Evergrande – Pulling on the thread that unravels the sweater at China’s largest property developer

Now that the major ratings agencies have declared China property developer, Evergrande’s, dollar-denominated debt to be in default, the second shoe has dropped and the risks to the entire Chinese economy become starkly clear. I’ll approach this in three sections: What the Chinese government has been trying to achieve, how Evergrande got into this mess and what’s at stake.

The Public Policy Goals

China’s highly centralized, top-down leadership had entirely reasonable policy goals in shaking up the property industry. The construction of millions upon millions of apartments nationwide has been a remarkable achievement and most urban families are now well-housed and own their own units. But with that milestone has been achieved, the central government determined that too much economic activity has been going into construction at the expense of a more broadly-based mature economy. Additionally, now that most families have been housed and there are an estimated 65 million empty units held solely for speculation, the government became concerned that there was a property bubble that might burst at any time. Xi Jin Ping has stated: Houses are for living in.

As by far the largest developer, Evergrande, with multiple projects in more than 200 cities nationwide and a bloated $300 billion in outstanding financial instruments (with more debt owed as I shall outline in a moment), Evergrande was ripe for being reined in. Indeed, it’s been wildly reported that Evergrande refused to act on stern warnings in 2020 to control its expansion and the central government has elected to come down hard on the firm for its disobedience.

The Length Breadth and Depths of the Evergrande Mess

The risks caused by Evergrande’s over-expansion are not simply the age-old story of a firm that grew too fast. In my opinion, it has all the hallmarks of a Ponzi scheme. Here’s why: Property companies throughout China accept advance deposits on new apartments that are often as much as the full purchase price. Purchasers are eager to put their money down to secure the best units and to buy before property prices inflate. Additionally, households have excess savings and meager opportunities to earn a decent return. Ordinary savings accounts pay very low interest, less than the rate of inflation. After too many ups and downs of the rather small Chinese stock market (many of the largest industries are still state owned) retail investors view equity investments as little more than a trip to the casino. Pre-purchasing unneeded apartments has been an entirely rational store of value.

Chinese families have the highest savings rates in the world, with about half of paychecks being saved as cash each month. The causes of this include an under-developed consumer economy and very high fees for both healthcare and education. Again, high savings rates are entirely rational.

The shocking risk to the financial system is that there has been a lax or entirely missing requirement to escrow these prepayments. So, while, Evergrande’s financial statements acknowledged such prepayments as a future obligation (the completed apartments were owed to the customers) the cash flowed straight to the firm’s corporate coffers. This use of deposits for current expenses is what leads me to my Ponzi conclusion. While much of the money received has indeed gone into completed apartments, the sloppy accounting suggests that there has been an unconstrained opportunity for at best inefficiency, and at worst, wholesale diversion of funds.

As if this weren’t bad enough, Evergrande sold “wealth management products”, poorly regulated quasi-bonds that were offered to the same consumers who were pre-funding construction. Imagine, then, that a family, earning say $60,000 a year from 3 working adults, whipped up $250,000 in savings of their own, from grandma and from borrowing from friends. This was invested in two unbuilt apartments, more than an hour away from the Central Business District. The family then invested their last $50,000 of cash savings into an Evergrande wealth management product sold by an independent broker sitting within their local branch bank. The false impression that these products were guaranteed by the bank is widespread among unsuspecting customers.

News of the company’s imminent collapse has understandably spread panic among retail prepurchasers who doubled down by buying wealth management products and who face losing their entire life savings.

The next systemic risk is the construction workers and subcontractors. Throughout China, Evergrande has legions of unpaid vendors. Many have been paid with IOU’s. The specter of many small firms going bankrupt and many unemployed workers has sent terror throughout the country.

China’s banks are also on the hook for untold amounts of money lent to Evergrande for operating capital or as investment bonds. One can only conclude that, as the banks are state-owned, there is no way that the government will allow its own banks to bear the burden of a default.

There is a relatively small amount of money that has been borrowed as dollar-denominated debt. The international markets are huge and the impact of default on these bonds poses no systemic risk. It is a truism that financial markets have short memories and the risk of contamination in ruining the appetite of international investors for future Chinese fixed income instruments is small. However, the risk of turning off this source of capital should not be understated.

Finally, Chinese cities large and small have come to rely on land sales as a primary and reliable source of revenue, in some cases for more than half a city’s budget in a country where real estate taxes are rare and small by world standards. The game works like this: A developer identifies a tract of farmland, suitable for building a large multi-tower residential development. The city agreeably contemns the land, disposes the people who were using it (there being no property rights in China, only untradable use permissions) and offers them meager compensation – after all, it was only poor quality farm-land. The city then resells the land in a sweetheart deal to the developers such as Evergrande at more than was paid in compensation, but still at a very cheap price. It’s pure speculation on my part that many a local official has been given the opportunity to buy into the new development at an unbelievably preferential price. If Evergrande collapses and other smaller development companies follow, the cities will be bereft of their primary financing vehicle.

What’s at Stake

The stakes for the central government cannot be understated. To be frank, the thought of a “soft landing” seems increasingly remote. In the absence of the checks and balances of a free market and instead the heavy hand of the Beijing government, I cannot be sanguine that this story ends happily.

The government knows that as a first priority they must protect the savings of ordinary families – a failure to do that would result in widespread and dangerous social unrest, not to mention ripple effects throughout the broader economy as consumer spending would immediately collapse. At the moment, the official position that there’s nothing to worry about and these projects will be delayed but eventually delivered, has been effective. But that illusion will soon evaporate. Many of the projects are, if not a “bridge too far” are an apartment complex way too far out in the countryside. The thought that other developers can take over and complete some of the projects surely applies only to a minority of the most well-located developments.

Next, the government would need to make whole retail investors in wealth management products. This is a smaller amount of money and could be accomplished simply by printing renminbi and distributing credit to state banks.

If the contagion from Evergrande’s collapse could be contained and the company reasonably wound down, then the damage to the state owned banks who made loans or bought bonds could be contained. Again, in the worst case, the central government can bail out the banks, albeit at the risk of causing quite a bit of inflation. At least this has the advantage of spreading the pain out into the future.

The foreign debt holders are already toast. The government will seek to position Evergrande as a renegade, exceptional firm. Whether this will reassure the broad international markets will remain to be seen.

As to the cities that had become over-dependent on land sales, the solution is to set up a system of real estate taxes to provide regular annual income. This is not as easy as it sounds as the whole mechanism of taxation is immature. To date, families that own multiple apartments have had a near free ride on the real estate that they own. Whether there is enough wage income economic activity to tax to support local government is unclear. To put this in perspective, while we in the west may grumble about paying our rates or real estate tax, imagine paying not only on your primary residence but also on two or three additional properties, empty and unrented that you had bought as long-term investments.

It will take a very savvy – and lucky – approach by the Beijing government for this to end well.