The collapse of Evergrande would have “profound consequences” for the Chinese economy

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Investors are bracing for the growing risk of Chinese real estate colossus Evergrande collapsing under the weight of more than $ 300 billion in debt. But experts say the Chinese Communist Party will have no choice but to save a company so emblematic of its model of economic growth – and whose collapse would send shockwaves through the global economy.

Western financial institutions believe Evergrande has a bleak future, if it has one.

JP Morgan slashed its target stock price for the company significantly on Friday, to HK $ 2.80 from HK $ 7.20.

It came after rating agency Fitch downgraded the foreign currency company’s credit rating from triple C more to double C on Wednesday, saying some form of default “seems likely.” The rating agency Moody’s downgraded Evergrande’s credit rating for the third time in three months, on the grounds that its creditors faced “poor prospects of recovery” should the company default.

Evergrande is the most indebted real estate developer in the world; $ 300 billion is roughly equivalent to Portugal’s total public debt. Unsurprisingly, senior executives admitted in August that they might not be able to meet all of their financial obligations.

“Debt-Dependent Growth Model”

This poses a serious problem for the Communist Party of China, as Evergrande has long been a symbol of the country’s economically highly productive urbanization.

In addition, Evergrande’s business model is representative of China’s “heavily debt-dependent growth model,” Jean-François Dufour, director of French consulting firm DCA Chine-Analyze, told FRANCE 24.

The company was founded in 1996, amid the Communist Party’s Herculean effort to move hundreds of millions of Chinese from the countryside to the cities, creating “very strong growth in the Chinese real estate sector,” Frédéric Rollin, an investment strategy advisor to the multinational Pictet Asset Management, told FRANCE 24.

Evergrande was the main beneficiary of this boom. It was pursuing a very aggressive growth strategy and depended on the goodwill of the banks as it was accumulating a proliferating portfolio of real estate projects at a rapid pace.

This expansion continued over the decades, as evidenced by Evergrande which raised $ 722 million when it went public on the Hong Kong Stock Exchange in 2009. The company now controls 778 real estate projects in 223 Chinese cities, employing almost 200,000 people directly. Evergrande claimed to have indirectly created more than three million jobs.

Huge pile of debt

But in the early 2010s, following that successful IPO, Evergrande expanded its tentacles into an array of other industries. The company was in a “race against time to diversify its activities, much more than other Chinese real estate groups,” said Dufour. The Communist Party had “made other sectors national priorities,” he continued.

As a result, Evergrande acquired stakes in video streaming companies, health insurance companies, milk producers and pig breeding cooperatives. It also bought out Guangzhou FC, a football club in the Guangdong region where it is based, and built amusement parks. Evergrande’s latest diversification project was an attempt in 2019 to start making electric cars – despite the lack of experience in this area.

Evergrande hit the nail on the head because he wanted to be present in “a sufficient number of priority sectors so that the State is more inclined to support it financially when the burden of its debt becomes too heavy to bear”, explained Dufour.

The debt is indeed very heavy. Evergrande to pay $ 15 billion to creditors by the end of 2021; but, at the end of June, he had only $ 13 billion to his credit. At the same time, the banks have become much more reluctant to lend him money. “It has become more complicated due to the restrictive monetary policy the government is currently pursuing,” Rollins’ said.

Risk of economic contagion

Evergrande has entered a downward spiral in which the banks no longer want to give it the funds to complete its real estate projects, depriving the company of new property to sell and therefore of fresh funds to reimburse creditors and reassure the banks.

“In a normal market economy, Evergrande would have gone bankrupt a long time ago,” said Dufour. But the Chinese model of capitalism has long encouraged the model of private debt.

“The rule was that as long as a business looked like it was moving forward – with many projects going on – banks would give it credit, with the understanding that the strength of China’s economic growth would always generate profits. “, he continued.

This thinking meant that “in 2020, Chinese corporate debt represented 160% of GDP, compared to only 85% in the United States and 115% in the euro area,” Rollin said.

Companies like Evergrande find themselves in a tight spot now that Beijing has pushed heavily indebted countries to deleverage over the past year.

But the Communist Party also faces a dilemma, as it must prevent Evergrande from collapsing, to avoid the “profound consequences this would have for the Chinese economy,” Dufour said.

If Evergrande were to go bankrupt, “at least one bank would go bankrupt,” Dufour continued. “This may well cause other banks to be more reluctant to terminate highly leveraged countries – and it would spell the end of China’s debt-fueled growth model.”

The collapse of the real estate giant would send shockwaves far beyond China. As the Financial Times noted: “Evergrande has large international companies among its investors, including Allianz, Ashmore and BlackRock. A default is likely to have ripple effects in global markets, where many investors have historically anticipated Chinese government support in times of distress. “

Given Evergrande’s importance to the Chinese economy, “it’s highly likely that the state will devise a debt restructuring program for it,” Rollin said. In other words, Beijing will force the hand of creditors while arranging the sale of Evergrande’s secondary assets.

“It will probably mean putting the business under state control while it finds a buyer; an approach that the Chinese government has taken before, ”said Dufour.

But cleaning up a mess as big as a $ 300 billion debt won’t happen overnight.

This article has been translated from the original into French.

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