Evergrande Isn’t Lehman — It's A Lesson In How To Think About China
In an interconnected world, the sight of angry workers and investors besieging a corporate HQ in a far-off Chinese city is enough to have global financial markets asking if a rerun of Lehman Brothers is on the horizon.
The debt issues surrounding giant Chinese residential real estate developer Evergrande have caused global stock markets to whipsaw over the past fortnight as investors worry its potential collapse might have a damaging effect on the Chinese economy, the world’s second-largest, and thus impact the fragile post-Covid economic recovery in countries like the U.S. and UK. The commercial real estate sector is relying on that economic recovery to help it recoup some of the ground lost during the coronavirus pandemic.
Fears that a debt default or total collapse of Evergrande could cause a Lehman-style financial contagion and credit crunch are receding, but investors, including those in commercial real estate, now have another question to address. How will China manage the restructuring of Evergrande, and what does it mean for the role of the Chinese government and the country’s major companies in the world economy going forward?
“There’s no doubt that President Xi Jinping wants to take China to become the No. 1 economy in the world,” S&J Private Equity Chief Investment Officer Shanka Jayasinha said. “The interesting thing with Evergrande is what it says about how China wants to portray itself.”
Investors with even a passing knowledge of the interface between Chinese politics and economics will be aware that the country is trying to forge a unique system that is authoritarian, but allows individual wealth creation. The unique complexities of Evergrande pose a challenge to that balance. How Beijing walks this particular tightrope will give an indication of what investors in real estate and beyond can expect from China in the coming years.
First, the question of Evergrande as China’s Lehman moment. It is not an exact parallel, but the worries about the impact that Evergrande might have on global financial markets are not totally far-fetched.
The company has more than $300B of debt, making it the most indebted real estate company in the world. For context, that is about half the amount Lehman had when it went under in 2008, but more than the sovereign debt of Argentina and Greece combined — and the debt issues of those two countries were more than enough to frighten global financial markets at the start of the millennium and in 2012, respectively.
Evergrande isn't as interconnected in financial markets as Lehman was. Most of its debt is held by domestic Chinese banks and investors rather than international institutions, which limits the potential impact if it does default on loans. And the Chinese banking system is a lot less complex than that of the U.S. in 2007 and 2008. There are fewer complex financial derivatives hiding who has exposure to problem loans, something that added to the fear that froze credit markets 13 years ago.
But Evergrande poses a different problem.
“An Evergrande collapse, even a managed one, would reverberate through the Chinese economy given the company’s liabilities are equal to 2% of the country's GDP,” Nuveen Real Estate Chief Investment Officer and Head of Funds Management Louise Kavanagh said in a note to clients. “Pessimistically, a full-blown collapse would send ripples through the Chinese economy.”
That is because so much Chinese household wealth is tied up in residential real estate — as much as three-quarters, Nuveen said.
“Beijing has a strong incentive to make sure that such wealth doesn’t go down in an exploding bubble,” Kavanagh added. “A collapse of Evergrande would be detrimental to property values, which would deal a blow to consumer wealth, and in turn lead to a slowdown in consumption and investment in addition to other consequences. The firm is so big that this ripple effect is highly likely.”
Anything that could cause a significant slowdown in the world’s second-largest economy inherently has the potential to impact the rest of the globe, too.
In addition, there is the social consequence of an Evergrande collapse that Beijing must factor in. The company directly employs more than 200,000 people and supports more than 3 million jobs. If the company does collapse, those jobs could be lost. On top of that, millions of Chinese who have bought homes off-plan from Evergrande might be left waiting for a home or lose their investment entirely.
Those people protesting angrily at the company’s Guangzhou HQ were small-time investors who bought bonds in the company through wealth managers, company staff who made the same investments and homebuyers worried their savings might be lost.
For that reason, the expectation is that the Chinese government will not allow Evergrande to simply collapse. Nor will it bail it out, which might create the perception among companies that if they get ‘too big to fail’ then the government will step in and save them. On the contrary, the Chinese government has tightened regulation on real estate firms in recent years in an effort to curb excessive leverage and reduce the threat any one company might pose to the system.
Instead the expectation is for the kind of managed default and breakup of Evergrande only possible in an autocratic country like China.
“In a business environment like China, any significant corporation owes a duty of stability to the entire country,” Bei Capital founder Collin Lau said. Lau has a good insight into the workings of Chinese finance and government, having previously served as head of real estate at CIC, China’s sovereign wealth fund.
“For anyone watching closely, and that obviously means regulators, too, I don’t think what is happening is a surprise," Lau said. "Regulators will have a plan B, C, D and E in place.”
Lau pointed out that much of the global coverage of Evergrande has focused on the size of its debt. But that $300B, while large for any single corporation, let alone a real estate firm, is dwarfed by the roughly $37 trillion of deposits savers have placed with banks, meaning Evergrande accounts for less than 0.2% of the country’s financial system, which can afford to absorb any potential shock.
For Nuveen, the most likely outcome is that the Chinese government steps in to guarantee that Evergrande’s development projects are completed and individual buyers don’t lose money on homes they’ve purchased, or end up with a home that isn’t finished. But financial investors who lent money to the central corporate entity are likely to face losses, as was the case with the breakup of another highly leveraged Chinese company, HNA. Coincidentally, the chairman and chief executive of HNA were arrested in China last week as that company’s restructuring nears an endpoint.
The image this projects to the world is that companies will not be allowed to run up huge debts with no consequence, nor will the government allow the market to deal with unviable companies as would happen in markets like the U.S. or UK, Kavanagh said. Importantly, it shows China will only assist companies seen as strategically important to its political and economic interests.
“The government has made it clear that it will now allow ‘debt bombs’ to detonate and only step in to save economically important firms,” she said, referring to the different attitudes to HNA, a financial conglomerate that invested heavily abroad, and Evergrande. “Evergrande will be a warning and education to the market.”
In this case the company will not be allowed to totally fail, but it isn't quite being bailed out either.
Since introducing regulations curbing outbound investment in real estate in late 2015 — a policy designed to stop Chinese companies running up offshore debt that might pose a threat to domestic financial stability — China’s investors have not been major outbound players in global real estate markets. But the deals that have happened and Evergrande's fate give an indication as to who is likely to keep investing and what form it might take.
Deals that have completed include the massive £11B acquisition of Blackstone’s European logistic business, Logicor, by CIC in 2017. That gives the Chinese government an important foothold in the movement of goods across Europe’s supply chains, a strategic investment for a country that is currently the factory of the world.
Developer R&F, which has close links to the government, has continued a huge London residential development drive, which continued with £430M of new funding for a £3B project last week. The company has close links to the Chinese government and the founders demonstrated their commitment to reducing R&F’s debt by putting up £750M to stabilise the company.
"If you look at what happened to Jack Ma [the digital billionaire who was censured by the government after criticising party policy], it is all part of Beijing cracking down," S&J's Jayasinha said. "Evergrande is just a symbol of Chinese control."
For Lau, the Evergrande crisis could also mark a subtle perception shift in how global investors view China: “If you look in a few months from now and China has basically just swallowed the issue with no major implications, there will be a recognition of the capacity of the Chinese financial system.”