Welcome back everyone.
Another piece on Evergrande, I wont dwell too much today on the details of the company,
as I’ve covered that reasonably well over the last few days.
Today I want to focus in on how this collapse ties in to the overall Chinese economy.
We will examine how the rise and fall of Evergrande is tied to certain economic choices made by
policy makers over the last three decades.
We will wrap up with how a typical bankruptcy works, and how this one is likely to be quite
different.
Evergrande as I’m sure you know by now is Chinas second largest property developer whose
slow collapse has transfixed the markets over the last few weeks.
Evergrande is the most-indebted property developer in the world and its on-balance-sheet liabilities
amount to nearly 2 percent of China’s annual GDP.
It’s off-balance-sheet obligations could add up to as much as additional 1 percent.
This on its own is big – some of the numbers are huge, but ordinarily it wouldn’t be
such a big deal if it wasn’t for the huge amount of leverage in the overall Chinese
economy.
I showed you this chart in yesterdays video from the bank for international settlements
showing that Chinese businesses have almost twice the leverage of American businesses.
The Chinese economy been plagued by debt problems and what we call moral hazard for quite some
time.
Policy makers have been (on and off) attempting to reduce this, and these attempts have to
a certain extent played into the collapse of Evergrande.
It is quite a sticky situation for them to sort out right now.
Ok, so there is (and has been for some time) a problem with excessive leverage in the Chinese
Economy, and this is no surprise to Chinese regulators who have been trying over the last
few years to reduce the economy’s overreliance on debt.
As part of these attempts, they implemented the “three red lines” for property developers
in August 2020.
The three red lines were hard limits on a property development company’s debt-to-asset
ratio, its debt-to-equity ratio, and its cash-to-short-term-debt ratio.
This policy has an instant effect on property development firms.
Not only could they no longer borrow, but they were basically forced to quickly pay
down their debts.
This meant selling assets often at fire sale values, laying off staff and taking losses
on the chin.
This caused a bit of a spiral, as the losses only made their ratios look worse, putting
further pressure on these companies to deleverage further.
Right now, Evergrande is the firm struggling the most, but the pain being inflicted by
the three red lines on Chinese property developers is much more widespread.
So was this a foolish move by Chinese policy makers?
It is hard to say.
It does make sense for them to worry about the high levels of real estate debt—and
debt in general.
China’s official debt-to-GDP ratio (which many argue is understated) has rocketed in
the last five years to one of the highest debt ratios for any developing country in
history.
Real estate and real estate valuations are usually found at the root of all debt.
Most loans are made against hard assets like real estate which can be repossessed.
As loans are made against real estate, this causes real estate prices to rise, and as
real estate prices rise, larger loans can be made against the real estate.
So, this is a self-reinforcing cycle both on the way up and on the way down.
In China, real estate developers typically sold apartments to homebuyers off the plans
– months or years before commencing construction.
This surprises people in other countries, but it makes a certain amount of sense in
a rapidly developing country like China, where people have migrated from the country to the
cities on a huge scale as the economy has grown.
In other parts of the world there are usually enough urban apartments available if you move
to a new city, making this unnecessary, but this is just the way things work in a rapidly
developing country.
There have been lots of issues with this model, where often the property developers cut corners
in construction because the buildings have been presold.
This has led to what the Chinese call “tofu dreg” construction, where the builder might
have skimped on rebar, or padded out the concrete with old bottles to save money.
If you search the term tofu dreg construction on YouTube you will see what I mean.
So Chinese property developers typically get substantial deposits well in advance of beginning
construction.
They pay subcontractors and suppliers with commercial paper and receivables instead of
cash.
In addition, they frequently have financing arms (or wealth management units) that sell
debt to retail investors and employees – I talked about this in yesterday’s piece.
At this point you can probably get a good impression of how leveraged the real estate
sector is in China, and all of this leverage allowed it to become a major component of
economic activity.
It is estimated to account for over a quarter of the country’s GDP.
The huge leverage also inflated a property bubble.
Average home prices have increased in value by 50% since 2015.
Property prices are very high in China relative to household income, meaning that Chinese
families borrow significantly more money than Americans do to buy a home, often multiple
generations of a family pool their savings to buy a home.
The worst part of this is that the huge historic returns on property, led to speculative overbuilding.
Up to a quarter of the total housing stock, especially in the most desirable cities is
owned by property speculators.
Because the value of apartments goes up so much, they don’t even rent out these homes,
they keep them empty and in perfect condition for eventual resale (hopefully at a huge profit).
Empty housing incurs significant economic cost while creating no economic value whatsoever.
Ok, so the Chinese government do recognize this as a problem and are trying to reduce
leverage and stabilize the housing market.
Up until last August and the Three Red lines, borrowing for large Chinese companies had
not been a problem.
It was assumed that politically connected firms like Evergrande would never be allowed
to fail, and so there was very little credit differentiation in the lending markets.
In Economics they use the term moral hazard to describe such a situation, where there
is no incentive to guard against risk in situations where you are protected from its consequences.
The idea being that you are more likely to lock the front door of your house when the
contents of your home are uninsured.
In the case of Chinese lending markets moral hazard underpinned everything.
Chinese regulators have quite deliberately decided not to bail out Evergrande with the
goal of transforming (and improving) the financial system.
There is a real goal in China to move away from unproductive growth and focus on real
growth.
This can even be seen in the recent crackdown on Chinese tech companies.
I expressed some surprise about this crackdown to a friend of mine a few months ago – he
is much more knowledgeable about emerging markets than I am.
He explained that the Chinese government don’t think of ride hailing apps or social media
as real technology.
Their focus is on supporting hard technology like chips, semiconductors, 5G and so on.
So, it is smart for regulators to concern themselves with moral hazard but there is
no easy solution to the problems they face in China.
Eliminating moral hazard from Chinese credit markets would entirely transform the pricing
of risk and would significantly change the value of loans that lenders hold on their
books right now.
It’s a noble goal, but the path to achieve it is extremely difficult (to say the least).
This is because every loan that has been made over the last thirty years is based more on
how likely the borrower is to be supported by the government than on their ability to
meet the debt repayment cashflows.
So how might all of these changes affect global markets?
As I mentioned in my prior videos on Evergrande, their estimated $310bn in debt is larger than
that of many sovereign governments, but most of that debt has been issued in China which
is a very large economy.
Around $20bn has been issued offshore, and this is trading at around 30 cents on the
dollar.
What is not being priced in is that foreign bondholders may get different treatment to
local lenders.
We will talk more about that in a moment.
US dollar denominated debt issued by other Chinese developers is much larger and trades
right now at around 85 cents on the dollar.
Markets might eventually decide that this debt should be priced more inline with Evergrandes
bonds going forward depending on how the Evergrande situation evolves.
Other sources of contagion are internal to China.
Potential homebuyers in China, worried about the news, are holding back on buying new homes,
they are worried about putting deposits down on unfinished apartments, and worried about
wealth management products, all of this is squeezing the developers.
Contractors are demanding that they be paid upfront, and are reluctant to accept commercial
paper.
The result, as Evergrande has already announced, is that construction projects are falling
well behind schedule.
This kind of internal contagion could put quite a drag on the Chinese economy.
This is why the Chinese government will probably need to move quickly.
The biggest problem is that Chinese policy makers can not eliminate moral hazard, and
walk away from unproductive growth to focus on real growth while continuing with their
politically determined GDP growth targets.
This is because ‘real growth’ simply won’t generate enough economic activity to allow
China to hit its GDP growth targets.
The way China hits its growth targets is through malinvestment by the real estate sector and
by local governments building unnecessary infrastructure.
Whenever high-quality growth declines, as it did last year due to Covid, the government
steps up malinvestment to make up the difference, then when high-quality growth picks up, they
try to reduce low quality growth as they appear to be doing this year.
Chinese debt has grown rapidly since the 1990’s and up until the mid 2000’s this debt funded
necessary and productive investment, which meant that the return on these investments
grew faster than the debt did.
In the mid 2000’s debt began rising faster than GDP, this means that the cost of this
additional debt was greater than the return achieved by investing it (this is what I mean
by malinvestment).
If the Chinese government sets GDP growth targets above the country’s high quality
growth rate, malinvestment will continue in order to fill the gap and debt will rise faster
than the economy’s ability to service that debt.
If your plan is to do this – to grow debt faster than your ability to service it, you
need creditors to lend on the basis of an implied guarantee that the government will
make up the difference.
You need moral hazard – otherwise no one would lend for these projects.
The fall out of this whole situation will be really interesting for a variety of reasons.
It will give us some real insights into Chinas likely path going forward.
Evergrande is essentially a company who has borrowed huge amounts of money, and they have
borrowed it from everyone - banks, investors, suppliers, customers, employees — and it
seems unlikely that these lenders knew what they were getting into.
As I said yesterday, the wealth management unit looks like a ponzi scheme.
When a big company goes bankrupt you typically look at the company’s capital structure
and those with the most senior claims get paid back first.
The most junior claims might get nothing, and the ones in the middle might get pennies
on the dollar.
Often the goal is to keep the core business running, so customers and suppliers might
be treated better than is legally required, creditors work with management to figure out
a plan that provides the best overall recovery for everyone.
In this situation, government officials can be expected to step in and decide who gets
paid and who does not, and this will be a political situation.
In yesterday’s piece I said that there were two coupon payments coming this Thursday,
a smaller local bond coupon and a larger dollar denominated bond coupon payment.
I predicted that they were more likely to make the payment on the local bond, and sure
enough they made an announcement shortly afterwards confirming that the local bond coupon will
be paid.
We will learn a lot more in the coming days.
In China because of this issue of moral hazard, it is difficult to know the risk of any loan.
The Evergrande situation just highlights this issue, and it will be years until we see how
the overall situation works itself out.
OK, that’s enough about Evergrande.
Here is a link to my video about how pubs replaced banks for a year in Ireland.
It will show you how basically anything could happen.
See you later, bye.