The Trouble with China’s Evergrande

Beijing has taken preliminary steps to deal with the failure of Evergrande, China’s second largest property developer.  This is not the end of the story, however, not by a long shot.  The picture too closely resembles the beginnings of America’s 2008-09 financial crisis to ignore, though thankfully it is occurring on a smaller scale.  Before it is resolved, it will demand more action from Beijing and perhaps from Washington and other capitals –– especially because the circumstances of Evergrande’s collapse point to more such trouble coming from other Chinese firms.  Nor are U.S. investors and markets immune, though to date their exposure seems contained.

The problem for China, and by extension for world-wide finance, is that Evergrande’s difficulties may be typical of many Chinese companies.  These are common in companies that have grown quickly in rapidly expanding economies, such as China has had until recently.  When opportunities abound (as they did in China), managements have the powerful temptation to use debt to take advantage of these business opportunities.  And as long as fast growth generates strong revenue streams, such debt is easy to shoulder.  Between 2010 and 2018, for instance, Evergrande’s revenues expanded at a breathtaking 33 percent a year.  By leveraging that flow of funds to take on more and more debt, Evergrande’s management took advantage of even  greater opportunities.  It expanded from its origins in Guangdong Province to become involved in some 2,800 commercial and residential real estate projects in no less than 310 Chinese cities, and it ventured into other businesses as well, including electric vehicles, tourism, hospital management, retirement communities, media, film, food services, music, and finance.  And as long as China’s development proceeded at speed, all Evergrande’s pieces hung together.  

But as China’s economy has slowed in recent years, matters began to unravel.  2019 saw slower growth, in part because of the “trade war” with the United States, but also, and more fundamentally, because no economy can grow so fast indefinitely.  Covid, of course, slowed business in 2020 and into 2021.  Since 2018, Evergrande’s revenues have grown at an annual rate of only 4.3 percent, a sharp change from most of the firm’s history.  But as the revenue flow turned to a relative trickle, Evergrande’s debt load remained.  In fact, it grew as management borrowed even more money to cover its growing revenue shortfall.  As of the most recent reports, the company has liabilities at more  than $300 billion.  Its 2020 assets were slightly higher than this figure, but because its assets have no doubt suffered with the company’s efforts to raise money, it is safe to assume that Evergrande is no longer as grand as it looked in last year’s accounting.  In fact, the company is insolvent and, far from being able to cope with its obligations to creditors, suppliers, and customers, it has already failed to make a critical interest payment on part of its debt

Everyone directly associated with Evergrande will now suffer.  Shareholders already have.  The value of the company’s stock has fallen more than 85 percent from this time last year.  Talk in financial circles suggests that bond holders will have to accept repayments at half the value they expected –– if they can get that much.   The company has some 1.5 million unfinished projects on which homebuyers and investors have made down payments.  Should Evergrande fail, these people stand to lose the money they have already paid as well as the property they had hoped to occupy.

If these losses, large as they would be, were all, it would be sad enough, but there is much more, and it is generating much wider concern.  Similarly to the U.S. in 2008-09, China’s entire financial system is at risk, and, consequently, its economy.  For one thing, Evergrande is huge.  Many people and businesses are directly involved with the company.  Even more dangerous is the fear that these prospective losses will lead to other business failure that are not directly involved Evergrande.  Because no one in a business deal or financial transaction, wherever it occurs, can know all of those at risk, anyone doing business, especially in China, will worry that other companies will also fail to meet their commitments.  This worry will extend not only to those who might be involved with Evergrande, but it will also ripple outward to entities that, if not directly vulnerable, may have exposure to those who are closer to Evergrande and who will become unable to meet their commitments.  As fear and hesitation spread ever wider, China’s financial markets may freeze up, and then so will its economy.  This is what happened in the United States in 2008 and what so worried Washington.  As it was, the U.S. meltdown precipitated the biggest U.S. recession since the Great Depression. 

As of this writing, Beijing has refrained from a full-scale intervention, but because other Chinese companies, facing the same temptations as Evergrande, no doubt followed similar paths, more action from the Chinese authorities is all but inevitable.  Beijing can take guidance from the American and European experiences in 2008-09 and earlier.  These would seem to offer Beijing four options: 1) flooding financial markets with liquidity generated by the central bank; 2) direct loans from the government to troubled firms; 3) a forced sale of troubled firms; and 4) a kind of government-directed reorganization, such as the United States created to deal with the savings and loan crisis of the late 1980s, and which Sweden employed in its own banking crisis in the 1990s.

Information has already emerged that several large U.S. investors have exposure to Evergrande.  That would be expected, because the company had issued dollar-denominated debt.  But that does not necessarily mean U.S. markets are in trouble.  All would depend on the extent of the exposure and whether it is large enough to create the kind of generalized fear that froze markets in 2008-09 and that threatens to do so now in China.  Much also depends on how quickly and effectively Beijing moves to stabilize its markets.  Even if the effect is minor, the fear of contagion will roil U.S. markets for a while.  Investors in for the long term would do well simply to weather the inevitable downdrafts, comforted by the knowledge that markets will more than recover before they have any need for the funds.  But investors who have short-term needs might do well to sell enough to meet those needs ahead of any worse damage to the markets.

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