Once the world's most valuable real estate firm, the collapse of Evergrande Holdings is a lesson for many. Debt brought Evergrande to stratospheric highs, and debt too brought Evergrande crashing down just as quickly. With thousands of housing projects left idle and incomplete, prospective homeowners across China are increasingly desperate as the crisis threatens to decimate the retirement nest eggs of millions. Will Beijing's ambitious whitelist mechanism for loans to embattled property developers reverse the slump? As capital outflows from China reach unprecedented highs, is this too little, too late?
Apartment buildings in Shenzhen. Image Credits: Anonymous
Debt-fueled Expansion
Founded in 1996 in the southern Chinese province of Guangdong, Evergrande Holdings rode the wave of rapid urbanization and capitalized on the infrastructure boom that swept across many Chinese cities. Targeting millions of the newly-minted middle class, Evergrande’s aggressive expansion was financed through the regular issuance of onshore and offshore bonds. Like many other Chinese real estate developers, Evergrande pre-sold homes - many Chinese consumers fork out full payment upfront for apartments rather than making a down payment and subsequently taking out a mortgage loan for the remaining sum. The odds are clearly stacked in the developer’s favor in a textbook example of moral hazard, whereby the stream of interest-free financing encourages developers to launch riskier projects or even venture into other non-core revenue streams given the lack of public scrutiny over the usage of these funds. For instance, Evergrande has sponsored its own football team, sold mineral water and developed electric vehicles over the past decade. Further propping up such a risky arrangement is Evergrande’s cozy, symbiotic relationship with many local governments: tax reforms in the 1990s that diverted tax revenue to Beijing culminated in shrinking revenue for local governments with the gap conveniently filled by land sales to property developers.
The Warning Signs
The story goes back to late 2020, when the Chinese government, concerned over the growing housing bubble, issued 3 major guidelines (otherwise known as the 3 red lines) that restricted the amount of debt property developers could take on. Evergrande was the first to reveal that it faced difficulties in interest repayments for its offshore bonds - dominated in USD and targeted at foreign investors - citing a liquidity crisis catalyzed by the new borrowing restrictions. Even selling uncompleted properties at a deep discount proved futile and the real estate giant finally defaulted on interest repayments for an offshore bond in December 2021. An investigation by the China Securities Regulatory Commission (CSRC) found that Evergrande allegedly padded revenue by recognising advance sales of uncompleted apartments. What followed was even more shocking. Accused of overinflating revenues by US$78 billion and fabricating close to 78% of their revenue for 2020, Evergrande used these allegedly falsified figures to boost investor confidence and continued selling bonds to generate working capital. Consequently, Evergrande was slapped with a hefty fine of $580 million, and its founder Hui Ka Yan currently faces a lifetime ban from the securities market. What does all this mean for the wider market?
As one of the largest developers in China, Evergrande’s collapse knows no bounds. The collapse led to a sector-wide evaporation of confidence as buyers are much less willing to put down hefty deposits for new projects (if the developer collapses, individual buyers are far behind on the creditor list and are unlikely to ever recover these deposits). Meanwhile, protests erupted across numerous Chinese cities over concerns that stalled projects would never resume construction again. Already, the contagion has spread to other similarly indebted developers, with the likes of Country Garden, Sunac and R&F Properties announcing their own defaults one after another.
Property forms up to 70% of household wealth and accounts for around 25% of China’s GDP. Pandemic-induced construction delays and cost overruns have only worsened the problem with a Nomura report estimating that there remain 20 million units of unconstructed and partially constructed pre-sold homes as of end 2022. Evidently, a herculean effort led by Beijing is required to clean up the entire sector and restore public confidence before the property crisis morphs into a threat to social stability.
A Step in the Right Direction?
But there is light at the end of the tunnel. Fast forward to early 2024, some barriers to borrowing have been removed by the Beijing authorities and a “whitelist” initiative has been drawn up to encourage municipal and provincial governments to work together with developers to provide credit for new projects. After all, the world’s biggest population needs a roof over their heads. Under the program, select projects will be recommended by local governments for special financing by state-owned lenders for a start with priority given to stalled projects that have already been fully paid for.
Too Little, Too Late
However, many remain sharply critical of the whitelist scheme. At present, the scheme merely covers 5% of Evergrande’s $300bn (and likely escalating) liabilities and will likely matter little in the grander scheme of things. Beijing, for its part, has repeatedly signaled its reluctance to provide the full bailout that Evergrande desperately needs even though the Chinese banking system could certainly make it a possibility. After all, doing so would imply backtracking on the Party’s own policy of de-leveraging the real estate sector. Hundreds of billions in distressed debt hanging over the Chinese economy spells nothing but gloom for the future - already, slumping home prices have shown no signs of abating while capital flight has reached its highest in 2023 as investors swiftly pulled out amidst the climate of uncertainty. Worse still, protracted weakness in the property sector has dragged down consumer spending. Even more dire are warnings of a deflationary spiral. Spooked by the severe crisis of confidence following the real estate crisis, many consumers are holding off purchases of big-ticket items. Sluggish domestic demand for consumer goods has only seen temporary reprieves thus far in 2024. Moreover, the bursting of the housing bubble has been accompanied by a housing glut as estimates suggest that China presently has an excess of around 50 million homes, enough to house 150 million.
Image Credits: Nikkei/ National Bureau of Statistics of China
Government Intervention - For Better or For Worse?
Another ambitious plan is on the horizon: a return to the roots. As part of an ongoing push to rein in a burgeoning private sector, Xi has presented an intriguing strategy to revive the ailing sector by placing the state firmly in control. Under the proposed plan, the shift to private ownership would be eventually reversed as excess home supply would be converted to state-subsidized public housing units that come with restrictions on subsequent resale. Sounds good on paper, but details are scant on how Beijing would obtain the funding required for such a project. With Xi being bent on avoiding a re-inflation of the property bubble, it remains to be seen how Beijing can purchase and convert distressed, partially constructed projects while steering clear of providing liquidity support to the very developers teetering on the edge of bankruptcy.
References
BBC News. (2021, December 9). Evergrande: China property giant misses debt deadline. BBC News. Retrieved from https://www.bbc.com/news/business-58579833
Bloomberg. (2022, July 11). Evergrande risks first local bond default as delay rejected. Bloomberg. Retrieved from https://www.bloomberg.com/news/articles/2022-07-11/evergrande-onshore-bondholders-reject-further-extension-plan-l5g4utyu?leadSource=uverify+wall
Bray, C. (2021, October 6). Fantasia downgraded to 'default' as China's property crisis worsens. South China Morning Post. Retrieved from https://www.scmp.com/business/banking-finance/article/3151335/fantasia-downgraded-default-status-rating-agencies-chinese
Goldenpitech. (2022, August 4). How do geopolitical issues affect debt market? - goldenpi: Blogs. GoldenPi. Retrieved from https://goldenpi.com/blog/essentials/bond-market/how-do-geopolitical-issues-affect-debt-market/
Hinchliffe, R. (2022, August 17). ‘Heartbreaking’ bond scandal calls FCA powers into question. FT Adviser. Retrieved from https://www.ftadviser.com/regulation/2022/08/17/heartbreaking-bond-scam-calls-fca-powers-into-question/
PBOC head says China’s property crisis has abated as default rumours VEX Vanke. South China Morning Post. (2024a, March 26). https://www.scmp.com/economy/china-economy/article/3256801/chinas-central-bank-head-dissuades-real-estate-woes-vanke-teeters-towards-default
Comments