Equity markets on September 22 and 23 turned in their strongest two-day performance since last May, as fears of contagion from China’s Evergrande real estate giant faded.
Far from a Lehman moment, the Evergrande crisis was a preemptive popping of a bubble – the sort of action that US authorities might have been wise to take in 2004 before the collapse of the US housing market nearly took down the global banking system.
Chinese authorities won’t bail out Evergrande, which with nearly 2 trillion yuan (US $430 billion) in liabilities is the biggest source of risky real estate credit in the world.
A 17% rise in Evergrande’s battered equity price in Hong Kong trading Thursday indicates that the company has a chance of survival in much-shrunken form – although without government help. The Chinese government will underwrite Evergrande’s existing obligations to home buyers, but nothing more.
The Evergrande crisis will accomplish a set of objectives, senior Chinese officials told Asia Times.
First, it will stop the growth of dangerous leverage in the property sector, an objective that Chinese regulators signaled in 2020 with “red lines” for developer leverage and curbs on lending to the property sector. “It’s dangerous to pop a bubble,” one official said, “but even more dangerous not to.”
Second, it will bring down home prices, in keeping with the government’s theme of “common prosperity” and more equitable distribution of rewards. Soaring home prices, particularly in coastal cities and Beijing, have put home ownership outside the reach of lower-income Chinese.
Third, it will suppress inflation by reducing speculative building and demand for iron, copper, cement and other raw materials.
Fourth, it will help drain the political swamp in Chinese local governments, whose finances have depended on property sales. The cozy relationship between local officials and property developers encourages corruption and inhibits the central government’s efforts to modernize the tax system. “The real estate bubble arose through corruption,” one official commented.
Fifth – and most important – it will shift capital allocation toward high-productivity industries like manufacturing and away from construction, an inherently low-productivity occupation.
Real estate now contributes a full quarter of China’s GDP, a distortion that could be justified in prior years by the need to house the 600 million Chinese who migrated to cities from the countryside over a 30-year period. Real estate, though, has been the investment of choice for Chinese households, whose direct and indirect investments make up barely 8 percent of household assets, compared to the mid-30% range in the United States.
China’s expansive monetary policy after 2017 incited an acceleration of loans to the property sector. During 2017-2019, total property lending exceeded credit to the manufacturing sector for the first time. The People’s Bank of China’s curbs on property lending capped the outstanding volume of real estate loans during the past year, while lending to industry rose rapidly.
Union Bank of Switzerland economist Wang Tao sketched out the likely disposition of Evergrande in a Sept. 21 article published by Caixin Daily:
Property delivery is the most important: Among Evergrande’s stakeholders (i.e., homebuyers, suppliers, and banks including bond investors), homebuyers are the most important from the point of view of social stability, and hence project delivery and paying suppliers’ payables will be prioritized.
Segregation of project companies from the group: Next, the key is to materialize the asset value and ensure the cash generated from asset disposal will flow to suppliers. We think a possible scenario is the segregation of Evergrande’s project companies away from the rest of the group. Cash flow from project companies would need to be put into a custodian account, with local government supervision, to ensure that cash inflow from property and land sales will be used for construction and supplier payables only, aiming to restore the confidence of homebuyers in its properties. At the same time, the project companies may also pay suppliers with properties.
Debt restructuring: At the group level, the banks and bond investors would need to undergo a debt restructuring and bear the loss from a haircut. We expect a debt restructuring (i.e., a haircut on debts and extension of debt) will be needed.
Equity investors in Evergrande and other property companies will lose most if not all of their stakes, and banks and bondholders will take a “haircut” – a negotiated reduction in their outstanding principal and interest. But the damage to China’s banking system will be limited, and the central bank will stand ready to provide liquidity where required.
It isn’t clear how far the pain will extend to China’s property sector. In April, more than half of China’s property development companies met the central bank’s “red line” criteria for leverage, including a cap of net debt at 100% of equity. Evergrande failed the test.
Chinese media are now reporting the details of Evergrande’s overreach, including vast amounts of hidden off-balance-sheet leverage and exorbitant expenditures on prestige items such as the company’s Guangzhou Evergrande football club, which was led to international victories by some of Europe’s highest-price coaches.
China has suffered from the same leveling-off of productivity (measured in the above chart by so-called “total factor productivity,” or the combined productivity of labor and capital) that affects the industrial nations.
The great conundrum in productivity measurement lies in the failure of the Information Technology sector to raise productivity in the rest of the economy. Rather than radiating productivity, the largest Internet companies in the West have earned rents as consumer monopolies. That is an outcome that China is trying to avoid, through anti-monopoly measures in the consumer Internet space.
In China’s case, that’s the result of allocating the lion’s share of capital to an inherently low-productivity sector, namely property. With an aging population, China needs high productivity growth to fund a pension and health system and support an increasing number of dependent elderly with a stagnating or shrinking workforce.
The message to the market from Chinese policymakers in the Evergrande crisis is that capital will flow to high-productivity sectors. Although large-capitalization internet stocks like Alibaba and Tencent have had a terrible year to date, the stealth performer in Chinese stocks is the CSI 500 Index, driven by strong performance among smaller industrial companies.
Markets appear to have gotten the message. China has lanced a boil that threatened the health of the economy and – despite some intermittent pain – will be better off for it.