For observers of China’s highly leveraged real estate market, the ongoing collapse of Evergrande, the country’s second largest — and the world’s most indebted — property developer, looks much less like the “black swan” event seen by many foreign investors than what officials in China like to call a “grey rhino” — a danger that lurks in plain sight.
This past week, the company, laden with liabilities in excess of $300 billion, was struggling to make interest payments. News of an impending default sent shock waves across global markets. If Evergrande’s precarious financial situation was hardly a secret in China, what was less clear is how far China’s Communist Party, and its leader Xi Jinping who has repeatedly called for reducing debt and attacked what he has called “fictional growth”, were prepared to go to tackle these grey rhinos.
After all, for all the obvious risk, firms like Evergrande remained key cogs in keeping ticking a debt-fuelled growth model. Would allowing them to fail send a clear message about the need for structural change? Or would it unleash a hard-to-manage contagion that would bring growth in the world’s second-largest economy, at a sensitive moment for global economic recovery, to its knees?
“Evergrande is a poster child of what is the most indebted industry in China,” Dexter Roberts, author of The Myth of Chinese Capitalism and a senior fellow at the Atlantic Council, told The Hindu . “A poster child of the model of real estate which is bringing on excessive leverage to build apartments, and usually pre-selling them before they're even built.”
Evergrande (known as Hengda in China) was founded in Shenzhen, in southern Guangdong province, by businessman Xu Jiayin in 1996 just as China’s property boom was beginning to take off. Rapid success in real estate — the group manages more than half a billion square metres of land and projects in China, or the equivalent of 5 million 100-square metre apartments, or the size of a small city — saw Mr. Xu branch into new, more flashy ventures, including taking over Guangzhou Football Club in 2010 (the club would hire renowned Italian coach Marcello Lippi and go on to become the first Chinese winners of the Asian Champions League in 2013, as Mr. Xu splashed the cash.)
The politics of land
What distinguishes China’s real estate sector, as Mr. Roberts put it, is the unique politics behind its growth model. Local governments in China are highly reliant on land sales for revenues, which account for, by some estimates, half of local revenues, needed for everything from infrastructure projects to social welfare. “This means that they need to continually develop new commercial and residential real estate in order to continue to make enough local revenues to run the government,” he says.
This model explains how China’s real estate sector — and key players like Evergrande — grew so big, and grew so big so quickly. According to a paper by Kenneth S. Rogoff and Yuanchen Yang published by the National Bureau of Economic Research last year, the “upstream and downstream contribution to GDP of China’s real estate sector” is as high as 29%. A 20% fall in real estate activity, they estimated, could lead to a 5%-10% fall in GDP.
But as China’s economy — powered in part by real estate growth — boomed, so did its debt levels. If Chinese authorities, over the years, sought to introduce a slew of new measures to slow growth, such as raising the requirements for down payments and forcing banks to cut down on mortgage loans, they were reluctant to take more extreme steps to reduce debt, worried primarily about the impact on GDP growth.
That changed last year, with Mr. Xi’s government introducing the toughest measures yet. The central bank put in place what it called “three red lines” that would force indebted developers to start deleveraging and bar them from getting new loans unless they fulfilled certain financial targets.
Indeed, Mr. Xi had given strong signals since the Party’s National Congress in 2017, which marked the start of his second five-year term, when he declared that “houses are built to be lived in, not for speculation”, a comment that rattled real estate developers.
Since then, the rise of housing prices has continued to slow in many second and tier cities with new measures that, for instance, make it tougher to buy second homes.
With the Evergrande crisis, the real estate model now stands at a crossroads. Beijing-based economist Michael Pettis, writing for the Carnegie Endowment this week, wrote that managing a calibrated landing will be far from straightforward with the spillover effects.
“The problem of spreading financial distress is a much more serious problem and one that the regulators seem not to have expected — at least to this extent,” he said. “Property purchases have fallen very quickly, and retail investors in wealth management products have already organised visible protests in many cities. Meanwhile, suppliers and contractors are reeling from potential losses, and since many of them have been paid in real estate, they are likely to try to sell these assets as quickly as possible to satisfy their own liquidity needs. This cannot help but disrupt the real estate market further.”
If Evergrande may be allowed to fail with a state-led restructuring process, the Party will certainly be concerned about the fall-out: the impact on homeowners who may never see homes they have paid for, on thousands of others who have purchased the company’s wealth management products, on the real estate driven sub-economy that sustains millions of livelihoods, on local governments and their financial vehicles that rely on land sales to balance the books.
A targeted bailout is one likely option that comes to the aid of some but not all creditors. At the same time, the Party is aware that actions taken to mitigate their losses in the short-term would, however, end up only making a longer term structural change, which every economist says is inevitable, all that more difficult.
“The central government is in a really hard place,” Mr. Roberts observed. “They made it clear they need to reduce leverage in order to have a more stable economy. But now they see as they do that, the pain starts to appear.”
“The dilemma then is, do they continue to pursue this course of deleverage, show that they’re serious about it, do what they need to do long term? Or do they decide to step back because of the fact that it is becoming abundantly clear that there could be real economic pain? The signs are they are ready to push further this time. They are ready to accept some pain.”