Evergrande and the ripple effects of Chinese deleveraging policy

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As Evergrande Group, China’s second-largest property developer, teeters on the brink of bankruptcy, observers are worried that its collapse could trigger a “Lehman moment” that sinks the global economy and financial system.

This concern is most likely unfounded. Of greater importance are the background factors that led to the Evergrande crisis: the speculative excesses, resource misallocations and social inequities accumulating from China’s economic growth miracle of the past three decades.

The Communist Party recently began to deal with these unintended consequences but the transition period could be a bumpy ride, as Evergrande illustrates. Indeed, the government’s new policy initiatives may have started a journey toward an extended period of sluggish growth – potentially similar Japan’s experience after its 1980s boom.

“Canadian high-net-worth investors, many of them with commodities backgrounds, have benefited from both investing in China’s real estate boom and the corresponding commodities boom,” noted Winston Ma, a former managing director at the sovereign wealth fund China Investment Corp. and author of The Digital War: How China’s Tech Power Shapes the Future of AI, Blockchain and Cyberspace.

“This ‘double-win’ play may come to an end for those investors,” he cautioned in an interview.

“Evergrande is not a classic ‘black swan’ crisis, but rather a conscious and deliberate consequence of Chinese policy aimed at deleveraging, de-risking, and preserving financial stability,” declared Stephen Roach in his Sept. 27 commentary for Project Syndicate.

Roach has written two books on the Chinese economy and is currently a senior fellow and lecturer at Yale University, following a lengthy career with investment dealer Morgan Stanley as their expert on China.

Like other proper ty development firms in China, the well-connected Evergrande had become instrumental to the country’s goal of bolstering economic growth thorough massive infrastructure and housing construction projects. However, the “disorderly expansion of capital” in real estate, as the Communists called it, had become a concern.

According to the Rhodium Group, there is enough vacant property in China to house more than 90-million people – more than double the population of Canada. Speculative excess in the Chinese property sector, according to Numbeo.com, also has pushed the house-price-to-income ratio to 28, far above the U.S. at 4. The ratios in Shenzhen, Beijing and Shanghai range between 35 and 45, compared to 11 in Vancouver.

This state of affairs was a factor in the recent decision of the Communist Party leadership to shift economic policy away from stimulating growth through the real property sector toward promoting technological innovation and manufacturing.

In 2020, President Xi Jinping directed Chinese banks to cut back on mortgage loans. Limits were also placed on how much property developers could borrow, consisting of: a ratio of liabilities to assets below 70 per cent; a ratio of net debt to equity under 100 per cent and a ratio of cash to short-term debt above 100 per cent.

Only one of the country’s 15 largest developers was compliant with the debt ceilings, according to the South China Morning Post. Evergrande was offside on all three metrics and thus forbidden from raising additional debt – the trigger for the looming default on its financial obligations to banks, bond holders, suppliers, consumers who prepaid for new dwellings and investors who put savings into its wealth products.

But a Lehman Bros.-style collapse is not likely in the cards because of the Communists’ firm grip of the banking system, media and most other elements of Chinese society. The politicians may let Evergrande go to the brink as a way to chasten other property developers into shoring up their balance sheets, but they still have the tools to bring about an orderly resolution, as demonstrated by recent precedents with HNA Group Co., Baoshang Bank Co., Anbang Insurance Group and Dalian Wanda.

Mortgage restrictions and debt ceilings can be rolled back. State-owned business enterprises can complete Evergrande’s unfinished projects and buy up chunks of the conglomerate to inject cash that can pay off liabilities. Censorship and police powers can be used to accentuate positive developments and suppress protests as part of the process of calming financial markets.

Financial markets are concerned about Evergrande but not overly so. When news of its troubles moved onto the front pages of the press in September, the fear gauge known as the CBOE Volatility Index (VIX) climbed from a low of 16 to a peak of 27 by Sept. 20 – followed by a slide back to just above 20 near the month’s end. By comparison, the VIX stood at 37 in January of 2021; it had soared to 60 during the Lehman Bros collapse in 2008 and to 57 when COVID-19 burst on the scene in March of 2020.

Less than an estimated 7.5 per cent of Evergrande’s US$300 billion in financial liabilities is owed to foreign investors. While the company met interest payments in September on yuan bonds, interest on foreign bonds was missed. There is a 30-day grace period before default is deemed, but many of the bonds in foreign hands are trading at depressed levels associated with impending default.

However, a research note from Sohrab Movahedi of BMO Nesbitt Burns Inc. indicates that Canadian financial institutions and pension funds have little exposure to the debt of Evergrande and its peers in China. It’s a similar situation for equity stakes and counterparty risk. If real estate in China does cool off dramatically, there could potentially be an echo effect in foreign locations favoured by Chinese buyers – such as Vancouver and Toronto.

Roach at Yale University has brushed aside gloomy predictions about China over the years, starting with the Asian financial crisis of the 1990s, followed by the dot-com recession of the early 2000s and the global financial crisis of 2008. “But count me in when it comes to sensing that this time feels different,” he now says.

Over the past year, there has been a major shift in the economic policies of the Communist Party, a notable aspect being a switch to a new growth model based on innovating and manufacturing advanced and green technologies. But will this new model ramp up right away to replace the high rates of growth generated by past models? And is there not a risk of coming up short over the longer run?

There is also now a greater emphasis on redistribution and social-engineering priorities, as highlighted by the Communist’s call for “common prosperity” and a widening of the regulatory net to include such things as e-cigarettes, business drinking, Internet games and celebrity fan culture. There also appears to be a concern for corporations becoming too powerful or close to the West, of which the visible manifestations have been crackdowns on Chinese Internet companies such as Alibaba Group and the scuttling of listings of Chinese companies, such as DiDi Global Inc., on foreign exchanges.

The result has been a flurry of market interventions within a short period of time, which increases the risk of policy errors and adverse interaction effects across different initiatives. An example is the current power crunch in China now shutting down factories. It arose because of coal shortages and the tightening of emissions standards brought on by a rush toward environmental goals.

“China’s most serious problems are less about Evergrande and more about a major rethinking of its growth model,” warns Roach. “It strikes at the heart of the market-based ‘reform and opening-up’ that have underpinned China’s growth miracle since the days of Deng Xiaoping in the 1980s.”

“It will subdue the entrepreneurial activity that has been so important in powering China’s dynamic private sector, with lasting consequences for the next, innovations-driven, phase of Chinese economic development,” continues Roach. “Without animal spirits, the case for indigenous innovation is in tatters.”

Ting Lu, chief China economist at investment bank Nomura, believes Beijing’s attempts to transition from one growth model to another could significantly depress growth in coming years. So do other China experts. Julian Evans-Pritchard, at Capital Economics, is expecting annual growth in China of only 2 per cent in 2030; Leland Miller, CEO at China Beige Book International, does not rule out growth of 1 or 2 per cent a year.