Monday, September 20, 2021

The Collapse of Evergrande?

Last Tuesday I wrote about the developing crisis around the Chinese real estate development and investment firm, Evergrande, and the risk it could have to the Chinese economy.  At that time, it was not clear if the Chinese government would be bailing out the firm or if a white knight investor would swoop in and save the company from ruin. 

    Since then, matters have grown more precarious for Evergrande. On September 16, the Asahi Shimbun, one of Japan's largest newspapers, reported that although "[a] collapse of Evergrande could ignite immense financial and social turmoil, the "leaders of the Chinese Communist Party have been taking a wait-and-see approach over the crisis instead of rushing to rescue the company." This is because a rescue "would run counter to President Xi Jinping’s stated policy of not favoring the rich." The article explains:

    Evergrande Group was established in Guangzhou in 1996, after China’s economic reforms.

    The company grew rapidly as its offer of compact apartments built in what it pitched as a “better living environment” proved popular at a time when China’s real estate industry was booming.

    Evergrande Group continued to develop more projects by borrowing funds from banks as it appeared that the more it built, the more it could rake in profits.

    With speculative money pouring in from international investors and the wealthy, it expanded and attempted to diversify its businesses, making forays into car manufacturing and movie production, among other things.

    But the diversification line backfired and ended up running 9.7 trillion yen in debt with interest as of the end of June, a figure impossible for the company to repay with its own funds.

    An additional blow came when the leadership of the Chinese Communist Party introduced rules to curb the ratio of debts against assets of a business.

    The move is intended to keep real estate prices in check, which have soared in urban areas to the point that the public can no longer afford to buy a place to live.

    Party leaders also restricted the amount of loans a company can get, making it more difficult for Evergrande Group to continue with its aggressive business approach using loans as leverage.

    The regime is not moving to bail out the company as those who have been hard-hit by Evergrande's crisis are deep-pocketed individual investors rather than the general public.

    Xi, in an effort to secure a third term, has begun to uphold the goal of pursuing wealth for a society as a whole by eliminating economic disparities between the rich and poor.

    Chinese leaders fear that coming to the rescue of wealthy investors would lead to a loss of popular support.

    Still, they will need to rein in damage to the country’s economy from a sudden collapse of a large company. Evergrande Group’s downfall could also trigger social instability.

    A challenge for the leaders will be how to help the struggling company make a soft landing while mitigating the shock of the company’s financial crisis.

The same article had noted that investors fearing that they have lost all of their money had started protesting outside the company headquarters. The company had said that it would repay investors with real estate rather than cash. This apparently didn't sit well with investors, however, as Zero Hedge then reported the next day, September 17, that the protests had escalated with nearly 100 investors having stormed Evergrande's headquarters to demand their money back, holding management hostage in their offices. As the article notes, "[a]fter accumulating some 1.97 trillion yuan (US$410 billion) in liabilities, the company - which became the country's largest high-yield dollar bond issuer (16% of all outstanding notes) - sparked protests across the country earlier this week after announcing they were forced to delay payments on up to 40 billion yuan in wealth management products." Another article reports that "[o]ne U.S. investor in China tells FOX Business 'just about every bank in China has exposure to the company,' which explains the heightened contagion fears."

    Today, the Daily Mail reported that the "Dow Jones plunges more than 700 points as Chinese real estate giant Evergrande teeters on the brink of collapse with debts of more than $300 BILLION and firm threatens top execs with 'severe punishment'." Markets in Europe and Hong Kong had also fallen as a consequence of fears of what impact a collapse of Evergrande could have on the global economy. This dragged down stocks in large manufacturers and banks including Bank of America and JPMorgan Chase. Per the article:

Many markets in Asia were closed for holidays and analysts said the thin trading accentuated volatility. Hong Kong´s benchmark sank 3.3%. Germany´s DAX dropped 2.9% to 15,038.17 and the CAC 40 in Paris shed 2.7% to 6,393.04. if both indexes close at those levels, it will mark their steepest declines since last October.

This means that once Asian markets open we may see even steeper declines. The article reported that "Ed Yardeni, president of Yardeni Research, told CNBC that it is unlikely Evergrande will have as severe a fallout as the Lehman bankruptcy which caused global and economy credit markets to collapse," based on his belief that the company is too big to fail and the Chinese government will be forced to intervene. Many other financial experts seemed to agree that China will likely do something to mitigate a collapse. 

    Other investment experts don't believe that a collapse would be as bad as some think because unlike Lehman Brothers, Evergrande has assets (real property) that can be sold. But I have to wonder at this: if the real property could be flipped so easily for cash, why are so many of Evergrande's investors unwilling to accept property in lieu of cash?

    The BBC has a helpful article that explains why the collapse of Evergrande would act as a contagion in the Chinese market:

    There are several reasons why Evergrande's problems are serious.

    Firstly, many people bought property from Evergrande even before building work began. They have paid deposits and could potentially lose that money if it goes bust.

    There are also the companies that do business with Evergrande. Firms including construction and design firms and materials suppliers are at risk of incurring major losses, which could force them into bankruptcy.

    The third is the potential impact on China's financial system.

    "The financial fallout would be far reaching. Evergrande reportedly owes money to around 171 domestic banks and 121 other financial firms," the Economist Intelligence Unit's (EIU) Mattie Bekink told the BBC.

    If Evergrande defaults, banks and other lenders may be forced to lend less.

    This could lead to what is known as a credit crunch, when companies struggle to borrow money at affordable rates.

    A credit crunch would be very bad news for the world's second largest economy, because companies that can't borrow find it difficult to grow, and in some cases are unable to continue operating.

    This may also unnerve foreign investors, who could see China as a less attractive place to put their money.

Barron's also explains that it could have deleterious impacts on some of the largest investment firms:

    Evergrande currently has some $300 billion in liabilities and only around $15 billion in cash on hand. Swiss bank UBS estimates that liability figure to be closer to $313 billion—which amounts to 6.5% of the total liability of the debt-laden Chinese property sector—of which $19 billion is made up of outstanding offshore bonds.

    The group also has a large network of loans. Monday was a deadline for domestic bank loan repayments, with a 24-hour grace period; in a note, Deutsche Bank strategists said there was a 24-hour grace period from the Monday deadline. Chinese authorities warned banks last week that Evergrande wouldn’t meet these obligations.

    A bigger pinch is likely to come Thursday when coupon payments for both domestic and offshore bonds are due. BlackRock (BLK), UBS (UBS) and HSBC (HSBC) are among the company’s bondholders.

 The article also notes that:

A very bad outcome, if not the worst-case scenario, would be for Evergrande to completely fail and be totally liquidated. If it defaults on loans, that could cause banks and other groups with large exposure to Evergrande to go under or be forced to restructure themselves.

 One unforeseen impact is on the values of cryptocurrencies. For instance, Forbes reports that "Crypto Markets Suddenly Lose $250 Billion In Value As Evergrande Turmoil Pummels Bitcoin, Ethereum And Other Major Cryptocurrencies."

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