Evergrande: A Giant Within China’s Real Estate Bubble

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  1. The Effect of Uncertainty

What is Evergrande?

Evergrande is one of the largest real estate developers in China. During the summer of 2022, their debt situation began to implode, and this took a lot of financial media by storm. During the time leading up to October, the value of their bonds plunged beginning in May for the next couple of months, dropping sixty, seventy, even eighty percent. This is something that is unprecedented, especially for one of China’s largest real estate developers, and was thought to be a significant indicator for some sort of economic event to occur. There were significant concerns that Evergrande was on the brink of the largest default in history since the Lehman Brothers, with $300 billion in liabilities and potentially up to an additional $300 billion in off-balance sheet liabilities. With a global economy still recovering from the COVID-19 pandemic and supply chains in disarray, nobody was exactly sure to what extent this would affect the global economy. However, despite Evergrande’s bond prices still sitting at an all-time low to this day, fears of a default have seemingly disappeared. Issues as severe as this do not simply disappear, so to gain a better understanding of this, it’s important to understand the Chinese macroeconomic and cultural background, what has led to these defaults, the dynamics of the bond market in specific to Evergrande, and what is likely to follow in the future.

Economic & Cultural Background: China’s Housing Market

China’s housing market has been unstable for quite some time now, which is something that needs to be investigated further from a global standpoint considering that the Chinese have not experienced a housing crash like that of the United States in 2008 and of Japan in the 90s. In fact, the Chinese housing market has been described as one of the largest financial bubbles ever for the last ten years (Batarags). Outside perception is very important in Chinese culture, and as a collectivist society, they care deeply about how their families look to the rest of the community and how their country looks to the rest of the world. Wealth is often associated with happiness, as success and happiness are very closely related in their society. Contrary to other cultures, they are much more concerned about social validation than how they might feel about their lives. One of the more visible status symbols that one can acquire is housing (Liao).

Thus, the property market has expanded heavily for quite some time, and it got to a point where its expansion was seen as paramount to maintain the heavy economic growth that China has seen the past 20 years as well as households’ net worth. The construction of housing continued along with their economic growth. However, in recent years it was recognized that supply heavily outweighed demand. This effect was amplified by their one child policy, which ended in 2016, as population growth peaked. There was a significant urbanization movement that peaked in 2013, but with this movement slowing and annual marriages in China decreasing by 40% since then, housing construction should have peaked as well. New housing projects hit an all-time high in 2019, however even the COVID-19 pandemic only marginally decreased this activity to keep the economy strong. In order to prevent the housing market, of the primary pieces of the Chinese economy, from crashing, this supply-demand gap needed to be filled, and it was done so by two types of buyers. These would be institutional investors and common citizens speculating that housing prices would continue to rise (Wright). As long as this supply-demand gap is filled, the economy will continue to thrive. However, an economy that is run in this manner and is backed by these cultural values is not sustainable and has contributed to the Evergrande debt situation, causing turbulence in the bond markets.

Bloomberg: New Home Prices in China

China as a nation has focused heavily the past 20 years on rapid urbanization and development as a society. However, much of this was funded by taking out great deals of debt and issuing bonds. From 2008 to today, Chinese banks balance sheets have quintupled in size. Starting in 2017, they began slowing credit growth to try and reduce the large systemic risk, however this poses limitations on their credit-fueled growth. Homeowners are starting to have their ability to purchase homes be limited due to the limited availability of new credit. Since 2015, households have added approximately $6.4 trillion in credit since 2015, which are similar to the levels that the United States saw from 2003–2008 (Batarags). While much of this data is difficult to monitor due to limited availability, it’s not difficult to see that the gap between supply and demand for housing is becoming more difficult to cover. The gap is so wide now, that China is the home of several “ghost cities” which are full of uninhabited apartment buildings that were government-funded projects. As of October 2021, about 20% of all housing in China is vacant, the majority of which including these empty high-rise buildings. Not to mention, house sales decreased 8% in July, 16% in August, and 33% in September, yet house prices have not changed much at all. Due to China’s overstimulated urbanization rate and the pumping of credit into the market, the result is forced continuation of building these projects to continue to provide jobs and prop up the economy (Batarags).

This “kicking of the can” is most likely due to the cultural aspect of “saving face” which is very common in Asian countries. Saving face is the concept of Figure 1: Bloomberg — Zhu trying to retain respect from others and avoid public humiliation by any means necessary. This is present in societies like China and Japan from the individual level all the way to the country level. The belief that real estate is the one of the best ways to preserve, create, and display wealth has stimulated the buying of additional properties among institutions and individuals. In fact, more than 20% of Chinese households own more than one property. On the flip side, the United States has a 65% property ownership rate (Batarags).

In order to prevent a decline in housing prices, the government is making it increasingly difficult to actually conduct a sale to the point where it dissuades homeowners from selling. They have introduced regulations that change the number of years for which you have to own a home before selling. Not to mention, they have the ability to fully stop transactions from going through, and if one tries to sell their house for too low, the intermediaries won’t issue a certificate of sale. There are fears of consumer debt contagion, as a significant amount of the borrowing is done via friends and family (Batarags). However, the greatest risks lie in institutional borrowing, especially in the bond market, where most of the volatility was seen recently. The founder of Evergrande, Xu Jiayin, is a member of the Chinese People’s Political Consultative Conference, which is a group of elite advisors who are extremely well-connected to politicians, which is a massive source of bargaining power in China. Him being a member of this group gave creditors a great deal of confidence in lending to them (Stevenson). Creditors kept lending them more money as the company grew, but eventually they had more debt than they could pay off. Evergrande has creditors from all over the world, and these are much more demanding of timely payments than Chinese creditors or government parties.

Default & Securities Trading Suspension

Evergrande Bond Price

Evergrande, among many other property developers in China, are extremely overextended on credit, with Evergrande having $300 billion in on-balance sheet liabilities. Evergrande rode the line of default for a very long time as their bond trading was halted multiple times and bond prices sank 80% in a matter of months. They constantly made coupon payments at the very last minute they were due, only after international creditors raised enough concerns that they would not receive their money. Funny enough, Evergrande never fully defaulted on their debt. After enough close calls with coupon payments, Fitch eventually placed Evergrande on “restricted default”, meaning that while it was a default, they have not submitted a bankruptcy filing, began a liquidation phase, nor anything else that would stop its operations. While they did state that they would work to cooperate with creditors and restructure or strip the company, it’s a very difficult process for international investors to go for assets overseas, especially with all of the regulatory hoops that one would have to jump through in China (Stevenson). There is no single, simple restructuring mechanism for them to go through, meaning you would need to work with multiple different jurisdictions, which is just enough of a headache to deter or slow down a lot of creditors. Thus, international bond and equity markets are easiest way for creditors and the market to express their disappointment for how they are structured financially.

As of March 18th , 2022, the trading of both shares and bonds of Evergrande were suspended, and they still are as of April 14th . Supposedly, the suspension would be temporary, pending an announcement from them, but no other details were given at the time, and no such announcement has been given. Although Figure 2: Business Insider Evergrande hasn’t had any onshore technical defaults, they have missed some payments on offshore bonds, which is a much less forgiving market. This is what pushed them into restrictive default, and they have not moved from this rating since they were downgraded by Fitch on December 9th . What is interesting is that some rating agencies have recalled their assessments due to a lack of information on the companies. This is becoming a common theme among Chinese property developers like Evergrande.

Transparency & Contagion

Transparency has been a massive issue as of late for these companies, and with the end of the annual reporting seasoning (March 31st) already passed, Evergrande must disclose the full details of their liabilities. By this deadline, companies are required to come to an agreement with auditors as to how much debt they are liable for and if they can pay this debt off. We know that Evergrande has $300 billion in onbalance sheet liabilities, but it is highly likely that there is more to the story, with some estimates laying around another $300 billion in liabilities off the books. A full audit would likely result in the inclusion of hidden liabilities (Horta e Costa).

Bloomberg: Evergrande Debt

However, the extent to which these liabilities appear depends on the auditor they use and how incentivized they may be to help hide these. Since the beginning of 2022, at least four auditors resigned or were replaced. If Evergrande cannot come to an agreement by this date and publish their audited financial statements, there is a rule that states that those who miss the March 31st deadline will have the trading of their shares suspended (Reuters Staff). As of now, there is no word regarding their audited statements, and with bonds and shares currently suspended since March 18 th, it’s difficult to tell whether they have come to an agreement or are currently sanctioned under this rule. However, the market itself understands how deep this issue goes, and share and bond prices are reflected by this. This should mean that these developers shouldn’t have much of a reason to hide anything, as the market already understands how bad things are. However, there is the chance that things are much worse than expected. Meanwhile, as housing sales have dropped, medium to long-term loans to households, which are often used as a proxy for mortgages, have fallen for the first time in over 15 years.

Bondsupermart: Bond Yields

Chinese dollar-denominated junk bond yields have risen to over 27%, and it seems as though contagion is spreading to other firms which were thought to be more stable. Evergrande’s bonds across the board have performed horribly this past year, with quotes on their 8.75% coupon 2025 bonds still down more than 80% and current yields to maturity sitting at about 130% (Bondsupermart). Bonds with nearer maturities, such as their 11.5% coupon bonds expiring in January of 2023, understandably so, tell a much more concerning story, with yields to maturity skyrocketing up to 1,300–1,400% (Bondsupermart). The international bond market seems to recognize the fact that these investors are basically not getting their money back any time soon, and the stripping of this company will be a very messy process.

The Effect of Uncertainty

Situations as massive as these do not just disappear, and there will most definitely be an economic fallout of some sort in the Chinese market. However, there is a great deal of political uncertainty that comes into play here, which makes it very difficult to say exactly what will come of this. The most likely scenario is that the Chinese government determines companies like Evergrande to be “too big to fail” (Stevenson). Due to the macroeconomic situation that they’ve put themselves into with massive gaps in supply and demand of the housing market, the backbone of their economy and a huge provider of jobs, letting them fail completely would be detrimental to China’s economy. The balancing act of over 60 million unoccupied households on top of inflated housing prices and unfinished projects being demolished is already enough to deal with, never mind a credit crisis. However, declaring something as too big to fail is still guaranteed to have significant effects on the economy, as we saw in the United States with the Lehman Brothers default and the 2008 financial crisis.

Additionally, with the lack of transparency seen from China’s side in multiple areas, it has been difficult to get an accurate assessment of the credit risk of individual companies. Exploring the depth and breadth of the web of effects that a default of this size would have on China and the world economy would be an almost impossible task to do from the outside without sufficient, accurate information. Furthermore, under normal circumstances, one would assume that the housing market would crash following such a default. However, the unprecedented grip that the Chinese government has on the market drives many uncertainties. Would they keep in place the restrictions that prevent the sales of houses too soon after being purchased or of those with prices deemed too low? Or would they let the market act without such restrictions as to achieve a more accurate valuation of the properties? In the first case, it seems as though housing sales would drop to practically zero and these vacant living spaces would be an eerie reminder of the debt crisis. These effects would be much easier to predict in a free market environment. However, with the rapid development of technology and the internet, we are more connected than ever both socially and financially, meaning contagion to other countries is highly likely. The unpredictable Chinese economic environment seems to act as a set of shades, potentially blindsiding counterparties around the world for what may result from this.

Conclusion

China as a country has expanded and developed immensely in the past 20 years. It worked very hard to keep up with its quickly growing population and economy. However, its reliance on the housing market and construction projects to support this growth is very unsustainable. In an effort to save face, the market was pumped with debt in the form of bonds to keep the lights on and transparency was significantly reduced to try and cover up these errors. To hold everything together, artificial buying was put in place along with tactics to dissuade homeowners from selling their properties. As a result, the market was left with incredibly overextended property developers, falling bond and stock prices, spiking yields, and a huge, tangled web of counterparties, jurisdictions, and regulations to tie it all together. After even more strain was placed on the global economy due to the complications that came with the COVID-19 pandemic, this balancing act became a lot more difficult and a lot more global. Once enough international creditors’ debt maturities pass, how the Chines e government handles the clean-up of this situation will be a large determinant of what direction they will be headed in the longterm, as well as any worldwide effects to be felt.

Sources

Batarags, Lina. “China Has at Least 65 Million Empty Homes — Enough to House the Population of France. It Offers a Glimpse into the Country’s Massive Housing-Market Problem.”

Business Insider, Business Insider, 14 Oct. 2021, https://www.businessinsider.com/chinaempty-homes-real-estate-evergrande-housing-market-problem-2021-10.

Bondsupermart Quotes. “EVERRE 11.500% 22Jan2023 Corp (USD).” Bondsupermart, Bondsupermart, 14 Apr. 2022, https://www.bondsupermart.com/bsm/bondfactsheet/XS2106834299.

Bondsupermart Quotes. “EVERRE 8.750% 28Jun2025 Corp (USD).” Bondsupermart, Bondsupermart, 14 Apr. 2022, https://www.bondsupermart.com/bsm/bondfactsheet/XS1627599654.

Business Insider Staff. “China Evergrande GROUPDL-Notes 2017(21/25) Bond | Markets Insider.” Business Insider, Business Insider, 14 Apr. 2022, https://markets.businessinsider.com/bonds/china_evergrande_groupdl-notes_201721-25- bond-2025-xs1627599654.

Horta e Costa, Sofia. “Time Running Out for China Developers to Come Clean on Debt.” Bloomberg.com, Bloomberg, 14 Mar. 2022, https://www.bloomberg.com/news/articles/2022-03-14/time-is-running-out-for-china-sdevelopers-to-come-clean-on-debt.

Liao, Jiangqun, and Lei Wang. “The Structure of the Chinese Material Value Scale: An Eastern Cultural View.” Frontiers, Frontiers, 27 Oct. 2017, https://www.frontiersin.org/articles/10.3389/fpsyg.2017.01852/full.

Reuters Staff. “Trading in China Evergrande Shares, Onshore Bonds Halted Pending Announcement.” Reuters, Thomson Reuters, 21 Mar. 2022, https://www.reuters.com/business/trading-shares-china-evergrande-units-halted-hkex2022-03-21/.

Stevenson, Alexandra, and Cao Li. “What to Know about China Evergrande, the Troubled Property Giant.” The New York Times, The New York Times, 10 Sept. 2021, https://www.nytimes.com/article/evergrande-debt-crisis.html.

Wright, Logan. “China’s Property Sector Has Bigger Problems than Evergrande.” Foreign Policy, The Slate Group, 29 Sept. 2021, https://foreignpolicy.com/2021/09/29/chinasproperty-sector-evergrande/.

Zhu, Charlie, and Emma Dong. “Chine Home Market Slump Persists as Prices, Sales Fall.” Bloomberg.com, Bloomberg, 14 Dec. 2021, https://www.bloomberg.com/news/articles/2021-12-15/china-home-market-slumpdeepens-as-prices-fall-for-third-month.