China’s Problems Are Larger Than Evergrande
The potential bankruptcy of Chinese real estate company Evergrande is much more than a “Chinese Lehman.” Lehman Brothers was much more diversified than Evergrande and better capitalized. In fact, the total assets of Evergrande outnumber the entire subprime bubble of the United States.
The problem with Evergrande is that it isn’t an anecdote, but a symptom of a model based on leveraged growth and seeking to inflate gross domestic product (GDP) at any cost, including ghost cities, unused infrastructure, and wild construction. The indebtedness chain model of Evergrande isn’t uncommon in China.
Many Chinese companies follow the “running to stand still” strategy of piling on ever-increasing debt to compensate for poor cash flow generation and weak margins. Many promoters get into massive debt to build a promotion that either isn’t sold or is left with many unsold units, then they finance that debt by adding more credit for new projects using unsaleable or already leveraged assets as collateral.
The total liabilities of Evergrande account for more than double the official debt figure (more than 2 trillion yuan, or $300 billion). Evergrande’s financial hole is equivalent to almost a third of Russia’s GDP. Its annual revenues don’t reach $80 billion, and it’s more than debatable whether those revenues are real, since a relevant part comes from payment commitments of doubtful collection. Even if they were real, these revenues aren’t enough to address the bond maturities, which exceed $37 billion in the short term.
Evergrande is much more dangerous than it seems: All the “Keynesian” solutions that you’re hearing about these days have already been implemented—massive liquidity injections, low-interest rates, and full implicit and explicit support from the Chinese regime. Let’s not forget that Evergrande was the largest issuer of commercial paper in China, $32 billion issued in 2020, a 390 percent increase from 2015, according to Reuters.
Evergrande represents less than 4 percent of the overall Chinese market, but its model has been used by many Chinese promoters. The 10 largest real estate developers account for 34 percent of the market and aggressive leverage practices are widespread.
The real estate sector is huge in China. Its direct and indirect weight, according to JP Morgan, is 25 percent of GDP, more than double the size of the real estate bubble in Japan or Spain. The sector has been growing with an indebted model at 15 percent per year in the past three years. The Chinese regime has introduced regulations to reduce the excess, but because it benefits from the increase in GDP and job creation, it has maintained a complacent position regarding the corporate debt model.
Chinese real estate companies, according to JP Morgan, have “reduced” their indebtedness to 92 percent of total assets from a monster 140 percent in 2018, with a profit margin of 9 to 13 percent. But those figures still show a larger and more concerning problem than the headlines imply. Most Chinese real estate developers have total liabilities of 50 percent to total assets, according to JP Morgan. The problem is that the value of those assets and the capacity to sell them is more than questionable.
The implications of an Evergrande collapse are far greater than investment banks tell us. The first risk is a domino effect in a very aggressively indebted sector. There’s also a significant impact on all those banks exposed to China and emerging markets, where China has financed ruinous projects in recent years. And there’s also the impact on global growth and countries that export to China to consider, because the slowdown was already more than evident. We also can’t ignore the impact on the solvency of the financial system despite billions of dollars being injected by the People’s Bank of China (China’s central bank).
A solvency problem can’t be solved with liquidity.
The hope that the state will fix everything contrasts with the magnitude of the financial hole. Be that as it may, we can’t overlook the negative effect on those sectors highly exposed to real estate growth, infrastructure, electricity, and services and on the hundreds of thousands of citizens who have paid an upfront fee for apartments that aren’t going to be built.
The problem with China is that the entire economy is a huge indebted model that needs almost 10 units of debt to generate one unit of GDP, three times more than a decade ago, and this whole catastrophe was already more than evident months ago. With total debt of 300 percent debt to GDP according to the Institute of International Finance, China isn’t the strong economy swimming in cash that it was a couple of decades ago.
The market assumed that, because it’s China, the state was going to hide these risks. Even worse, the Evergrande collapse only shows a dangerous reality in several Chinese sectors: excessive indebtedness without real income or assets to support it.
This episode comes at the worst possible time, after the regime has launched a massive crackdown on large companies. International investors are already concerned about corporate governance and intervention in China, and now the fears of credit contagion make the risk even worse.
Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.