Evergrande is only a small drop in an ocean of Chinese debt
Anton 
Chinese property developer, Evergrande, has been in the news recently as its liquidity crisis continues to worsen.
The company is China’s second property developer by sales and its presence across the country is nearly ubiquitous.
“For decades, the Chinese developer Evergrande Group was an embodiment of the success of the rapidly growing Chinese economy. Increasing disposable personal income fuelled a growing passion for purchasing property which in turned propelled the rise of Evergrande, as well as its billionaire founder Xu Jiayin,”explains Quartz.
Previously known as Hengda, Evergrande employs about 200,000 people and the company owns more than 1,300 real estate projects in over 280 cities. Moreover, Evergrande’s property management division is involved in about 2,800 projects across China. It also has ventures in other industries, including healthcare, electric vehicles and consumer products.
However, to get to this size, Evergrande fuelled its growth with debt. After years of aggressive expansion, the company is now sitting on c.$300bn of liabilities (the equivalent to almost ¥2trn).
Evergrande typically sells the properties it develops to buyers who pay in advance while its payment to suppliers reply on short-term IOUs (which also form part of these liabilities).
Meanwhile, total borrowings can be broken down into onshore bonds, offshore bonds and bank borrowings plus “others”:
As with all liquidity crises, the core issue is that Evergrande is short of cash to meet some of its liabilities that are coming due. The company already delayed payments to suppliers and construction fees and it faces some $130m of interest payments on its USD-denominated bonds in September 2021, with a total of $850m due this year.
Evergrande is rushing to generate cash by selling some of its assets. However, with its credit ratings downgraded by both Fitch and S&P, banks are refusing to lend while more companies are refusing its commercial paper, pushing the property developer down the vicious spiral of forced deleveraging.
Mark Williams, chief Asia economist at Capital Economics, stated that: “Evergrande’s collapse would be the biggest test that China’s financial system has faced in years.”
Indeed, a disorderly restructuring or liquidation of the company’s assets could see other parts of the Chinese economy suffer as the shock would spread across the country’s financial system. For example, Fitch reports that:
“Banks have direct loan and bond exposure to Evergrande, as well as exposure to off-balance-sheet wealth-management products, through trust loans. The firm’s liabilities in these areas amounted to about CNY572 billion at end-1H21, much of which we believe was held by banks and other financial institutions.
Banks may also have indirect exposure to Evergrande’s suppliers – the developer’s trade payables stood at CNY667 billion. Smaller banks with higher exposure to Evergrande or to other vulnerable developers could face significant increases in non-performing loans (NPLs), depending on how any credit event involving Evergrande develops.”
Whether China’s political leadership will manage to prevent the Evergrande liquidity crisis from spiral out of control ahead of CCP’s 20th Party Congress in 2022 will remain to be seen.
More importantly however, the Evergrande’s story is part of a bigger problem that China is facing: the method through which the property developer got itself in this difficult position is an example of how the entire Chinese economy has been growing for the last 20 years – via aggressive debt creation.
As German newspaper DW observed, “Evergrande has vastly grown due to a spectacular real estate boom caused by China’s unprecedented growth,” growth fuelled by piles of debt.
According to analysis from the Bank of Finland, at the beginning of 2021, China’s debt to GDP ratio approached 300%.
China’s GDP in 2020 was estimated to be around $14.7trn. If we round up the latest debt to GDP ratio to 300%, that gives us around $44.1trn of Chinese total debt at the end of 2020 – beginning of 2021.
Debt to GDP however is not that useful. Key questions remain, such as:
- Can the Chinese economy generate the necessary cash flows to pay off these liabilities on time?
- If the answer to the above question is negative, can Chinese regulators achieve a managed deleveraging?
- How much of this debt is “bad debt” and how much is productive debt?
- Who owns the debt? In other words, how much is denominated in foreign currencies versus how much is denominated in Renminbi?
In order for the Chinese economy to generate enough cash flows to pay off its debts, the economy must “grow into” the leverage. However, even before the SARS-CoV-2 pandemic, alarm bells were ringing about the sustainability and health of the Chinese economy. In late 2019, the Financial Times reported that China’s economy was approaching a 30-year low. Moreover, the recovery from the lockdowns hasn’t been smooth either, with recent news that China’s economy is losing momentum.
To boost economic output, productivity must increase. Given China’s declining population, this won’t be an easy task.
Michael Pettis, Professor at Peking University explains: “Beijing announced last year that it expected to double China’s real GDP in the next 15 years. This requires average real GDP growth of 4.7% a year. Yet a declining working population means that China’s productivity per worker must increase at a faster rate: 5.2% to 5.3%, rather than the 4.5% it would have needed when the working population was still rising.”
Productivity can also be increased through innovation, which may offset some of the economic headwinds coming from an aging population. In China, technological progress has been impressive in recent years and the country has a long history of bringing innovations to the world.
However, given that China’s communist regime is unfriendly towards free enterprise and therefore, it creates a hostile environment to put one’s imagination at work and make the best use of these novelties, innovation boosting productivity remains a big “maybe”.
Therefore, if the economy might not grow into its leverage, can the regulators achieve a well-managed deleveraging?
For several years, Chinese regulators have been trying to reduce the debt burden in parts of the economy, especially “shadow debt” or non-bank financing.
“One of the most troubling aspects of China’s debt problem is the surge in the more opaque and less regulated shadow banking sector,” explained Charlene Chu, a senior partner at Autonomous Research.
One of the reasons for why non-bank finance can be a risk to China’s financial system is its opaque nature. More specifically, this type of financing makes it difficult to know with enough certainty how much of the debt in the Chinese economy is “bad debt” (i.e. unproductive debt).
PwC estimated in 2020 that the pool of non-performing loans (NPLs) has grown from $1.4trn in 2018 to $1.5trn in 2019. To contextualise this figure, in 2019, China’s GDP was $14.3trn and its total debt was about $37.2trn. Therefore, the pool of NPLs in 2019 represented about 10% of its GDP and 4% of its total debt.
However, the total amount of NPLs might be higher than what is officially reported. Both Fitch and the IMF have suggested this in the past.
Meanwhile, the number of companies which are not making enough money to meet their liabilities has been growing. “During the first half of 2020, 2.3 million companies or 6 percent of all companies in China have gone belly up ; most of them were probably small private firms,” writes Tianlei Huang from the PIIE. Indeed, the financial health of Chinese companies has been deteriorating for a few years prior to the pandemic.
Source: PIIE
Source: Reuters Graphics
Regulatory authorities in China have already put in motion several mechanisms to curb “shadow banking”, in an attempt to manage the country’s deleveraging. Indeed, this approach has been in place for the best part of the last 5 years.
How efficient these measures have been is debatable. In November 2019, the Asia Global Institute published a research paper called “China’s failed deleveraging and implications for OECD countries”. In It, the Institute argued that Chinese authorities have to choose between meeting their economic growth target or deleveraging, but they cannot have both.
Furthermore, as recent as September 2021, Caixin published an in-depth analysis entitled “The Never-Ending Battle to Curb China’s Hidden Debt”, highlighting once more the difficult battle with the high levels of debt.
Indeed, the efficiency of China’s regulatory actions is questionable especially when we consider that the fight against “bad debt” has been linked to the liquidity problems faced by big property developers such as Evergrande. Bloomberg recently wrote: “A tightening of Chinese developers’ use of secretive funding is threatening to curb growth in the world’s second-largest economy.” A similar line of thinking has been echoed by PIMCO and Fitch.
Consequently, the answer to the question of whether a managed deleveraging can be obtained is not a clear yes – the answer it is perhaps tilting towards a negative, as the information above suggests.
There is one more piece of the puzzle on which we should aim to shed some light: who owns China’s debt?
As Bridgewater’s Ray Dalio explained in his book, “Big Debt Crises”, debt denominated in other currencies can be deadly for the debtor’s economy and financial system, as the indebted country does not control the currency of these liabilities.
“China’s foreign debt in currencies other than the yuan includes private sector firms’ borrowing from foreign banks, trade-related credit to Chinese firms from foreign trading partners and debt securities issued by Chinese state-owned and private sector firms to foreign investors,” writes Amanda Lee from South China Morning Post.
The above chart is in Renminbi. If we do a rough approximation, given that Evergrande’s debt of about ¥2trn equates to c.$300bn, China’s external debt of close to ¥2.5trn would be close to $375bn in 2020. This is not a lot, considering that its total debt was about $44.1trn for the same year.
However, it is not an insignificant amount either. In a connected financial system, defaults can spread across markets in minutes, creating unexpected problems in other parts of the system: risk can not be destroyed, only moved around.
Therefore, Chinese regulators would surely keep a close eye on this pile of foreign debt (which, as the chart above shows, has been growing substantially over the years).
In conclusion, Evergrande’s liquidity problems are a symptom of a much bigger issue that China is facing: how to deal with its high level of debt without causing too much disruption to its economy or financial markets.
The answer is complicated but clear: at some point, a more thorough deleveraging must happen, likely causing lower economic growth. The caveat is whether this process could be managed in order to mitigate spillovers, or it would spiral out of control as China would face its Minsky moment? Time will tell.
Thank you for reading.
