asset managers for their wealthy clients.
Since a dollar bond coupon was not paid out last Thursday, it is clear that Evergrande’s foreign debt is being restructured. If you take the group China Fortune Land as an example, which is itself in the process of restructuring, this does not necessarily have to take the form of a nominal haircut, but can also mean that the terms are extended and the interest payments due are reduced. If it comes down to that, overseas investors will likely be relieved as they will have clarity about the future of their investments in Evergrande.
However, the company is still largely indebted domestically (of the $ 300 billion total debt). These loans have to be serviced – especially the equivalent of $ 200 billion that Evergrande received from Chinese households in advance. Almost 1.5 million households in the country are waiting for Evergrande to complete their housing units. This will certainly happen as other real estate developers are also heavily dependent on prepayments. So if Evergrande failed to deliver on its promises, pre-sales of real estate in China would dry up, bringing most property developers to the brink of collapse. Furthermore, it does not fit with the strategy of shared prosperity to pass the losses on to households. So the Chinese government has already clearly signaled that the local governments will take care of the unfinished projects.
Economic success is no longer the goal and financial excesses are punished.
Two fundamental conclusions can be drawn from this about the future of the Chinese economy. First, the Chinese real estate sector is not going to collapse because of the Evergrande problems as public funds are used to alleviate the impact on the Chinese economic system. However, this does not mean that everyone, especially foreign investors, will be fully compensated. Evergrande must also act as a warning sign of the risks of excessive indebtedness. The second lesson is that China’s growth will suffer from all of this. Not only will the real estate sector, which is critical to the country’s investment, employment and growth, slow down after Evergrande’s decline, but investors in general will be increasingly cautious in light of the drastic shift in Chinese priorities.
In short, economic success is no longer the goal and financial excesses are punished. The most important strategy is now to contribute to the common prosperity – and this also at the price of disappointed private investors and thus a possible stagnation of the economy.