Economic Affairs: Ripples from the Evergrande crisis

The collateral damage could be considerable, and extend beyond China.

29 September, 2021

Vikram Khanna
Associate Editor

It is now widely accepted that the crisis that has engulfed Evergrande, which is weighed down by more than US$300 billion (S$406 billion) in debt, will spread beyond the Chinese property developer itself. But the question is: how far?

Will it be contained as a domestic real-estate crisis or will it be more than that? What other entities will be impacted within China and beyond its shores? What second-order effects could there be?

Some observers have speculated that the Evergrande crisis may be China's "Lehman moment" - a reference to the collapse of the US investment bank Lehman Brothers in 2008 which ushered in the global financial crisis. This fear should be laid to rest.

Evergrande is not a bank, nor does it have derivative exposures around the world. At around US$20 billion, its external debt is relatively modest and its direct links to the global economy are of little consequence, other than losses for some foreign bond and equity holders. Its institutional counter parties - mainly domestic banks - are mostly government controlled or influenced.

But that said, the implications of Evergrande's crisis for China's economy could still be profound and take on many dimensions - some of which could have significant regional and global repercussions.

Canary in the coalmine

While in and of itself, Evergrande is not "too big to fail" - its debts are a minuscule proportion of China's total bank loans of 160 trillion yuan (S$34 trillion) - it could be the big canary in the country's property market coalmine. What is happening to Evergrande could also happen to some of China's other property developers, many of which, like Fantasia Holdings, Risesun, Guangzhou R&F, Sinic Holdings, Yuzhou Group and China Fortune Land are also burdened by huge debts, have been downgraded by credit rating agencies and seen their stock and bond prices collapse.

Standard and Poor's expects Evergrande to default on some of its debts. If other developers were to follow suit on a large scale - some defaults have already occurred - a domino effect would be set in motion. Developers would be increasingly shut out from funding by banks as well as bond and equity markets. Like Evergrande, they too would be unable to pay their suppliers - many of whom would also be forced to default - and hard pressed to complete their projects; more than half of Evergrande's almost 800 projects across more than 200 cities are unfinished, and many of them have been pre-sold to buyers.

In a desperate bid to raise cash, Evergrande has been trying to sell properties at discounts of up to 40 per cent for cash buyers, according to the Chinese financial portal Caixin. Faced with liquidity shortages, other developers are also under pressure to unload their inventories quickly. But having watched their mounting troubles, buyers have been staying away from the property market of late. Home sales in August were down about 20 per cent year on year in value terms. To bring buyers back, price cuts are all but inevitable.

Price cutting would widen the crisis. More than 40 per cent of bank loans are tied to the property sector, directly or indirectly; many non-property loans are also collateralised by property.

Real estate accounts for the bulk of household assets, which would effectively be devalued by price cuts. The property sector accounts for almost 30 per cent of China's gross domestic product (GDP).

A sharp decline in property values would bleed into the banking sector, as well as affect non-banks, which are also exposed to the property market. Facing higher non-performing loans as well as declining demand for property, these financial institutions would cut back on their lending, leading to lower investment. Consumer spending would also take a hit.

Lower economic growth

The upshot would be a decline in China's GDP growth, which could start to be felt in the fourth quarter this year. This in turn would have regional and global effects. The immediate impact would be felt in the markets for materials directly tied to China's property sector, including commodities such as iron ore, steel, copper, cement, timber and glass - the prices for many of which have already softened. Makers of such items as elevators, construction equipment, furniture, bathroom fixtures, white goods, lighting equipment, tiles and roofing materials - both within China and overseas - will also be affected.

The second-order effect of the slowdown in consumer spending would be felt by companies that depend especially on discretionary spending, such as automakers, manufacturers of consumer electronics and luxury goods retailers. Multinational corporations which have operations or subsidiaries in China will fall into this category, as well as the companies that supply them, many of which are spread across Asia.

Among services, outbound tourism from China would also be affected. In varying degrees, China's growth slowdown would impact all Asian counter parties which have significant trade linkages with China, as well as those elsewhere, such as in the United States, Germany and Brazil.

The extent of the collateral damage from China's property sector will depend to a large extent on the government's policy response. So far, the most visible action has been the pumping of liquidity into the banking system by the People's Bank of China (PBOC). What strategy the government will deploy to resolve the crisis is still unclear.

Whereas in the past, Evergrande would probably have been bailed out by the government, this is less likely now that the official policy is, quite rightly, to rein in the excessive leverage and overbuilding by property developers. A full bailout of Evergrande and other developers would compromise this policy and send the wrong signals.

However, the government would obviously want to prevent a systemic crisis. It would also want to minimise social unrest involving buyers of unfinished properties as well as suppliers who have been stiffed by Evergrande and potentially, other developers. Its priority will be to ensure that home buyers get delivery of their units and suppliers get paid, which means that as many projects as possible get completed.

But this will need resources. Some will have to come from developers selling their non-core assets, which in Evergrande's case include theme parks, Internet businesses, an electric car company and a part ownership of a football team. It may also have to sell parts of its land bank.

Local governments will also be encouraged to provide funds for the completion of projects, some of which may be taken over by healthy developers or state-owned enterprises. Banks may practise forbearance by extending repayments and restructuring debts, but some will have to suffer significant losses. Bondholders would also have to take haircuts, particularly offshore holders of dollar bonds, who will probably be last in the queue of creditors that get repaid; Evergrande has already missed a US$85 million coupon payment due last week.

While the Chinese government and regulatory authorities have several tools at their disposal as well as coercive powers which can help speed up the workouts, given the scale of the deleveraging to come, they will find it hard to prevent a property market correction, a wave of insolvencies, consumption cutbacks and a growth slowdown, which would impact China's trading partners.

Capital flight risk

Another risk that should flagged is that of capital flight, the danger of which often increases amid domestic economic stress and rising uncertainty. For example, when the trade war with the United States was intensifying in 2019, China experienced significant capital flight during the first half of that year, which the Washington-based Institute of International Finance estimated to be worth US$131 billion.

Another episode of capital flight occurred in 2015, when the US Federal Reserve announced its policy of "tapering" - that is, unwinding its bond purchase programme - after about seven years of quantitative easing, which led to expectations of US interest rate increases. In that year, capital flight was associated with a rout in China's stock markets, and led the PBOC to devalue the yuan by around 2 per cent against the US dollar.

Although China maintains capital controls to limit outflows, people and businesses exploit loopholes to get their money out, for example, by aggregating amounts they are legitimately allowed to withdraw in foreign currency, under-invoicing exports, over-invoicing imports - particularly from Hong Kong - and increasing investments in foreign assets.

The rising risks of foreclosures on assets by banks and government authorities amid a real-estate crisis, coupled with the prospect of another announcement of tapering by the Fed over the coming months could trigger another bout of capital flight from China, raising the risks of a yuan devaluation, which could also impact Asian currencies.

Thus, even under a scenario of an orderly restructuring of the highly leveraged Chinese property sector and the absence of a systemic crisis in the country, which is the base case of most analysts, there are risks that lie ahead, both for China's economy and those of its trade partners.