Max J. Zenglein on the Evergrande crisis

Is Evergrande really threatened with insolvency, and could such an insolvency result in the collapse of the real estate and financial markets?

I do not expect Evergrande to become insolvent. Nor do I think that the Chinese real estate market will collapse or that will trigger a financial crisis in China. The Chinese government wants to avoid that at all costs. It will try to let the pressure out of the real estate bubble in a slow and controlled way. This process will drag on for many years. Evergrande itself is threatened with breakup. It is also possible that the group will be placed under government control, as we have seen for example with Anbang in 2018. 

Why has the government let it get this far?

The government and regulators have been warning for some time that they would no longer tolerate the excesses in the Chinese real estate market. Real estate developers like Evergrande have taken on massive amounts of debt to build new apartments. At the same time, many Chinese have speculated in real estate, driving up prices. Xi Jinping has been warning for years that houses are for living, not speculating. Now the government has made financing more expensive for real estate developers and restricted land sales. It has also formulated “three red lines”, i.e., thresholds of financial ratios, to improve financial health back in October 2020. Beijing wants to prevent the emergence of even greater risks to China's financial system. 

What kind of toolkit does the government have at its disposal to manage the situation? 

The immediate risk posed by Evergrande would be a default on some of its liabilities, which is already underway due to the absence of cashflow to make payments to lenders or to continue construction activities. Evergrande has been trying to sell assets to raise cash, but other than a few cases, most companies are unwilling to buy what they view to be toxic assets. Beijing could command its SOEs to buy some assets or take over contracts and see them completed to help stem the bleeding and buy time. The party could also make it a political mission of private companies to take over some of these assets in return for political favor, or the state could create some incentives for them to do so. 

A government bailout, however, should not be expected. Instead, the government’s policy priorities will determine a hierarchy on how liabilities will be dealt with. The foremost priority will be on limiting the impact on private households and contractors for the sake of minimizing the immediate economic risk. The tanking stock market will affect domestic and foreign investors alike, but this is hardly a development that concerns the government as long as it can contain the overall fall out of Evergrande on financial markets. Foreign bond holders can expect to be at the bottom of the list and should brace themselves for default on payments. 

What consequences could Evergrande's situation have for international bondholders?

Evergrande has borrowed a total of more than USD 20 billion from international investors. Some of them will probably lose a lot of money. Nevertheless, I don't think a global shock wave is likely. However, the case shows the risks that lie dormant in the Chinese financial system. Foreign investors have recently had more and more opportunities to operate directly on the Chinese market.

Looking beyond Evergrande, how will China’s property market change?

The biggest challenge will be to prevent housing prices to collapse as China’s economy becomes less reliant on real estate for economic growth and private investors diversify their investment portfolios. Looking forward I do expect more regulation coming that will shake up real estate, including an end or at least a limit to how homeowners pay in advance for property that is not yet built. I could also imagine a form of government mandated investor protection for real estate investment. Or why not a mandate for real estate companies to contribute to “common prosperity” by building “affordable” housing.