Here We Go Again - Maybe - Vested

Here We Go Again — Maybe

Evergrande, China’s second largest property developer, threatens bankruptcy and with it the stability of Chinese finance.

Recent developments in China cannot help but raise bad memories from the 2008-09 financial crisis and make a person wonder if a new mess lies on the horizon. Thankfully matters there are occurring on a smaller scale than they did in America thirteen years ago.  Though Beijing has taken tentative steps to contain the situation, it will surely have to do more, especially because the circumstances of Evergrande’s collapse point to more such trouble in other Chinese firms.  U.S. and European investors and markets are not immune, though to date the 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.

Such debt excesses are, after all, common in economies that have grown as fast as China’s has.  When opportunities abound, as they did in China’s fast-growing economy, all managements have a powerful temptation to use debt to take advantage of them.  As long as fast growth generates strong revenue streams, the 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 with debt, the company’s management took advantage of still more opportunities.  Evergrande 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 into other businesses as well, including electric vehicles, tourism, hospital management, retirement communities, media, film, food services, music, and finance.  While China’s development proceeded at speed, everything hung together.  

But as China‚Äôs economy slowed in more recent years, things began to come unwrapped.¬† The year 2019 saw slower growth, in part because of the ‚Äútrade war‚ÄĚ with the United States but also more fundamentally because nothing can grow at such a rapid pace indefinitely.¬† Covid, of course, held back business in 2020.¬† Over that two-year stretch, Evergrande‚Äôs revenues grew at an annual rate of only 4.3 percent, a stark change from most of the firm‚Äôs history.¬† But as the revenue flow turned to a relative trickle, the debt load remained.¬† Indeed, it grew as management borrowed to cover the revenue shortfall.¬† As of the most recent reports, the company has liabilities at just over the equivalent of $300 billion.¬† The accounting for 2020 sets assets slightly higher than this figure, but since values have no doubt suffered with the company‚Äôs efforts to raise money, it is safe to assume that Evergrande is no longer as grand as it looked in last year‚Äôs accounting and is, in fact, insolvent.¬† Far from being able to cope with its obligations to creditors, suppliers, and customers, the company has already failed to make an interest payment on its dollar denominated debt.¬†

Now the big question is how many other Chinese firms succumbed in a similar way.

For the moment, everyone directly associated with Evergrande is suffering.  The value of the company’s stock has fallen more than 85 percent from where it stood this time last year.  Talk in financial circles suggests that bond holders will have to accept repayments of the equivalent of less than 50 cents on the dollar, if they can get that much.  What is more, 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 a property they had hoped to occupy.  It is these unfortunates who make up most of the protesters in front of Evergrande offices.

If these losses, large as they are, were all, it would be sad, but there is much more, and that creates much wider concerns. 

Like the American situation in 2008-09, China’s whole financial system is at risk, and so, consequently, is its economy.  For one, Evergrande is huge.  A large number of people and businesses are directly involved.  Even more dangerous is that the fear these prospective losses will instill broader fears in others who are not directly involved.  Because no one in business deals or financial transaction knows who is at risk, all will worry that others will fail to meet their commitments. 

That fear will not only extend to those who might be involved with Evergrande, but it will also hover around those who, if not directly vulnerable, might have exposure to those who are closer to the trouble whose failure to meet their commitments will make others unable to do so.  As fears and hesitations spread wider, financial markets will freeze up and so will the economy.  This is what was happening in the United States in 2008 and forced the authorities to act in ways that could restore confidence.  As it is, that trouble precipitated the biggest recession since the Great Depression. 

So far, Beijing has taken only tentative steps, largely through provincial jurisdictions, but especially since other Chinese companies faced the same temptations as Evergrande and no doubt have followed similar paths, action from Beijing is all but inevitable.  When leadership there moves, it 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. Making direct loans from the government to troubled firms or forcing stable firms to make such loans
  3. A forced sale of a troubled firm
  4. A kind of government-directed reorganization, such as the United States used to deal with the savings and loan crisis of the late 1980s and Sweden used in its banking crisis in the 1990s

From this side of the Pacific, information has already emerged that several large U.S. investors have exposure to Evergrande.  That would be expected since the company had issued dollar-denominated bonds.  That does not necessarily mean U.S. markets are in trouble.  All depends on the extent of the exposure and whether it is sufficient to create the kind of generalized fear that froze markets in 2008-09 and that threatens to do so 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 at least a while.  

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