What do Dominoes do?

Lehman Moment? Probably not, but Evergrande is the result of several intrinsic issues of the Chinese economic system. The need of the hour is recalibration.

On the 15th of September 2008, hundreds of employees dressed in their sharp-cut suits were forced to walk out of their Wall Street office with boxes in hand as Lehmann Brothers, one of the largest investment banks in the world at the time, filed for bankruptcy. 13 years later, headlines from all over the world may be heralding a similar moment – a ‘Lehman Moment’ – for China’s second-largest property developer, Evergrande. Sensationalism aside however, how close is Evergrande to its ‘Lehman Moment’, really?

Codeword: Leverage

The word of the day is ‘leverage’: $300 billion worth in the case of Evergrande, to be precise. And as was the eerily similar case 13 years ago, defaults are playing out mid-September. But before moving forward, let’s break down this blanket term of ‘$300 billion’ that everyone’s been harping on about. If you’re not into numbers, feel free to conveniently skip over to the next graph.

The $300 billion liability, amounting to about RMB 2 trillion, is relatively diverse. A little over half of it lay in payables/acceptance bills, while another 14% (approximately), lay in wealth management products (WMP). This 14% accounts for about $42 billion – a relatively small blip in case there was to be a default – in the $6 trillion annual Chinese consumer sector, according to a Barclays research report from last week. Of the remainder of the debt, about 11% lay in bank loans, and about another 10% in combined offshore- and onshore- bonds.

Essentially, on paper, even if the Chinese authorities took no action and Evergrande was to default on all of the above liabilities, the impact on the financial system would be minimal, to stay the least. This then obviously begets the question: what’s all the fuss about?

The fuss, as often is, is about perception.

The Ever-Grande Moment

Systemic worries surrounding Evergrande are not driven by fears of the failure of the firm alone, but of it causing a domino effect that, in its worst case, may just cause enough stress on an already stretched global economic system to wreak havoc to global markets. Markets have already reacted rather edgily last week as well, with Evergrande’s 85% drop in share price being echoed by the 2% fall in both of the United States’ major stock markets.

In the short-term, this could be followed by finance fleeing from other debt-strapped property companies, housing and land prices crashing, and several thousands of Chinese savers suddenly finding the properties that they invested in becoming less-valued than what they paid for them in the first place. Commodities suppliers, including concrete, wire, steel etc would collapse, while unemployment would soar.

The globality of the event would be echoed first by the coal and iron ore suppliers based in Brazil and Australia (among others), followed by the financial contagion from the failures of those making long-term bets on the Chinese stock or bond market. With Evergrande now looking likely to default on the bulk of its liabilities (except for a relatively paltry $36 million (RMB 232 million) repayment on one of its bonds last week), there is widespread concern over the kind of impacts it will have on China’s property markets and on investors as a whole.

Does this mean other over-leveraged property firms in China are on the line as well? What if there is a fire sale of Evergrande’s real estate? What would that mean for the $50 trillion housing market in China? A recent article from the Financial Times reported that there were approximately 90 million unoccupied homes in China – enough to fit in the whole population of several small Nordic countries, in fact. What would a failing housing market mean for this massive hoard of unoccupied inventory?

While much of these answers depend on what unfolds over the coming weeks – especially on what Beijing has to say about the conundrum – speculation is rampant, especially about the levels of lofty corporate debt. Market participants currently believe that the Chinese government will allow Evergrande to default on at least some of its debt, leaving foreign investors to foot much of that bill, whilst protecting domestic homeowners and suppliers that the real estate giant owes money to.

Interestingly, it’s not as if Evergrande’s default hasn’t been coming. Over the past few months, several of the major global players – BlackRock, UBS, Fidelity and Allianz to name a few – have slowly been taking their positions out of Evergrande stock. But what’s truly concerning for China at present, according to the Wall Street Journal, is the fact that:

“The risks stemming from China’s markets stem far beyond debt and real estate. A continuing regulatory campaign has targeted Chinese technology giants including Alibaba Group Holding Ltd. and Tencent Holdings Ltd. over issues including alleged anticompetitive practices, data security and other matters. Alibaba’s shares in Hong Kong are down by about a third year to date while those of Tencent—the maker of the popular WeChat app in China—are down by more than 20%.”

So we need to firmly place our eyes on China as a whole, and not just China’s property markets.

The Challenge of the Chinese rebalancing act

Evergrande, much like China has, for a long, operated under the model that it is prudent to borrow in order to build. Consequently, foreign investors have also considered China an essential part of their ‘risky’ portfolios, with most considering an 8-10% holding prudent. Hence, with Evergrande’s business today running out of credit (partly owing to major shifts in policy by the Chinese government), the omens seem to be bleak.

Recently, the Chinese government, led by Xi Jinping, has placed much emphasis on achieving a sustainable and equitable growth model as it recovers from the impacts of the COVID-19 pandemic. Wealth and income disparities in China over the past few years have been rather large, exacerbated by years of its own brand of trickle-down capitalism, which have, in the least, led to the burgeoning of a broad middle-class spectrum. However, how congruent the objective is, given the plethora of over-leveraged firms and firmer regulatory constraints on foreign investment, is a question Evergrande seems to be answering first-hand.

The Wall Street Journal writes: “Several “macro” hedge funds that invest based on their views of big-picture market movers like the economy, politics and regulation have started betting against China in recent months as the wave of regulatory surprises has continued, investors said. One view is that political infighting in China leading up to an important Communist Party meeting slated for late next year could mean more shocks to come for investors.”

The fact that China today is pushing back against ‘unsustainable debt-driven growth’ will raise several problems, much like Evergrande. It will involve weaning the Chinese populace off believing that empty apartments are a good investment vehicle (without destroying their savings); persuading people that they must spend more and save lesser; reallocating vast capital and labour from the broader construction sector that accounts for one-eighth of China’s GDP, and raising taxes to augment falling land sales as a source of income. What’s worse is that they’ll have to do all this whilst adding less debt and maintaining growth rates. The Chinese model, put simply, requires much rebalancing. Debt cannot persist the way it has over the past decade.

So, is this a Lehman Moment for the economy? Probably not, but much now depends on the current course of action by the Chinese government. What this certainly is, however, is a warning sign. The Evergrande moment is unfolding, and the ball is well and truly now in Beijing’s court.