Evergrande’s troubles cannot help but bring up memories of the global financial crises of 2008-09. Thirteen years ago, first in the United States and then in the western world generally, company failures led to fears of more failures, fears that eventually interrupted normal financial dealing, threatened economies, and forced governments and central banks to take extraordinary steps. The prospective failure of Evergrande has not yet brought that horrible chain reaction to China, but it threatens sufficiently to rivet the attention of the country’s leadership in Beijing, not the least because Evergrande may only be an early sign of more such troubles to come.
Evergrande, formerly the Hengda Group, is in some respects an archetypical product of any rapidly growing economy. That fact is why it may be only the first of other Chinese companies to fall like this. When opportunities abound, as has been the case in China at least until recently, managements have had every reason to use debt to leverage those abundant opportunities. As long as rapid growth provides strong streams of revenues, those who take on the debt can meet their obligations. Especially since Evergrande had its base in real estate development, an area especially sensitive to growth, it could hardly resist the lure of this debt-based approach to business. But as China’s growth rate has slowed, the burden of debt has overwhelmed Evergrande, as it would any other firm that used this approach and will likely do so to other Chinese firms that have played the economy’s rapid growth in similar ways.
Certainly, Evergrande’s story until recently is one of rapid expansion based on debt. Taking full advantage of China’s breakneck pace of growth, it expanded from its origins in Guangdong Province to become involved in some 2,800 commercial and residential real estate projects in no less than 310 Chinese cities. It used returns from its early ventures and still more debt to expand into other businesses, including electric vehicles, tourism, hospital management, retirement communities, media, film, food services, music, and finance. As long as China’s development proceeded at speed, everything hung together. Between 2010 and 2018, for instance, the company’s revenues expanded at a breathtaking 33 percent a year. More and more debt was easy to shoulder and attractive since it enabled the company to take advantage of additional revenue-generating ventures.
But as China’s economy slowed in more recent years, things began to come unwrapped. The year 2019 saw slower growth, in part because of the “trade war” with the United States but also more fundamentally because nothing can grow at such a rapid pace indefinitely. COVID-19, of course, held back business in 2020. Over that two-year stretch, Evergrande’s revenues grew at an annual rate of only 4.3 percent, a stark change from most of the firm’s history. But as the revenue flow turned to a relative trickle, the debt load remained. Indeed, it grew as management borrowed to cover the revenue shortfall. As of the most recent reports, the company has liabilities at just over the equivalent of $300 billion. Its 2020 assets are slightly higher than this figure, but since values have no doubt dropped in the company’s efforts to raise money, it is safe to assume that Evergrande is no longer as grand as it looked in last year’s accounting and is, in fact, insolvent. Far from being able to cope with its obligations to creditors, suppliers, and customers, it is not even clear that the firm has the resources to make the next interest payment on part of its debt.
Everyone directly associated with Evergrande will now suffer. Shareholders already have. The value of the company’s stock has fallen some 85 percent from where it stood this time last year. Talk in financial circles suggests that bond holders will have to accept repayments of the equivalent of only 75 cents on the dollar, if they can get that much. What is more, the company has some 1.5 million unfinished projects on which homebuyers and investors have made down payments. Should Evergrande fail, these people stand to lose the money they have already paid as well as a property they had hoped to occupy. It is these unfortunates who make up most of the protesters in front of Evergrande offices.
If these losses, large as they are, were all, it would be sad, but there is much more, and that is what worries Beijing, or should. Like the American situation in 2008-09, China’s whole financial system is at risk, and consequently, so is its economy. For one, Evergrande is huge, China’s second-largest property developer. A large number of people and businesses are directly involved. Even more dangerous is the fear these prospective losses will inspire in others not directly involved. Because no one in a business deal or financial transaction knows who is at risk, all will worry that others will fail to meet their commitments. That fear will not only extend to those who might be involved with Evergrande, but it will also hover around those who, if not directly vulnerable, might have exposure to those who are closer to the trouble and so will become unable to meet their commitments even though they have no direct connection to Evergrande. As fears and hesitations spread wider, financial markets will freeze up and so will the economy. This is what was happening in the United States in 2008 and so worried the authorities. As it is, the trouble precipitated the biggest recession since the Great Depression.
If China’s Evergrande saga has not yet reached this point, the possibility is real and near. Beijing will have to act. For now, China’s authorities seem to be playing a wait-and-see game, hoping no doubt that the firm pulls through or that fear does not metastasize as it did in America’s crisis. The risk is, however, too great for Beijing to delay action much longer. After all, stability and prosperity are promises the Communist Party has made to “legitimize” its rule, and the picture just painted would make a lie of both.
If then a laissez-faire approach is too risky, the American experience would seem to offer Beijing four options: 1) flooding financial markets with liquidity generated by the central bank; 2) a direct loan from the government to troubled firms; 3) a forced sale of a troubled firm; and 4) a kind of government-directed reorganization, such as the United States used to deal with the savings and loan crisis of the late 1980s and Sweden used in its banking crisis in the 1990s.
Washington used the first three options simultaneously during the 2008-09 crisis. The Federal Reserve (Fed) pushed interest rates down close to zero and poured funds into financial markets through direct purchases of bonds, what the Fed called “quantitative easing.” Washington also forced the failing broker-dealer Bear Stearns to sell itself at a bargain price to J.P. Morgan and used taxpayer funds to lend directly to banks through what was called the Troubled Asset Relief Program (TARP). All these actions aimed at reassuring businesses and financial actors that there was no need for fear or hesitation, that any counterparty to a deal or trade would have the wherewithal to meet its obligations. The authorities did not use the fourth option during this crisis. It would have involved a kind of government bank, called the Resolution Trust Corporation (RTC) in the United States, to take over failing banks, sell off their good assets to help meet their obligations while keeping the bad assets on the government’s books to dispose of in a non-disruptive way gradually over time.
Given Beijing’s preference for complete control and discretion, it is unlikely to create a Chinese version of the RTC or anything like it. Though this approach has the virtues of coherence and predictability, such arrangements have rigid legal constraints of the sort that would limit Beijing’s preference to pick winners and losers. Such arrangements would also lose their appeal to Beijing by forcing a migration of power from the central authority to subordinates, presumably experts in financial matters.
Since there is a good chance that the Evergrande situation will get worse, Beijing will likely turn to monetary ease and emergency loans from government or even impose them on other businesses as well as forced sales. Even if this particular crisis passes without such needs, they nonetheless will likely be needed sometime soon. After all, many Chinese firms succumbed, like Evergrande, to the leveraging temptations of China’s once-rapid growth environment and will suffer in the slower-growing future, threatening financial and economic stability accordingly.
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