Over the past several months, China Evergrande Group (HKSE:03333, Financial) has careened from crisis to crisis with precious little respite. As with so many business disaster stories, Evergrande’s troubles stem from an overindulgence in leverage. Indeed, Evergrande is not only the biggest property development company in China, but also the most indebted.
A forlorn hope
As I explained in July, Evergrande’s unsustainable debt burden has put it on a course to insolvency. The company’s only chance of survival appeared to be a government bailout. Unfortunately, such a rescue package has failed to materialize to date, a fact that has led a growing number of investors to give up on the embattled developer.
Hopes of a bailout were briefly reignited this week when it was announced that another distressed Chinese company, China Huarong Asset Management Co. Ltd. (HKSE:02799, Financial), would receive a government rescue. The bailout came on the heels of Huarong’s announcement it had lost just shy of $16 billion in 2020, as Nikkei Asia’s Noriyuki Doi reported on Aug. 18:
“The embattled company cited a ‘decline of contract performance ability of certain customers’ amid the coronavirus pandemic, which led Huarong to reassess asset risks and book large impairment losses. The liquidation of risky assets acquired under former Chairman Lai Xiaomin's aggressive expansion strategy also contributed to the massive loss.”
The relatively kind treatment of one struggling Chinese titan may have fanned what few embers of hope still remained for Evergrande. However, Evergrande’s shares sank again on Aug. 19 as the result of investor capitulation, according to Bloomberg:
“Huarong’s bailout was reassuring for investors who went through months of agony guessing just how determined the Chinese government was in combating moral hazard. But even with $300 billion in liabilities that could roil banks, suppliers and home buyers, junk-rated Evergrande is seen as a separate case as authorities crack down on excessive leverage in the property sector.”
Evergrande’s problems are clearly distinct from Huarong’s in both their nature and scale. Mismanagement may have played some role in precipitating Huarong’s crisis, but many of its problems were exogenous in nature. Evergrande’s crisis, on the other hand, is the result of years spent piling on debt in an effort to maintain the appearance of growth. The sheer scale of Evergrande’s debt burden, which currently stands in excess of $300 billion, also makes its case very different from the apparently more easily salvageable Huarong.
Xi puts his foot down
While China has been ready and willing to rescue the nation’s corporate standard bearers when they got over their skis in times past, government attitudes have hardened under the administration of President Xi Jinping. Xi’s government has declared a number of red lines that it will no longer cross in order to save wayward Chinese enterprises, and it has upheld those boundaries to date.
Even the recent bailout of Huarong is within the bounds Xi has set, which aim to limit interventions only to companies that are systemically important. Huarong certainly fits that bill. The state-sponsored enterprise plays a pivotally important role in the wider economy, namely cleaning bad debt out of the financial system. That makes Huarong systemically important by almost any definition. Evergrande, on the other hand, is ultimately a private property developer, even if its size makes it stand out. As macro commentator Ye Xie observed on Aug. 19, being the largest property developer in the country is not enough guarantee a government rescue:
“One day after Beijing engineered the recapitalization of Huarong, financial regulators pressured Evergrande, the world’s most leveraged real-estate developer, to resolve its debt problem. In a rare public rebuke, regulators demanded the struggling developer refrain from spreading untrue information. Evergrande’s bonds due in 2022 fell to a record 47 cents on the dollar, even before the news came out late Thursday...Evergrande is bigger than Huarong...So the fact that Beijing is determined to let Evergrande sort out its problem on its own shows that Huarong’s rescue is an exception rather than the rule.”
While Beijing’s refusal of Evergrande has left its red lines intact, it is unclear whether the government is prepared to deal with the potential fallout should the company collapse into bankruptcy. Obviously, $300 billion is an astonishingly large amount of debt exposure on its own. In the context of the wider Chinese financial system and real estate market, Evergrande’s fall could trigger systemic reverberations. Should that happen, the central government might have no choice but to step in.
My take
As things currently stand, it looks to me like the Chinese government is willing to leave Evergrande to its fate. That decision may shore up confidence in Xi’s commitment to excising moral hazard from China’s financial markets, but it may also trigger an uncontrollable cascade of financial dominoes.
In my assessment, the risk of Evergrande’s collapse causing such a systemic shock may be the only thing that could even potentially induce the central government into softening its stance.
