China's nightmare Evergrande scenario is a messy crash

Social unrest and impact on capital markets among factors that could prompt govt action

SHANGHAI • Chinese state-run Global Times' editor-in-chief said on Thursday that China Evergrande Group should use market means to save itself and should not bet on a government bailout as it deems itself "too big to fail".

Mr Hu Xijin said on his WeChat social media account that he did not think an Evergrande bankruptcy would trigger a systemic financial storm like Lehman Brothers did in the United States, because it is a real estate business and the down payment ratios in China are very high.

But nearly all of the bankers, analysts and investors interviewed for this article say Beijing is in no mood for a Lehman moment. They predict that regulators, rather than allowing a chaotic collapse of Evergrande into bankruptcy, will engineer a restructuring of its US$300 billion (S$404 billion) pile of liabilities that keeps systemic risk to a minimum. Markets seem to agree: The Shanghai Composite Index is less than 3 per cent from a six-year high and the renminbi is trading near the strongest level in three months against the US dollar.

Yet a benign outcome is far from assured. Beijing's bungled stock market rescue in 2015 showed how difficult it can be for policymakers to control financial outcomes, even in a system where the government runs most of the banks and can exert outsize pressure on creditors, suppliers and other counterparties.

Contagion risk was on full display on Thursday. Chinese junk-bond yields jumped to an 18-month high and shares of real estate companies plunged after Evergrande had its credit rating downgraded and requested a trading halt in its onshore bonds. Some banks in China appeared to be hoarding yuan at the highest cost in almost four years, a sign they may be preparing for what a Mizuho Financial Group strategist called a "liquidity squeeze in crisis mode".

Where Chinese President Xi Jinping will ultimately draw the line remains a mystery. And while China's top financial regulator has urged billionaire Evergrande founder Hui Ka Yan to solve his company's debt problems, the authorities have yet to spell out whether the government would allow a major debt restructuring or bankruptcy.

Even senior officials at state-owned banks say privately that they are still waiting for guidance on a long-term solution from top leaders in Beijing. Evergrande's main banks were told by China's Housing Ministry this week that the developer will not be able to make interest payments due next Monday, according to sources familiar with the matter.

China's government is not averse to taking over companies from the private sector if needed. It seized Baoshang Bank in 2019 and assumed control of HNA Group, the once-sprawling conglomerate, early last year after the coronavirus pandemic decimated the company's main travel business. Court-led restructurings have also become more common in recent years, with more than 700 being completed last year.

The Evergrande endgame may depend largely on how Mr Xi decides to balance his goals of maintaining social and financial stability against his multi-year campaign to reduce moral hazard. The timing is particularly tricky as China juggles an economic slowdown, a sweeping crackdown on the private sector and rising tensions with Washington - all in the run-up to a once-in-five-year leadership reshuffle next year at which Mr Xi is set to extend his indefinite rule.

Here are some of the factors that may sway Chinese leaders:

SOCIAL UNREST

Maintaining social order has always been paramount for the Communist Party of China, which has little tolerance for protests of any kind. In Guangzhou, home buyers surrounded a local housing bureau last week to demand Evergrande restart stalled construction.

Disgruntled retail investors have gathered at the firm's Shenzhen headquarters for at least three straight days this week, and unconfirmed videos of protests against the developer in other parts of China have been shared widely online.

Evergrande had 1.3 trillion yuan (S$271 billion) in pre-sale liabilities at the end of June, equivalent to about 1.4 million individual properties that it has committed to complete, according to a Capital Economics report last week.

"If Evergrande had to dump its inventory onto the market" it would "drag down property prices substantially", said Bocom International chief strategist Hao Hong.

Without a social safety net and with limited places to put their money, Chinese savers have for years been encouraged to buy homes whose prices were only ever supposed to go up. Today, real estate accounts for 40 per cent of household assets and buying a house (or two) is a cultural touchstone. While housing affordability has become a hot topic in the West, many Chinese are more likely to protest over falling home prices than spiking ones.

"Given that the bulk of people's wealth is already in property, even a 10 per cent correction would be a serious knock to many people," said Mr Fraser Howie, an independent analyst and co-author of books on Chinese finance who has been following the country's corporate sector for decades. "It would certainly knock their hopes and dreams and expectations about what property is."

Another potential flashpoint is whether Evergrande can repay high-yield wealth management products (WMPs) that it sold to thousands of retail investors, including many of its own employees. About 40 billion yuan of the WMPs are due to be repaid, according to Caixin, a Chinese financial news service. Evergrande is trying to free up cash by selling assets, including stakes in its electric car and property management businesses, but has so far made little progress.

CAPITAL MARKETS

Evergrande is the largest high-yield dollar bond issuer in China, accounting for 16 per cent of outstanding notes, according to Bank of America analysts. Should the company collapse, that alone would push the default rate on the country's junk dollar bond market to 14 per cent from 3 per cent, they wrote in a note this month.

While Beijing has become more comfortable with allowing weaker businesses to fail, an uncontrolled spike in offshore funding costs would risk derailing a key source of financing. It could also undermine global confidence in the country's issuers at a time when Beijing is pushing for larger foreign investor ownership. Yields on China's junk dollar bonds are nearing 14 per cent, up from about 7.4 per cent in February, according to a Bloomberg index.

The stakes are higher on the mainland, where the credit market is about 15 times the size at US$12 trillion. While Evergrande is less of a whale onshore, a collapse could force banks to cut their holdings of corporate notes and even freeze money markets - the very plumbing of China's financial system. In such a credit crunch, the government or central bank would likely be forced to act.

Banks involved in property lending may come under pressure, leading to an increase in soured loans. Smaller banks exposed to Evergrande or other weaker developers may face "significant" rises in non-performing loans in the event of a default, according to Fitch Ratings.

ECONOMIC IMPACT

Concern over Evergrande comes at a time when China's economy is already slowing. Aggressive controls to curb outbreaks of Covid-19 are hurting retail spending and travel, while measures to cool property prices are taking a toll.

Data this week showed home sales by value slumped 20 per cent last month from a year earlier, the biggest drop since the onset of the coronavirus early last year. Responding to a question on Evergrande's potential impact on the economy, National Bureau of Statistics spokesman Fu Linghui said some large property enterprises are running into difficulties and the fallout "remains to be seen".

China's current priorities of promoting "common prosperity" and deterring excessive risk-taking mean there is unlikely to be any easing of property curbs this year, according to Macquarie Group. The sector will be a "main growth headwind" for next year, although policymakers may loosen restrictions to defend growth goals, Macquarie analysts wrote in a note on Wednesday.

A correction in China's property market would not only slow the domestic economy but have global consequences too.

"A significant slowdown in property construction over the next few years appears probable already, and would become even more likely in the event of an Evergrande failure or bankruptcy," said Dr Logan Wright, a Hong Kong-based director at research firm Rhodium Group.

"A long-term slowdown in property construction, an industry that represents around a fifth or a quarter of China's economy by most estimates, would cause a significant decline in GDP (gross domestic product) growth, commodity demand, and would likely have disinflationary effects globally."

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A version of this article appeared in the print edition of The Straits Times on September 18, 2021, with the headline China's nightmare Evergrande scenario is a messy crash. Subscribe