24 novembre 2021

The case of Evergrande

  Economia e innovazione



The Evergrande Group is the second largest property developer in China by sales, founded in 1996 by the real estate tycoon Xu Jiayin. The company sells apartments to mostly upper and middle-income dwellers and in 2018 it became the most valuable real estate company in the world, with more than 400 billion Yuan ($62 billion) in revenues. Evergrande was listed on the Stock Exchange of Hong Kong in 2009. It currently owns more than 1300 projects in more than 280 cities across China.


Over the past 15 years the company has embarked on an impressive growth journey based on its “high debt, high leverage, high turnover and low cost” business model. This growth, however, has occurred amidst China’s broader organization and housing boom, which urbanized much of the country and caused nearly three quarters of household wealth to be tied up in housing. Thus, it came as no surprise that Evergrande was put at the centre of an economy that was dependent on its property market for economic growth.



Source: authors’ elaboration on data from Statista.



At its peak, Evergrande Group’s business model was not just limited to real estate development in the mass market but incorporated a much wider array of businesses including selling bottled water, owning China’s best professional football team and even started producing electric cars.


However, all of these positive developments came to a halt in recent times, when Evergrande’s extreme usage of leverage, that underpinned its incredible expansion, eventually backfired. Actually, in recent years Chinese supervisor entities have cracked down on real estate financing via shadow banking channels (such as trust loans and wealth management products), required banks to institute stronger oversight over real estate lending and compelled local governments to adopt more strict qualification criteria for developers to enter land auctions. Meanwhile, the Chinese property market has slowed down, resulting in less demand for new apartments. This is contributing to an overall slowdown of the Chinese economy, which worsened Evergrande’s troubles.


At the time of the crackdown, Evergrande was the most leveraged real estate developer in China and the most exposed to shadow banking as a source of financing. In early 2017 Evergrande began making changes to its business model, focusing on improving cash flow and profitability rather than just scale. Amongst other strategies, Evergrande focused on a more ‘asset light’ business model, offloaded a $8.9 billion of short-term debt, reduced its land acquisition cost, increased the share of real estate in smaller, less tightly regulated cities, and diversified into new business lines (including electric vehicles, tourism, and finance). Since then (March 2020), Evergrande has targeted to cut its debt by $23.3 billion annually for 3 years.


However, in August 2020 regulators met with 12 major property developers (including Evergrande) and introduced a ‘three red lines’ scheme that required them to contain debt by establishing some thresholds for three key debt ratios (Liability to asset ratio < 70%; Net gearing ratio < 100%; Cash to short-term debt ratio > 1x). If developers were to fail to meet any of these conditions, regulators would place strict limits on the extent to which those developers could grow their debt. In other words, regulators forced property developers to deleverage over the upcoming 3 years.


As of September 2020 Evergrande was breaching all the three limits. Hence, in the following 12 months, the developer tried to sell some of its businesses and properties at discounted prices in order to generate some cash, but such attempts were unsuccessful. By September 2021 Evergrande’s debt burden amounted to $305 billion, becoming the most indebted real estate company in the world. On Sept 14th 2021, Evergrande officially informed its investors it would not have been able to fulfil all its debt obligations, as it struggled to generate demand for its contract sales, leading to low cash flows. 


What could happen now?

The fact that Evergrande missed interest payments has not formally triggered default yet. Nevertheless, an eventual default was already very likely as of September 2021, given the low chances of a sudden turnaround of the company’s fortunes and a number of other interest payments due in the last quarter of the year. This bleak outlook became promptly reflected in the trading levels of Evergrande and comparable companies’ prices, as shown in the graph below. Later, some of Evergrande’s peers, such as Sinic and Fantasia, failed as well to meet their interest payment obligations. Although the People’s Bank of China (PBoC), the country’s central bank, deemed the risk of a contagion of the financial system from these actual and potential defaults as controllable, the news also affected economic growth outlooks and sovereign credit default swap (CDS) spreads. In October, Evergrande avoided imminent default by making the coupon payment it had missed almost a month earlier. Even if this payment resulted in good news for the stock and bond markets, the delay in its settling did not clear the need for Evergrande to engage with its creditors.



Source: authors’ elaboration on data from Yahoo finance.


In the meantime, it remained unclear how Chinese authorities would respond if the default would actually materialize. While Evergrande, and more broadly the Chinese real estate development sector, might be considered as too big to fail, PBoC officials took a tough stance, blaming the company’s failure on poor management and incautious growth policies while emphasizing the strength of the broader market. In this way they signalled that official support for the firm was not to be expected. However, given the pre-sales of unfinished apartments into which many of the customers have invested their life savings, the Chinese government opted for a softer restructuring of debt (a so called “tidy default”) that foresees the block of the sales of such projects and assigns its completion to other developers, so to maintain social stability.


Beyond this immediate response, a default of Evergrande is likely to lead to a complicated and lengthy restructuring process, one of the largest in Chinese history. Valuable lessons about this scenario can be drawn from similar cases from the past. For example, in 2018, the default of Chinese conglomerate HNA could not be prevented despite large-scale asset sales. What followed was a years-long and still unfinished restructuring process of the firm that prompted strong dissatisfaction among smaller creditors. The case has come under broader scrutiny by investors regarding it as a precedent of what is to come for Evergrande.


What effects could this crisis have on the global economy?

To date, during 2021 the group has lost approximately 80% of its value on the Hong Kong stock exchange and, at the same time, this has led to a generalized devaluation of the Chinese real estate industry. The Hang Seng Property index, which includes many companies in the housing industry, has indeed dropped to an historical minimum. The value of the Yuan with respect to other currencies has been affected as well. The main market indexes in US and Europe, instead, remain largely unaffected.


Aside from investors, homebuyers and suppliers, the credit market has been heavily struck, in particular the banking and insurance sector: if housing prices fall, banks have less assets as a guarantee of their loans and will have to raise provisions. A document released by the Chinese government shows that Evergrande’s liabilities are linked to 128 banks and 121 non-bank-institutions, to whom the PBoC has required to revise their exposure to loans and to assess financial risk on a monthly basis.


Chinese GDP growth during the third semester of 2021 has registered an increase of 4.9%, which confirms the slowdown (previous projections estimated 5.2% growth rate) caused by the crisis. This comes as no surprise, since the real-estate industry represents nearly 25% of the Chinese economy. In late September, the fear of Evergrande’s collapse shocked all stock exchanges, especially hedge funds and common funds exposed to the Chinese real estate sector and to the eastern bond market in general. The risk of a world domino effect caused by Evergrande’s crash is alarming since China alone represents around 18% of global GDP and a deterioration of this crisis would lead to a slowdown in other countries too.


This time is different

Some journalists and financial analysts have defined the Evergrande’s downturn as the ‘Chinese Lehman Brothers’ due to its analogies with the events of the Great Financial Crisis and for the great fear and uncertainty that seem to have brought investors back in those bleak days of 2008. However, although the comparison is suggestive, in the last weeks this narrative has lost support.


First, Evergrande is not as interconnected with the rest of the financial system as Lehman Brothers was. The latter owned several assets related to low-quality loans (called sub-prime), and when the real estate bubble burst it found itself with billions evaporating from its balance sheet, causing a contagion effect to other banks and financial institutions. Evergrande, instead, operates also in different sectors apart from real estate (it owns a football team and it is now present in the car industry). It is faulty of having adopted a business model too heavily reliant on leverage, but its exposures remain lower than those Lehman had in 2008.

Moreover, according to analyses by JP Morgan, the loans by the banking sector to Evergrande represent 0.2% of the total Chinese loans’ stock. Therefore, repercussions of the eventual collapse would be severe but confined in the Chinese property market. Indeed, only 20 out of its 305 $ billion of debt are owned abroad by investors and companies.

Finally, in the case of Evergrande a contagion effect could be avoided by the Chinese government. In fact, it is expected to use its wide control over the country’s financial system to get banks and private investors to act when and as needed in order to soften Evergrande’s default. It clearly aims at preventing unemployment to jump, and avoiding the impoverishment of millions of families that nowadays can glimpse the hope of an increase in income and quality of life.

In conclusion, the two crises can hardly be compared as the relative importance of the US economy and its currency in 2008 was far bigger than China’s and Yuan’s current ones, and while the American government let Lehman Brothers fail without intervening, in China the government will not allow an uncontrolled housing crisis. 



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Immagine: Evergrande, Crediti: IlSole24Ore, 2021.

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