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What are the systemic risks of an Evergrande collapse?

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CHINA’S FINANCIAL authorities are honing a new skill: the “marketised default”—or an orderly market exit and well-managed restructuring for troubled companies. The term has surfaced in government documents and local media as of late as regulators become adept at managing larger, more frequent and highly complex defaults. They have had some successes. Evergrande, a massive Chinese property developer on the brink of collapse, is proving to be anything but.

The company, the world’s most indebted property firm with $300bn in liabilities, is expected to default on September 23rd on both yuan- and dollar-denominated interest payments. Far from being a well-managed process, the distress is roiling markets across the globe and dragging other weak developers down with it. Major indices in Europe and America fell on September 20th as Evergrande’s situation appeared to worsen. Yields on the bonds of a number of struggling Chinese developers have soared.

Hong Kong-traded shares in one large Shanghai-based group, Sinic Holdings, collapsed by nearly 90% on September 20th on fears that it, too, would fail to repay a bond due in October. R&F Properties, another highly indebted group, has said it will raise up to $2.5bn by borrowing cash from company executives and selling a property project. Several financial institutions with high exposure to the property sector have suffered falls in their market value. The price of iron ore fell below $100 per tonne on September 20th for the first time in a year on fears that Chinese homebuilders will construct fewer properties.

The crackdown on developer debt is not an isolated event but one of several campaigns Xi Jinping, China’s president, is using to remould the country. A sweeping clampdown on internet-technology companies has wiped out more than $1trn in shareholder value since early this year. A number of New York-listed Chinese companies have seen their entire business models destroyed. These changes, along with the goal of improving housing affordability and ridding the property market of speculation, have been encapsulated by Mr Xi in the phrase “common prosperity”. “A regime shift is occurring without necessarily the markets fully comprehending the enormous underlying change to the structure of the economy,” said Sean Darby of Jefferies, an investment bank.

Analysts and short-sellers have been predicting the death of Evergrande for years. Its chairman, Xu Jiayin, who founded the company in 1996, put up $1bn of his own cash in 2018 to meet a shortfall in demand for an Evergrande bond with a 13% coupon. The company has relied on ever-increasing short-term debts, often at higher and higher costs, to fund a business model that relies on borrowing money to develop properties and selling them years before they are completed to generate cash from buyers’ deposits.

When central-government regulators stepped up their campaign against leverage last August, the first major cracks began appearing in its business. Authorities have constricted developers’ capacity to continue accumulating debt, limiting liability-to-asset ratios to less than 70%, net debt-to-equity ratios to less than 100% and mandating levels of cash that are at least equivalent to short-term debt. The policy has changed the nature of the business. Unable to continue perpetually expanding their debts, Evergrande and several other weak companies have slashed home prices and halted projects in order to preserve cash. Evergrande is said to be offloading housing projects in an attempt to generate just enough cash to make payments to suppliers. It is also selling off its land at a 70% discount, says one investor. UBS, a Swiss bank, has identified ten other Chinese property groups with 1.86trn yuan ($290bn) in contracted sales that are in similar risky positions.

How far will the turmoil spread? The volatility leading up to the expected default on September 23rd has already given investors a taste of the risks emanating from China’s deleveraging campaign. However, many analysts still believe severe contagion can be ring-fenced to groups with known connections to Evergrande and other weak property developers.

Start with banks, the main area of concern on regulators’ minds. China’s banking sector has lent heavily to developers in recent years. A stress test on banks’ exposure to the property sector conducted recently by the central bank concluded that an extreme scenario, in which loans to developers suffered a 15-percentage-point rise in their non-performing ratios, would eat up 2.1 percentage points of banks’ overall capital-adequacy ratios, reducing the industry average to 12.3%. Such a drop in the banks’ capital buffers, evenly spread across the banking sector, would be a tolerable depletion of protection. But such a crisis would not hit banks even-handedly; weaker banks would see a much larger reduction, note analysts at S&P Global, a ratings agency.

Ping An Bank and Minsheng Bank, both hit by sell-offs in recent days, had 10.6% and 10.3% of their total loan books extended to property groups in the first half of the year. Minsheng has tight links to Evergrande. Shengjing Bank, which is majority-owned by Evergrande, is thought to have lent heavily to the property company. A banking crisis is not the base case for many investors watching the situation. But “the situation would change very quickly” if a bank of Minsheng’s scale proved vulnerable, says a China-based executive at an asset manager. Central authorities would probably step in swiftly at the first sign of distress at a major bank, the investor adds.

Of more immediate concern are Evergrande’s links to China’s shadow banking system. About 45% of its interest-bearing liabilities in the first half of 2020 were from trusts and other shadow lenders, which are opaque and typically charge higher rates, compared with just 25% for bank loans, according to Gavekal, a research firm.

Panic in the offshore bond market is another worry. Chinese developers are the largest issuers of dollar-denominated bonds traded in Hong Kong, and among them Evergrande is the single largest issuer. The company’s bonds have traded at less than 30 cents to the dollar over the past week. Many other developers’ yields have shot up above 30%. Investors are waiting for a signal from Beijing. So far the absence of any strong sign of support has shown that regulators do not want to step in as they did recently with Huarong, a state-owned distressed debt investor that required a full bail-out in August. The treatment of Huarong, which is intricately connected to China’s financial system, suggests that Mr Xi is still intent on avoiding a generalised market meltdown.

If Evergrande does default, there is still the possibility that the government may step in to help individuals. The state, which is likely to be worried by protests in recent days by savers who have bought Evergrande’s wealth-management products, is expected to be forced to broker a partial bail-out for assets most connected with social stability.Such a process would be focused on the properties the company has already sold to ordinary people and which are not yet built. Capital Economics, a research firm, estimates there are about 1.4m of those. This could involve a number of companies carving up construction projects across the country and taking over assets in the provinces where they are based. By keeping these projects under development, suppliers and contractors would also in effect be bailed out.

One trick in organising such a bail-out will be finding buyers. The crackdown on leverage has left few developers with excess cash to make such purchases. Therefore, says Stephen Jen of Eurizon Capital, an asset manager, local governments may need to step in.

Perhaps the biggest contagion risk flaring up in the market is not that posed by Evergrande itself but by Mr Xi’s unyielding crackdown on leverage. In this sense Evergrande is not the root cause of the troubles in China’s property sector, says Logan Wright of Rhodium Group, a research firm. Instead it is a symptom of the Chinese Communist Party’s efforts to reshape the nature of the market. Following the assault on China’s vibrant tech sector Mr Xi has given analysts every reason to believe he intends to see this deleveraging campaign through, says Mr Wright.

These implications are bigger than the current market rout. China’s property sector accounts for 20-25% of its economy. An extended campaign against developer debt could significantly lower China’s growth prospects, says Tommy Wu of Oxford Economics, a research firm. But such a strategy could lead to much greater economic and financial turmoil further down the road. Regulators may eventually be forced to bail out the property industry along with the financial one, Mr Wu says. Such a worst-case scenario poses concerns far beyond the fate of Evergrande, and raises questions over where Mr Xi’s relentless and wide-reaching campaigns are leading China.

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