The COVID-19 pandemic dealt an unprecedented blow to the Chinese economy, and getting it back on track required taking on an unprecedented level of debt risk. From local government financing vehicles to property developers to state owned enterprises (SOEs), China’s debt markets have seen waves of defaults since the latter part of 2020 as business incomes faltered. Halfway through 2021, 25 Chinese businesses had defaulted on about $10 billion worth of bonds, setting a new record.
The string of bond defaults marked a change in Chinese Communist Party (CCP) thought. Historically, Chinese state-owned enterprises and economically important private firms have accepted a certain level of moral hazard. Overleveraged, risky investments were okay, as it was assumed that the government would step in with a bailout in times of trouble. Domestic and foreign investors have generally factored this into their risk models as a given. This assumption led to bondholders’ surprise when Beijing allowed Yongcheng Coal, Huachen Automotive, and Tsinghua Unigroup – all state-owned enterprises – to default over the past year. The CCP has made it clear that it will now allow “debt bombs” to detonate and only step in to save economically important firms.
In the second half of 2021 to date, investors have been given plenty opportunity to ponder on the question of which firms are economically important enough for a bailout. Huarong Asset Management, one of China’s big four state-owned asset managers and distressed debt collectors, served as a prime example. In April 2021, the firm announced that it would be delaying its annual financial statements, which triggered a collapse in bond prices. After a four-month delay, the statements were released, revealing that the firm saw its profits drop 90 percent year-over-year during the pandemic. Effectively, the firm was on the chopping block for default and Beijing had a Lehman-sized issue on its hands.
Given that it was responsible for mopping up non-performing and deteriorating loans in the traditional banking sector, Huarong’s failure had the potential to send shock waves through the entire economy. So, after months of back-and-forth, a $7.7 billion bailout was arranged in which Citic Group and other state-owned investors would inject the company with liquidity. Since the onset of China’s wave of defaults last year, this has been the first clear case of a company that was “too big to fail.”
Now, bond investors are once again holding their breath as Evergrande Group, China’s second largest private property developer, teeters on the brink of default. The firm holds the title of being the “world’s most indebted property developer” and serves as a symbol of corporate excess. As things often go during a boom, Evergrande leveraged outrageous amounts of credit during China’s real estate craze to fuel growth. With the onset of the pandemic and a long-term slowdown in China’s property market, things have quickly come spiraling down on the developer.
A subsequent debt squeeze has led to payment delinquencies to suppliers and put the firm at risk of bond defaults. Chinese regulators ordered the firm to sell off its assets, which include an electric vehicles firm and other side ventures, in order to survive. Giving anything short of a bailout, regulators also signed off on a reset of Evergrande’s debt terms, which will allow the firm to renegotiate deadlines with banks and other creditors.
Unfortunately, the yard sale and a reset of Evergrande’s debt terms are unlikely to provide more than a temporary reprieve. For one, according to the company’s 2020 annual report, the firm has more than $52 billion worth of debt set to be due within a year. Second, the results of the firm’s fire sale have been disappointing so far. Evergrande is yet to sell off prime candidates like its electric vehicle business; many speculate that potential buyers are waiting for a default so that they can buy these assets at a steep discount. In light of this reality, both Moody’s and Fitch have downgraded Evergrande’s bonds.
As investors and analysts alike have been considering whether or not Evergrande is economically important enough to warrant a bailout, investor sentiment is largely pessimistic on government intervention. Evergrande’s plight differs from Huarong’s for many reasons due to the nature of their business and the size of their debts, all of which point to Evergrande not being “too big to fail.”
Most importantly, the government has declared deleveraging and de-risking to be one of the five core government tasks of 2021. Historically, Chinese firms have been granted relatively easy access to credit, and non-financial corporate debt growth has ballooned at an unsustainable pace. Since 2015, Beijing has embarked on a targeted deleveraging campaign; however, these efforts were reined in hastily during the onset of the COVID-19 pandemic. Now, in a relatively calmer post-pandemic environment, and particularly as credit-fueled growth was prominent in 2020, the government has set to work on reinstituting its deleveraging campaign.
Beijing particularly wants to trim over-indebtedness in the real estate industry. Last year, the Chinese government instituted a lending limit that applies to property developers known as the “three red lines.” The new policy seeks to ensure sustainable growth within the industry by setting caps on the amount of debt that can be held relative to cash on-hand. The “three red lines” specifically refer to debt-to-equity, debt-to-cash, and debt-to-assets, of which the policy limits their annual growth at no higher than 15 percent.
The sheer scale of Evergrande’s debt burden also contributes to the low likelihood of a bailout. Standing in excess of $300 billion, Evergrande’s liabilities exceed Huarong’s total liabilities of $238 billion. By bailing out its most bloated property developer right now, Beijing would shoot itself in one foot to save the other. A $300 billion bailout would just transfer the liability to the government and worsen the government’s preexisting debt hangover.
If bond prices and ratings agencies are anything to go by, it seems that default is all but imminent for Evergrande, which will help truly usher in Beijing’s newfound mentality of letting “debt bombs” explode. Though less likely at this point, the alternative argument is feasible: Chinese regulators may struggle to look the other way in the case that the firm defaults in a shorter-than-expected time frame.
In an effort to drum up cash, the company has presold 800 apartment projects across the nation. As a result, up to 1.2 million people could be waiting to move into their new homes – homes that might never be finished. Upstream suppliers contributing materials or other resources to the projects are also awaiting payment. A near-term default for Evergrande could then mean temporary homelessness for many buyers and empty hands for Evergrande’s suppliers.
Even more dangerous, a full-blown collapse could send ripples through the Chinese economy. Currently, more than three-quarters of household wealth in China is tied up in real estate, and Beijing has a strong incentive to make sure that such wealth doesn’t go down in an exploding bubble. A collapse of Evergrande could be detrimental to property values, which would deal a blow to consumer wealth and in turn lead to a slowdown in consumption and investment, in addition to other consequences. Because the CCP has focused its attention on de-risking the property sector and other developers have done good jobs of reducing their debt burdens so far, it should reduce the effect of an Evergrande collapse. Nonetheless, the firm is so big that this ripple effect is possible.
In the end, there are plenty of outspoken individuals on both sides of the aisle, and only time will tell how serious Beijing is about de-risking. Regardless of outlook, investors should play the bet with caution. In the case of a default, Beijing has made clear that bondholders will be the lowest on the totem pole for receiving anything in a bailout.