Evergrande is going bust and nobody knows what that means. Here is its HK regulatory filing that reads like an obituary:
Beijing has also retained bankruptcy specialists.
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The unhappy investors who were happy to take huge yields but not the risk that comes with it stormed Evergrande head office:
“Evergrande return our money!” pic.twitter.com/F6zbJu21jF
— David Kirton (@DavidKirton_) September 13, 2021
Naturally, spreads are blowing out across the developer segment and share prices are crashing:
This will continue until we get clarity on the restructuring. TS Lombard has more:
Exorbitantly wealthy owners, speculative bubbles, poorly financed businesses with strong prospects for default, monopolies/oligopolies and rampant corruption are all evidence of a lack of meaningful external discipline on an industry.
In our Asia property research, we have long highlighted the lack of regulation of China’s pre-sale property market and the funding risks surrounding Chinese developers. Most Chinese property developers are, in effect, industrial companies building for inventory. They report profits but have negative free cash flows and are heavily dependent on external funding.
Evergrande is an extreme example, but it is not the only over-leveraged Chinese developer. Evergrande’s creditworthiness–like that of other developers–has long rested on its ability to attract liquidity when its liabilities came due. With strong political support, it was typically perceived as ‘too big to fail’ by many investors. But not, it seems, anymore. Having covered property developer securities for more than 20 years, I have learned that there is always more debt than we think and more than we are told. Banks do not stop lending when they make bad loans but when they run out of money–so they are one of the last to know there is a problem. And not even the best fiction writers could make up some of the ways debt is disguised on company balance sheets.
Take Evergrande’s 2020 year end balance sheet, which shows the company’s total liabilities to tangible equity at 2,518% compared with its credit rating agency preferred debt-to equity-ratio of153%. If bear markets are a process of discovery, then uncovering the extent and inter-connected nature of Evergrande’s debt is only just beginning. Suppliers being paid in unsold units is just the start.
Of course, many sell-side analysists are now pointing to the cash on Evergrande’s balance sheet and the large land bank that the company could monetize. We expect both to prove illusionary. Cash on the balance sheet is likely to be far from usable while all that investment in working capital is not simply an overinvestment but the inability to turn “assets” into cash.
The speed at which Evergrande’s business model is now unwinding is unsurprising. Constrained by Beijing’s “Three Red Lines” policy in their efforts to raise debt, developers have increased their reliance on unfettered pre-sales funding to meet short-term liabilities. But, as sales slow, it becomes evident that some developers do not have the cash to complete the developments they have already sold.
As a result, banks ask for more pledged assets and higher guarantees, suppliers ask for earlier payment, and pre-sales get worse as the developer cuts prices and end-users do not trust the company to complete the development. Evergrande’s August trading statement shows sales were down 26%–including amounts “sold” to creditors in lieu of payments–and sales prices were 33% lower than two years ago.
That Beijing appears to be forcing Evergrande to prioritize the delivery of pre-sold units to buyers comes as no surprise. Social stability matters. But this also means a restacking Evergrande’s capital structure in favour of onshore creditors–households and banks–at the expense of off-shore equity and bondholders. Indeed, Chinese offshore bonds, which are dominated by property firms, are now trading at average yields of more than 13%, according to Bloomberg.
Any ultimate restructuring of Evergrande is a political decision. Yet it is no coincidence that as the Chinese government focuses on wholesale import substitution, it is reducing the excess rents earned in sectors linked to China’s birth rate.
The problem with China’s mercantilist economic policy is that “too much money chases too few goods” and that much of that excess money finds its way into non-tradable goods such as residential property, medical care and tuition fees, which makes raising children very expensive. This explains the current political pivot in Deng’s famous statement away from allowing “some people to get rich first” and towards achieving“common prosperity”.
The emergence of an exorbitantly wealthy entrepreneurial class, supported by unregulated markets and government funding, showed that the system worked. But as wealth gaps have further widened and the exorbitantly wealthy threaten to become a political class, they have now become symbols of the inequality across Chinese society as reflected in falling urban birth rates.
Common prosperity is about removing implicit government puts, regulating markets and centralizing state control. This has been evident across sectors. The banking sector has seen the PBoC remove its previously assumed 100% lending guarantee. It is now the turn of the property sector, which is witnessing the removal of the implicit “too big to fail” government guarantees, easy access to debt and unregulated sales proceeds.
Higher credit spreads on Chinese bonds simply reflect the removal of implicit political puts that allowed investors in their “reach for yield” to underestimate their exposure to currency risk, credit risk and liquidity risk. Credit spreads will now have to reflect the quality of the borrower and it is likely that offshore lenders will have to bear the brunt of any losses. For holders of Evergrande’s nearly US$20bn in international bonds, that should prove expensive.
An Evergrande restructuring looks increasingly inevitable, but how it will ultimately play out is far from clear. Other developers remain at risk. As Blackstone’s failed bid for Soho China shows, any investment in China is now on China’s terms, through China’s markets and managed by China’s regulators.
Given that the authorities have long known about the excessive leverage of Evergrande, it would be reasonable to expect that they have a plan to deal with the extent and interconnected nature of its debt and the knock-on effects on other property developers and the end market. If they do not, things could get very messy.
I wonder if that is not the wrong question. With a bankruptcy this large and complex (121 banks are rumoured to be involved) the question has to be is there any possible way to restructure the firm in an orderly fashion at all?
Think Enron, Worldcom and Lehman Brothers, all operating within the most experienced and efficient bankruptcy markets in the history of the world, yet the disruption was still immense.
I fear that there is no process orderly enough to prevent major contagion into Chinese property developers, realty and commodity markets.
If so, this will become a global shock.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
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