Michael Pettis on Evergrande et al

Note from Michael Pettis at Carnegie:

Policymakers in Beijing are in a tough position on what to do about Evergrande, the Chinese property developer whose slow collapse has transfixed the markets. Evergrande is the most-indebted property developer in the world. Its on-balance-sheet liabilities amount to nearly 2 percent of China’s annual GDP, and its off-balance-sheet obligations add up to as much as another 1 percent.

This wouldn’t be as much of a problem if Chinese property developers, state-owned enterprises, local governments, and even ordinary households did not all have excessively high debt levels. But because the Chinese economy has long been plagued by debt problems and moral hazard, the situation will be much more difficult for regulators to sort out.

CHINESE REGULATORS’ CRUSADE AGAINST EXCESSIVE DEBT

For the past several years, Chinese regulators have worked hard—if unsuccessfully—to reduce the economy’s overreliance on debt. As part of this regulatory push, regulators implemented what became known as the three red lines for property developers last year. These consist of hard limits on a company’s debt-to-asset ratio, its debt-to-equity ratio, and its cash-to-short-term-debt ratio.

The three red lines almost immediately began to affect the operations of highly indebted developers. Because they were no longer able to borrow, and in many cases were forced to pay down debt, they had to liquidate assets, often in fire-sale conditions, and were sometimes forced to cut back on their operations. The resulting losses often only worsened their reported debt ratios and put further pressure on them to cut back. Although Evergrande is the most visible of these large property developers, and perhaps suffers from greater financial distress than any other, the impact of the three red lines on Chinese property developers has not been limited to Evergrande.

It is easy to understand why policymakers have been so worried about real estate debt—and debt in general. China’s official debt-to-GDP ratio has soared by nearly 45 percentage points in the past five years, leaving it with among the highest debt ratios for any developing country in history. The property sector is notorious for its addiction to debt. This addiction has expressed itself not just in borrowing from banks and bond markets but in a variety of other ways. Property developers regularly presold apartments to homebuyers many months or even years in advance, for which they received the full price or at least a substantial deposit. They paid off contractors and suppliers with commercial paper and receivables instead of cash. Their financing arms even sold credit products known as wealth management products to retail investors—mainly, it seems, to employees of the borrowing companies, their banks, and their suppliers.

All this borrowing has enabled the property sector to become one of the main engines of economic activity for the Chinese economy, accounting for as much as 25 percent of the country’s GDP (considerably higher than is typical in other countries). But this borrowing spree has also helped stoke a substantial real estate bubble in a country in which housing prices are several times higher, relative to household income, than they are in the United States or other major economies. Perhaps worse, the property bubble has resulted in a lot of empty homes and apartments—between one-fifth and one-quarter of the total housing stock, especially in more desirable cities—owned by speculative buyers who have no interest in either moving in or renting out. Empty housing creates no economic value, even if it incurs a significant economic cost.

By clamping down on leverage among property developers, Beijing was hoping to accomplish at least two things. First, this measure was intended directly to address surging debt among one of the most indebted sectors in China’s economy. Second, the hope was it would help stabilize the housing market by constraining what regulators believed was one of the sources of speculative frenzy, the debt-fueled competition among developers to scoop up as much land as possible.

Borrowing for large Chinese companies like Evergrande had never been a problem in the past. It was widely assumed they would never be allowed to default on their obligations. Local governments and regulators were expected always to step in at the last minute to restructure liabilities and recapitalize the borrower if necessary. As a result, there was very little credit differentiation in the lending markets. Banks, insurance companies, and bond funds fell over each other to lend to large, systemically important borrowers. Moral hazard, in other words, underpinned the entire credit market.

That is why Chinese regulators have decided to have a showdown with creditors over Evergrande. By convincing lenders that they will no longer stand behind large Chinese borrowers, they are trying to transform the country’s financial system by making Chinese lenders more reluctant to fund nonproductive investment projects. These projects generate what Chinese leader Xi Jinping, in an important recent essay for Qiushi (the leading official theoretical journal of the Chinese Communist Party) disparaged as “fictional growth,” in contrast to the “genuine growth” he called for.

CAN REGULATORS TURN THEIR BACKS ON EVERGRANDE?

Regulators are right to worry about the important role moral hazard plays in generating overall leverage within the Chinese economy, but it isn’t an easy problem to resolve. If they intervene to support creditors, they will reinforce moral hazard and lose credibility. If they do not, and effectively force the borrower and its creditors to work out their disputes using just Evergrande’s internal resources, there are at least three important subsequent problems the regulators would face. These include roiled credit markets, widespread financial distress, and the role of debt in propping up China’s nominal GDP growth.

CONTAGION IN THE CREDIT MARKETS

The first and most obvious risk is that of credit-market contagion. Any credible elimination of moral hazard must transform the Chinese credit markets and the ways in which they allocate risk. While this almost certainly would be a good thing in the long term, it is just as sure to be a financially disruptive process in the short term.

This is because for three decades, Chinese lenders have made loans based on the assumption that large borrowers would be bailed out. As a result, loan and bond portfolios have been built around political perceptions and pressures rather than around credit risk and the portfolio needs of creditors, and there has been very little discrimination in credit pricing. To erase the assumption of moral hazard would mean wiping out the structural underpinnings of the country’s credit markets. Financial markets, in other words, would have to undergo a major repricing of credit and a corresponding reallocation of credit risk portfolios.

The problem is that there would be a vicious circularity to this process. Bankers wouldn’t know how to restructure credit portfolios until they understood what the restructured market would look like. But knowing this would require answers to questions like: Who will still be able to access credit? How much and in what form? At what prices, and what guarantees, if any, will remain?

But, of course, they could only know what the restructured market would look like after they have collectively restructured their credit portfolios. Among other things, this means that individual lenders should rationally wait for all other lenders to restructure their portfolios before doing so themselves.

Yet if all lenders behave rationally, the consequence could be the type of financial contagion with which global investors have become all too familiar in recent years. Lenders would try to liquidate a substantial portion of their credit portfolios, or at the very least refuse to extend new credit, until they have clarity about how the market will ultimately clear. Their very reluctance, however, would create distortions in the clearing process and would ensure levels of financial disruption and contagion that could easily spread even to nominally healthy borrowers. An article in Monday’s South China Morning Post cites a credit analyst who worries, correctly, that “for companies with large amounts of maturing debt, a couple of months of liquidity drain could be devastating.”

ECONOMY-WIDE FINANCIAL DISTRESS

This leads directly to the second problem, which is much less discussed but perhaps much more important: the risk of financial distress spreading throughout the economy. In finance, indirect financial distress refers to adverse changes in the behavior of stakeholders who are responding to a rising risk of insolvency, with this behavior in turn further raising the probability of insolvency. Financial distress behavior is a highly pro-cyclical process during which an incremental deterioration in credit conditions suddenly begins to accelerate, so a linear decline in credit becomes nonlinear. It is why, as Hemingway once put it in The Sun Also Rises, bankruptcy usually occurs “Gradually, then suddenly.”

The Chinese economy is already seeing this process in action. Property developers there have long claimed that the success of their business is driven by the three carriages—high turnover, high gross profit, and high leverage. But all of these proverbial carriages are breaking down as the effects of Evergrande’s crisis spread throughout the economy. Potential homebuyers, for example, frightened about what they read in the news, are becoming reluctant to close on homes, resulting in an already sharp decline in home sales. What is more, they are likely to refuse to prepurchase unfinished apartments or put down deposits, except at large discounts, thereby squeezing liquidity and raising financing costs for the developers.

At the same time, sales agents and other employees are likely to be highly distracted during working hours, worrying about their employment prospects and in some cases the loss of their savings in wealth management products. Such circumstances can cause a sharp decline in labor productivity. What’s more, contractors have been suspending construction work until their payment prospects have been assured, while suppliers, similarly, are less willing to accept commercial paper as payment for their deliveries. The result, as Evergrande has already announced, is that construction projects are rapidly falling behind schedule.

The consequences are reduced revenues, higher operational and interest expenses, and increased frictional costs—the combination of which turns net profits into net losses. These headwinds make repayment prospects even more difficult, thus reinforcing the cycle.

The most worrying aspect of financial distress behavior is that once it is set off, it often seems to spiral quickly out of control. Before that can happen, a credible outside agent must step in to guarantee the continued operations of the company and its ability to service its debts. Because this financial distress behavior affects not just Evergrande but the whole Chinese property sector, if it isn’t quickly halted, it could even drive property developers with strong and relatively liquid balance sheets into insolvency.

THE ROLE OF DEBT IN CHINESE GDP GROWTH

The third problem with allowing Evergrande to fail and refusing to support creditors is the most fundamental problem of all. As I have explained before, on this blog and elsewhere (including here and here), China’s ability to achieve politically determined GDP growth targets requires moral hazard, and the country’s financial regulators cannot eliminate moral hazard until Beijing scraps the growth target and allows growth to fall to whatever underlying rate the economy can accommodate.

This is because what Xi referred to in his Qiushi essay as “genuine growth” (as opposed to what he called “fictional growth”) cannot generate enough economic activity to allow China to hit its GDP growth targets. This high-quality growth (to use Beijing’s usual terminology) consists mainly of consumption (driven by increases in household income rather than rising household debt), exports, and business investment. By my estimates, high-quality growth has probably accounted for barely half of China’s GDP growth rate in recent years.

But for China to achieve the required GDP growth rates, it needs another source of economic activity, which I will refer to as residual growth. This growth, for the most part, has consisted mainly of malinvestment by the property sector and by local governments building excessive amounts of infrastructure. Whenever high-quality growth declines, as it did last year when China’s growth rate was actually negative, Beijing steps up residual growth to make up for this decline, but whenever the pace of high-quality growth picks up again, Chinese leaders quickly put downward pressure on residual growth, as it seems to be doing this year.

The fact that Beijing regularly tries to constrain residual growth to the minimum amount needed to achieve the GDP growth target suggests that China places little value on this kind of growth. More importantly, China’s debt history provides a concrete reason for recognizing that much recent investment has been malinvested.

Chinese debt has risen sharply for more than three decades, but until the mid-2000s, it attracted little attention. This is because most of the increase in debt went to fund productive investment, with the result being that China’s GDP rose at least as quickly as the debt. This is almost the definition of a productive use of debt: the resulting increase in the economy’s debt-servicing capacity (for which GDP can be a proxy) exceeds the resulting increase in debt-servicing costs.

But this changed around the mid-2000s, when debt began rising faster than GDP. Given that most Chinese debt continued to fund investment, the fact that over many years debt-servicing costs accelerated even as debt-servicing capacity decelerated was clear evidence of systematic malinvestment, eventually on a massive scale. As long as Beijing sets GDP growth targets that exceed the country’s high-quality growth rate, China has no choice but to rely on residual growth to meet its target; and as long as it relies on residual growth, debt must rise faster than the overall economy’s debt-servicing capacity.

But this arrangement also requires that creditors are willing to bankroll projects that are not able to repay the debt out of higher earnings—or, to put it differently, it necessitates that creditors lend on the basis of an implied guarantee that the government will make up the gap. This, of course, is just another name for moral hazard. That is why Chinese regulators cannot truly eliminate moral hazard and nonproductive lending from China’s financial system until Beijing gives up targeting GDP growth, and there is no evidence so far that Chinese leaders are willing to do so.

BEIJING MUST MAKE IMPORTANT POLITICAL TRADE-OFFS

Each of these three problems is different and creates a separate set of issues Chinese regulators must address.

SOLVING THE CONTAGION PROBLEM

The problem of contagion in the credit markets is straightforward, and Chinese regulators are in a very strong position to control it. Because the Chinese financial system is largely closed (meaning that the presence of foreign and independent creditors is very limited) and because the regulators are powerful and credible, they can quickly intervene and force a restructuring of liabilities to prevent the Evergrande contagion from causing a more general breakdown in the financial markets.

If property developers and other large borrowers that they deem to be viable begin to run into liquidity problems, the regulators can easily pressure banks and other institutional creditors to extend loans. For example, Evergrande executives reportedly have suggested that the group’s operations could be taken over by local governments and large state-owned developers on a “region-by-region” basis, but they added that such a complicated rescue would be a “last resort.”

SOLVING THE FINANCIAL DISTRESS PROBLEM

The problem of spreading financial distress is a much more serious problem and one that the regulators seem not to have expected—at least to this extent. Property purchases have fallen very quickly, and retail investors in wealth management products have already organized visible protests in many cities. Meanwhile, suppliers and contractors are reeling from potential losses, and since many of them have been paid in real estate, they are likely to try to sell these assets as quickly as possible to satisfy their own liquidity needs. This cannot help but disrupt the real estate market further. What is more, Evergrande’s 200,000 employees, not to mention hundreds of thousands of employees at other property developers and at affected upstream and downstream businesses, are probably beginning to feel fairly aggrieved.

Before financial distress spreads further throughout the economy, regulators must address this as rapidly as possible by drawing very clear lines about what will and what will not be rescued so as to suppress the uncertainty Evergrande has created in the economy.

SOLVING THE DEBT-FUELED GDP GROWTH PROBLEM

The third problem is almost impossible to resolve. This year, when high-quality growth can deliver at least 5–6 percentage points of GDP growth (mainly because of a partial reversal of last year’s contraction in consumption), the regulators will seem to have pulled off their debt stabilization goals: GDP growth this year will likely be on either side of 7 percent with a very small increase in the country’s debt-to-GDP ratio. But beginning again next year, the regulators will once again face the impossible contradiction between rapid GDP growth and stable debt. The point is that until Beijing learns to accept much lower—but healthier—GDP growth rates, it will not be able to stabilize the growth in debt.

CONCLUSION

So what is next for Chinese regulators as they assess the Evergrande disaster? This is such a complicated problem, with politically conflicting objectives, that it is very hard to predict just how Beijing will react. It is clear, however, that the regulators must act quickly to contain the spread of financial distress costs. My best guess is that in the next few days or weeks, perhaps as late as the national holiday in the first week of October, they will take concrete steps and make announcements aimed at toning down the spread of financial distress costs. This will involve what Zhou Xin, of the South China Morning Postdescribes as another “cocktail of proven tricks: rolling over debt, haircuts on assets and emergency payments to the most vulnerable.”

Most analysts expect—correctly, in my opinion—that there will be a hierarchy of creditors, with the most protected being retail investors, although if investors in wealth management products are substantially bailed out, this will only reinforce the idea that the risks of wealth management products are nonexistent. Local suppliers and contractors are likely next in line for protection, as they did not choose voluntarily to be Evergrande creditors, and any losses they might suffer could threaten in some cases to bring them down.

Because local banks are expected to continue to fund growth, they will probably be next in line, followed by other Chinese creditors, with external-currency creditors probably bringing up the rear. A surge in lawsuits as these foreign creditors claim unfair discrimination can be expected. A hunt for those who will be held responsible for especially egregious forms of financial losses could also be in the offing.

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