Evergrande has stolen the headlines this week — so what is it?
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Chinese property developer Evergrande Group has moved to the front of the financial news cycle this week — a development which has left many foreign investors asking… what is it exactly?
Shares in the Hong Kong listed company held steady in Tuesday trade, but the stock has slumped by more than 85% in 2021 as markets weigh its capacity to pay interest bills due on mountains of debt (estimated around US$300bn).
As far as global investors are concerned, the main question is the extent to which problems in China’s financial system have the capacity to spill over to other markets.
We’ll address that, but firstly…
Evergrande was founded in 1996, which is around the same time new laws were introduced in China that allowed for private property ownership.
The company listed in Hong Kong in 2009 and spread into other markets, including a high-profile acquisition of the Guangzhou Football Club. It also bought and sold interests in sectors such as dairy, grain and water.
In its core real estate division, Evergrande made land acquisitions and developed properties using a high-leverage model that was tied to the broader growth in China’s property sector, stemming from the 1990s law changes.
Speaking on the Bloomberg Odd Lots podcast, Hong Kong-based analyst Travis Lundy said in light of that growth, real estate now accounts for around 16-17% of China’s GDP — a higher ratio than US real estate before the 2007 sub-prime crisis.
Lundy explained that a feature of Evergrande is that it did a lot of development work in the lower tiers (Tiers 2 & 3) within China’s city tier system.
Around the same time as China’s private property laws were passed in the mid-90s, budget reforms were also enacted which required local governments to balance their budgets without using external funding.
Consequently, land sales became their central source of funding and Evergrande thus endeared itself to local councils outside of the Tier 1 cities, by being on the other side of the trade.
In such an environment, property developers like Evergrande built up “land banks” with up to five years worth of land, Lundy said.
“You hope it appreciates, and the real estate on top appreciates at a higher rate than your funding costs. So if you’re funding debt at 10% and the asset appreciates at 15%, you can make a 5% carry on a very large business.”
But the problem with that model is “you can’t ever stop growing”.
“If you do slow down you have to sell assets and repay debt,” he said.
While China’s real estate market has been a wealth driver for its huge middle class, it’s also created an environment of speculation with the associated financial stability risks.
In the middle of last year, authorities introduced the ‘three red lines’ rule — a campaign aimed at reducing sector leverage by assessing real estate companies based on the following three criteria (source: UBS):
– Liability-to-asset ratio (excluding advance receipts) of less than 70%
– Net gearing ratio of less than 100%
– Cash-to-short-term debt ratio of more than 1x
Companies that didn’t meet all three criteria would face restrictions on how fast they could grow.
Since then, Lundy said Evergrande made a number of unusual moves, but its issues snuck under the radar.
Earlier that year, Evergrande chairman Xu Jiayin (Hui Ka Yan in Cantonese) flagged plans to reduce the company’s debt by RMB150bn (~US$22.5bn) per year over the next three years.
The company engaged in share buy-backs through the middle of 2020 that boosted its stock price. A positive trading update was followed by a profit warning.
Shortly after, Evergrande bosses were called up for their ‘three red lines’ meeting. The company did an equity raise but “only sold around half what they wanted at a big discount”, Lundy said.
By the end of last year, Evergrande still remained in breach of all three criteria in the red lines policy.
“Things just kind of snowballed, and I think people were fairly complacent. It’s a case where if things slow down, it’s not necessarily a problem but it can roll into a problem relatively quickly.”
As ever with China, assessing the actual state of internal debt contagion is difficult for external observers.
Lundy said Evergrande has around US$90bn in US dollar bonds outstanding that foreign investors know about, along with another US$180bn of supplier-based contract liabilities on its balance sheet.
The company’s debt is also linked to a web of wealth management products — bundled securities that are packaged up and sold to Chinese retail investors.
One observation Lundy added is that in previous major debt restructurings in China, it’s not always the case that founders lose their equity stake in order for bondholders to get paid.
To the external observer, Xu remains politically connected and was seen in attendance at the Communist Party’s centenary celebration in Beijing on July 1. He also “still owns 77% of the company”, Lundy said.
Yesterday, Xu published a letter (otherwise light on details) pledging that Evergrande will “walk out of its darkest moment”.
In research yesterday, CBA analyst Carol King said the bank doesn’t anticipate “systemic contagion” across global markets stemming from Evergrande’s debt problems.
However, “the potential default may unnerve foreign investor confidence in Chinese assets for a time”.
That said, King cited data which showed so far the crisis has had only a “limited impact” on foreign capital flows into mainland Chinese stocks on the Shanghai Composite exchange.
She added that in recent historical context, Chinese policy makers have been consistent in their rhetoric to reduce corporate leverage.
But whether the state steps in to bail our or take over Evergrande entirely is “still unclear”.
“The recent volatility in China’s financial markets may turn out to be a case of ‘short term pain for long term gain’,” King said.
“We continue to expect robust foreign capital inflows into China so long as Evergrande’s issues do not cause a systemic event.”