Is China About to Receive a Lesson on “Too Big to Fail?” »Its second real estate developer, China Evergrande Group,
with 1,300 projects in 280 cities, has some $ 300 billion in liabilities. Evergrande owes investors up to 1.6 million unfinished apartments, and on financial debt, it owes banks and bondholders $ 88.5 billion with $ 37 billion owed in a year. He has already missed a coupon payment of $ 83.5 million on September 23 and a payment of $ 47.5 million last Wednesday. Evergrande has a 30 day grace period, so time flies towards a fault.
Is Evergrande too big? Is there an implied guarantee for Chinese real estate investments similar to the stupid American implied guarantee of the debt of Fannie Mae and Freddie Mac? No one knows yet.
China is littered with phantom developments and half-completed projects. During a visit to Shenzhen over ten years ago, I saw empty buildings with homeless people living in the rubble of the hall. Debt financing is always dangerous.
The press keeps touting a “Lehman moment” and predicting financial collapse. I doubt it, it’s more like Bear Stearns, a strong warning to others who are heavily in debt. Evergrande’s short-term debt accounts for around 1% of China’s foreign exchange reserves, so a bailout is possible. But China has dozens of large real estate companies in debt, including Sunac, whose bond investors are busy selling. Will China let real estate explode?
The answer is usually this: China does not have a strong safety net or retirement system, so most Chinese households – up to 70% (but like most statistics in China, who knows if this ‘is true?) – put their wealth in real estate. When new buildings are announced, there is a frenzy to buy apartments, although many remain vacant for years. The reasoning is as follows: prices in Hong Kong have more than tripled since 2004; the same will surely be true for mainland China in the future. This is the logic of the bubble.
So while Xi Jinping and the Chinese Communist Party can hammer internet companies and make them pledge allegiance to a “common prosperity” policy, limit video games, decimate the after-school tutoring industry, and even denigrate celebrities of television as “sissies” they can not let real estate fail. It would be like emptying every individual retirement account and canceling everyone’s retirement in the United States. It will not happen. China needs to orchestrate a drop in real estate values, perhaps 10-20%, instead of letting failure trigger a massive rout. The Communist Party cannot afford the political fallout from the other Evergrandes. Can China do this? We’ll see.
But notice, Chinese leaders are happy to let foreigners lose money – dollar-denominated bonds are at risk of default, Chinese bank debt is not. It’s almost as if the Chinese government has chosen a class of hated investors to hurt as it restructures its economy.
Oh wait, it’s like when the Obama-Biden administration stole hedge funds to support union retirement plans during the bankruptcy restructuring of General Motors. GM bondholders, mostly hedge funds and private equity firms, were offered just 10% of the company for their $ 27 billion outstanding amount, while the United Auto Workers got a 17.5% stake for forgiving $ 10 billion in bonds.
Communists learn from the best! The Chinese can play with bondholders, but that would likely make foreigners reluctant to invest there again, not smart until a huge round of funding for manufacturing and semiconductor plants to alleviate shortages. Institutional memory is short and investors who cannot resist Chinese growth will return, but their demand for yield will increase. Bond yields with even a hint of potential default are always higher. This is why it is called junk debt.
Personally, I think the Communist Party should let Evergrande fail and then sell its assets quickly to other developers and investors. I doubt. Instead, it will likely bury bad assets in SOEs and prolong the pain. Beware of repeating Japan’s problems with dreaded NPLs. For decades, Japanese banks carried debts on their books from zombie companies that had no intention of repaying loans, all because a default would cause unrest or someone would lose face. Often these loans were linked to Yakuza gangsters, and it was literally dangerous to register defaults. Thus, Japanese banks appeared rich in paper assets, but had no capital to lend, which contributed to the lost decades.
Evergrande’s stock is down more than 75% this year and its founder, former steel executive Xu Jiayin, will likely be vilified and his billions will be diluted in a restructuring. The big question is: can China allow Evergrande to fail and risk the wrath of citizens who suffer huge losses in retirement? Or will China cover Evergrande’s losses and risk Japanese-style stagnation? It’s a tough, tough place.
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