Welcome back everyone. Another piece on Evergrande, I wont dwell
too much today on the details of the company, as I’ve covered that reasonably well over
the last few days. Today I want to focus in on how this collapse
ties in to the overall Chinese economy. We will examine how the rise and fall of Evergrande
is tied to certain economic choices made by policy makers over the last three decades. We will wrap up with how a typical bankruptcy
works, and how this one is likely to be quite different. Evergrande as I’m sure you know by now is
Chinas second largest property developer whose slow collapse has transfixed the markets over
the last few weeks. Evergrande is the most-indebted property developer
in the world and its on-balance-sheet liabilities amount to nearly 2 percent of China’s annual
GDP. It’s off-balance-sheet obligations could
add up to as much as additional 1 percent. This on its own is big – some of the numbers
are huge, but ordinarily it wouldn’t be such a big deal if it wasn’t for the huge
amount of leverage in the overall Chinese economy. I showed you this chart in yesterdays video
from the bank for international settlements showing that Chinese businesses have almost
twice the leverage of American businesses. The Chinese economy been plagued by debt problems
and what we call moral hazard for quite some time. Policy makers have been (on and off) attempting
to reduce this, and these attempts have to a certain extent played into the collapse
of Evergrande. It is quite a sticky situation for them to
sort out right now. Ok, so there is (and has been for some time)
a problem with excessive leverage in the Chinese Economy, and this is no surprise to Chinese
regulators who have been trying over the last few years to reduce the economy’s overreliance
on debt. As part of these attempts, they implemented
the “three red lines” for property developers in August 2020. The three red lines were hard limits on a
property development company’s debt-to-asset ratio, its debt-to-equity ratio, and its cash-to-short-term-debt
ratio. This policy has an instant effect on property
development firms. Not only could they no longer borrow, but
they were basically forced to quickly pay down their debts. This meant selling assets often at fire sale
values, laying off staff and taking losses on the chin. This caused a bit of a spiral, as the losses
only made their ratios look worse, putting further pressure on these companies to deleverage
further. Right now, Evergrande is the firm struggling
the most, but the pain being inflicted by the three red lines on Chinese property developers
is much more widespread. So was this a foolish move by Chinese policy
makers? It is hard to say. It does make sense for them to worry about
the high levels of real estate debt—and debt in general. China’s official debt-to-GDP ratio (which
many argue is understated) has rocketed in the last five years to one of the highest
debt ratios for any developing country in history. Real estate and real estate valuations are
usually found at the root of all debt. Most loans are made against hard assets like
real estate which can be repossessed. As loans are made against real estate, this
causes real estate prices to rise, and as real estate prices rise, larger loans can
be made against the real estate. So, this is a self-reinforcing cycle both
on the way up and on the way down. In China, real estate developers typically
sold apartments to homebuyers off the plans – months or years before commencing construction. This surprises people in other countries,
but it makes a certain amount of sense in a rapidly developing country like China, where
people have migrated from the country to the cities on a huge scale as the economy has
grown. In other parts of the world there are usually
enough urban apartments available if you move to a new city, making this unnecessary, but
this is just the way things work in a rapidly developing country. There have been lots of issues with this model,
where often the property developers cut corners in construction because the buildings have
been presold. This has led to what the Chinese call “tofu
dreg” construction, where the builder might have skimped on rebar, or padded out the concrete
with old bottles to save money. If you search the term tofu dreg construction
on YouTube you will see what I mean. So Chinese property developers typically get
substantial deposits well in advance of beginning construction. They pay subcontractors and suppliers with
commercial paper and receivables instead of cash. In addition, they frequently have financing
arms (or wealth management units) that sell debt to retail investors and employees – I
talked about this in yesterday’s piece. At this point you can probably get a good
impression of how leveraged the real estate sector is in China, and all of this leverage
allowed it to become a major component of economic activity. It is estimated to account for over a quarter
of the country’s GDP. The huge leverage also inflated a property
bubble. Average home prices have increased in value
by 50% since 2015. Property prices are very high in China relative
to household income, meaning that Chinese families borrow significantly more money than
Americans do to buy a home, often multiple generations of a family pool their savings
to buy a home. The worst part of this is that the huge historic
returns on property, led to speculative overbuilding. Up to a quarter of the total housing stock,
especially in the most desirable cities is owned by property speculators. Because the value of apartments goes up so
much, they don’t even rent out these homes, they keep them empty and in perfect condition
for eventual resale (hopefully at a huge profit). Empty housing incurs significant economic
cost while creating no economic value whatsoever. Ok, so the Chinese government do recognize
this as a problem and are trying to reduce leverage and stabilize the housing market. Up until last August and the Three Red lines,
borrowing for large Chinese companies had not been a problem. It was assumed that politically connected
firms like Evergrande would never be allowed to fail, and so there was very little credit
differentiation in the lending markets. In Economics they use the term moral hazard
to describe such a situation, where there is no incentive to guard against risk in situations
where you are protected from its consequences. The idea being that you are more likely to
lock the front door of your house when the contents of your home are uninsured. In the case of Chinese lending markets moral
hazard underpinned everything. Chinese regulators have quite deliberately
decided not to bail out Evergrande with the goal of transforming (and improving) the financial
system. There is a real goal in China to move away
from unproductive growth and focus on real growth. This can even be seen in the recent crackdown
on Chinese tech companies. I expressed some surprise about this crackdown
to a friend of mine a few months ago – he is much more knowledgeable about emerging
markets than I am. He explained that the Chinese government don’t
think of ride hailing apps or social media as real technology. Their focus is on supporting hard technology
like chips, semiconductors, 5G and so on. So, it is smart for regulators to concern
themselves with moral hazard but there is no easy solution to the problems they face
in China. Eliminating moral hazard from Chinese credit
markets would entirely transform the pricing of risk and would significantly change the
value of loans that lenders hold on their books right now. It’s a noble goal, but the path to achieve
it is extremely difficult (to say the least). This is because every loan that has been made
over the last thirty years is based more on how likely the borrower is to be supported
by the government than on their ability to meet the debt repayment cashflows. So how might all of these changes affect global
markets? As I mentioned in my prior videos on Evergrande,
their estimated $310bn in debt is larger than that of many sovereign governments, but most
of that debt has been issued in China which is a very large economy. Around $20bn has been issued offshore, and
this is trading at around 30 cents on the dollar. What is not being priced in is that foreign
bondholders may get different treatment to local lenders. We will talk more about that in a moment. US dollar denominated debt issued by other
Chinese developers is much larger and trades right now at around 85 cents on the dollar. Markets might eventually decide that this
debt should be priced more inline with Evergrandes bonds going forward depending on how the Evergrande
situation evolves. Other sources of contagion are internal to
China. Potential homebuyers in China, worried about
the news, are holding back on buying new homes, they are worried about putting deposits down
on unfinished apartments, and worried about wealth management products, all of this is
squeezing the developers. Contractors are demanding that they be paid
upfront, and are reluctant to accept commercial paper. The result, as Evergrande has already announced,
is that construction projects are falling well behind schedule. This kind of internal contagion could put
quite a drag on the Chinese economy. This is why the Chinese government will probably
need to move quickly. The biggest problem is that Chinese policy
makers can not eliminate moral hazard, and walk away from unproductive growth to focus
on real growth while continuing with their politically determined GDP growth targets. This is because ‘real growth’ simply won’t
generate enough economic activity to allow China to hit its GDP growth targets. The way China hits its growth targets is through
malinvestment by the real estate sector and by local governments building unnecessary
infrastructure. Whenever high-quality growth declines, as
it did last year due to Covid, the government steps up malinvestment to make up the difference,
then when high-quality growth picks up, they try to reduce low quality growth as they appear
to be doing this year. Chinese debt has grown rapidly since the 1990’s
and up until the mid 2000’s this debt funded necessary and productive investment, which
meant that the return on these investments grew faster than the debt did. In the mid 2000’s debt began rising faster
than GDP, this means that the cost of this additional debt was greater than the return
achieved by investing it (this is what I mean by malinvestment). If the Chinese government sets GDP growth
targets above the country’s high quality growth rate, malinvestment will continue in
order to fill the gap and debt will rise faster than the economy’s ability to service that
debt. If your plan is to do this – to grow debt
faster than your ability to service it, you need creditors to lend on the basis of an
implied guarantee that the government will make up the difference. You need moral hazard – otherwise no one
would lend for these projects. The fall out of this whole situation will
be really interesting for a variety of reasons. It will give us some real insights into Chinas
likely path going forward. Evergrande is essentially a company who has
borrowed huge amounts of money, and they have borrowed it from everyone - banks, investors,
suppliers, customers, employees — and it seems unlikely that these lenders knew what
they were getting into. As I said yesterday, the wealth management
unit looks like a ponzi scheme. When a big company goes bankrupt you typically
look at the company’s capital structure and those with the most senior claims get
paid back first. The most junior claims might get nothing,
and the ones in the middle might get pennies on the dollar. Often the goal is to keep the core business
running, so customers and suppliers might be treated better than is legally required,
creditors work with management to figure out a plan that provides the best overall recovery
for everyone. In this situation, government officials can
be expected to step in and decide who gets paid and who does not, and this will be a
political situation. In yesterday’s piece I said that there were
two coupon payments coming this Thursday, a smaller local bond coupon and a larger dollar
denominated bond coupon payment. I predicted that they were more likely to
make the payment on the local bond, and sure enough they made an announcement shortly afterwards
confirming that the local bond coupon will be paid. We will learn a lot more in the coming days. In China because of this issue of moral hazard,
it is difficult to know the risk of any loan. The Evergrande situation just highlights this
issue, and it will be years until we see how the overall situation works itself out. OK, that’s enough about Evergrande. Here is a link to my video about how pubs
replaced banks for a year in Ireland. It will show you how basically anything could
happen. See you later, bye.
