What Can Evergrande’s Unraveling Teach Us About China’s Credit Market, Real Estate Prices and Policy Making?

RESEARCH NOTE

For the last few days, the press has claimed the imminent Evergrande bond default will create a financial crisis similar to what the Lehman collapse triggered 14 years ago. Let’s explore that.

There are certainly similarities. The 2007 GFC was fueled by an over-levered real estate sector, along with the institutions and investors who financed the irrational property bull run. Lehman was not alone, but it did trigger the avalanche that nearly swallowed the global financial ecosystem and debilitated the world economy. So, could Evergrande trigger something similar?

Those who believe that Evergrande is Lehman redux tell the following story:

China has experienced an enormous real estate bull market. Pointing towards affordability with respect to average household income, the last ten years have often been labeled a bubble. China Evergrande is China’s second largest real estate developer and owes US $300B in debt to Chinese and global financial institutions. Its inability to service its debt reflects the beginning of the end for the Chinese real estate market. Evergrande’s predicted collapse could cripple Chinese banks and create a run on financial institutions, which would spiral out of control. This would trigger a collapse comparable to Lehman.

The story above is intuitive and compelling for many China-watchers in the West. The West has always been skeptical of Chinese banks’ true balance sheet strength and has also been predicting a Chinese real estate crash for nearly a decade. It’s really these factors, not anything specific about China Evergrande as a firm, that is at the heart of the doomsaying. And this fits the Lehman narrative well. After all, the Lehman collapse didn’t cause the Global Financial Crisis. Rather, the bursting of the real estate bubble caused the Lehman collapse and the ensuing GFC.

Unfortunately, the neat narratives that Western reporters crave about China aren’t always accurate. One cannot easily draw parallels between the developed economies and their biggest trading partner.

Ironically, it is precisely because past lessons (the Japanese real estate bubble and the 2007 GFC) are so vivid and relevant that these painful historical episodes are less likely to be repeated in China. The Chinese regulators are neurotically fixated on avoiding the Japanese real estate crash that derailed the rise of Japan Inc. I will speak more on this topic in a separate article. But in this post, let me focus only on China Evergrande, disregarding some of the finer nuances for the sake of clarity.

The most salient question for anyone trying to predict the impact of Evergrande’s unraveling is about the state of the Chinese real estate market. Is it a bubble? Is the bubble about to burst?

To answer these questions, one can examine price trends for used apartments in China. Used apartment prices continue to advance upward for all major cities; more interestingly, they are higher than the prices for new apartments! Why are used apartments more expensive than new? Simply, the government has imposed price caps thru pre-agreements with developers before auctioning off public land and approving development proposals.

A new get-rich-quick scheme in China is to participate in “new apartment purchase” lotteries: a lucky winner can flip her new apartment in the secondary market for a large profit. (Note that the government recently instituted a 5-year holding period requirement to discourage this). Setting aside the question of whether Chinese real estate prices are rational, the tremendous buying demand and the willingness to pay have simply shown no sign of waning.

If real estate prices aren’t cracking, might the Chinese financial system be so fragile that the demise of Evergrande would cripple it? It is certainly true that easy liquidity resulting in too much leverage makes for a ticking time bomb. Additionally, if housing prices have not buckled, what then ails Evergrande? Why can’t it pay the interest on its debt? To answer both questions we need to understand the credit market—or more precisely, the lack of one—in mainland China.

Contrary to popular claims, mainland China has not been free flowing with easy credit. Real estate developers in China often have to pay 10% to 15% in financing on fully collateralized debt to raise capital for construction projects. The debt is generally short-term in nature—1 to 2 years, with 1-year notes being the most widespread. Lenders keep a very tight leash and apply tremendous on-going due diligence as most projects require debt rollover.

Importantly, Chinese lenders do not lend based on a developer’s overall balance sheet and income statement. They simply assume that most developers will siphon off money and leave the lender holding an empty bag. In China, credit is not just expensive, it is generally unavailable. You qualify for a loan only if you have hard assets as collateral. The bank doesn’t care about your credit—they only care about the value of the assets you hand over to back the loan.

Once we understand how real estate development financing works in China, we can begin making sense of the mess that is Evergrande. Evergrande does have a fantastic land bank and many high-quality development projects. This was precisely why it was able to borrow so much, and why it could always roll its debt. It had and still does have solid collateral.

However, Evergrande was also one of the most speculative developers in China; it pursued a strategy of amassing an ever-increasing land bank and slow-played its construction pipeline to benefit from the real estate bull market in China. This was once considered genius; it was also a textbook adoption of Hong Kong real estate tycoons’ standard playbook. But over time, this strategy ran into problems.

In September 2020, Beijing announced that it would begin disincentivizing developers from hoarding land and driving up prices by restricting financing available to offending developers. This is widely referred to as the “Three Red Line” policy which was formalized in January 2021. However, due to a combination of too-big-to-fail hubris and too-big-to-pivot inertia, China Evergrande stood out as defiantly non-compliant.

The “Three Red Line” policy essentially forbade financial institutions from lending to developers with too much debt compared to their assets and who don’t generate enough cash to cover their short-term liability. The government recognized these as signs of a developer who isn’t developing and selling homes effectively. Rather, these reflect a developer who is hoarding land and financing interest payments with new debt. As a result, China Evergrande could no longer access debt.

It is important for investors to understand that the inability of China Evergrande to refinance is not due to a decline in collateral value. Rather, it is due to a drying up of liquidity for refinancing its real estate. Stated differently, this is a controlled and targeted liquidity crisis engineered on purpose by Beijing to change behavior.

Now, let’s consider how China Evergrande might be broken up in an orderly fashion. First, note that the overwhelming majority of China Evergrande’s US $300B debt consists of hundreds of loans, each made by a local lender collateralized by a local real estate construction project. That means each construction project is largely isolated from the other. We know how dysfunctional the standard bankruptcy workout process for a massive debtor can become as people trample over each other trying to get paid ahead of the next creditor—working on side deals and preventing management from conducting the necessary business activities to sustain enterprise value. Frankly, a long and complicated bankruptcy work-out process might do more to destroy creditor (asset) value than prevent further management malfeasance.

So, instead of a messy bankruptcy, Evergrande’s future is shaping up to be hundreds of separate debt restructuring conversations with respective lenders for each local project. Each can move forward to resolution if the terms are right. But there won’t be a complicated, consolidated bankruptcy process that freezes up all projects and capital.

As it stands today, it looks like the substantial majority of projects and their debt will be sold to various local developers at a meaningful discount. Indeed, new lenders are happy to come in to refinance these x-Evergrande projects to completion as collateral quality is high and the new developer will be a qualified borrower under the “Three Red Line” rule.

Generally, we expect this to largely keep the lenders whole while wiping out the equity value in these Evergrande projects. The consensus is that the Evergrande land bank and real estate projects are solid quality and, upon completion, will generate more than sufficient value to repay debt. Put another way, this is a liquidity-driven crisis (Evergrande cannot qualify for loans because of policy); this is not an asset value-driven crisis.

Of course, there is the Evergrande credit debt —US $19B worth— sold in Hong Kong to global bond investors. The kind that is issued based on the good name and good credit of Evergrande’s Chairman Hui Ka Yan…the kind that has cash flow priority before equity shareholders but no priority before the savvier domestic lenders who explicitly took hard collateral before shaking hands with Hui and extending him a loan. Those Evergrande credit bonds will likely suffer tremendous value destruction. (They are already trading at 26 cents to the dollar.)

At the end of Evergrande’s restructuring, very little, other than bad publicity and a cautionary tale on leverage and hubris, will be left. Perhaps, global bond investors could look to Chairman Hui to give back the US $7B cash dividend payments he received over the past years, which were financed with the credit debt that Evergrande floated. I have my doubts, but it never hurts to ask.

This article was first published to LinkedIn:
https://www.linkedin.com/pulse/what-can-evergrandes-unraveling-teach-us-chinas-credit-jason-hsu/

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