After years of fighting to stay ahead of its creditors, China Evergrande Group (HKSE:03333, Financial) has finally lost its battle against insolvency. The former top dog of the Chinese property development market is now headed toward bankruptcy restructuring.
With Evergrande now caught up in the painful process of restructuring, one might be tempted to close the book on the troubled company. However, the Evergrande saga is far from over. Indeed, the next chapter may see China’s entire financial system put to the test.
Racing to restructure
Having accumulated liabilities to the tune of $300 billion before being forced to throw in the towel, Evergrande is now reaping the bitter fruits of an unsustainable debt spiral. As I discussed back in July, the company has been piling on unsustainable debt for years. In the months since, Evergrande has sought to wriggle out of its debt crisis, but its efforts amounted to little more than kicking the can down the road.
Delaying tactics could only work for so long, however, and Evergrande finally ran out of time this month. On Dec. 3, Reuters reported the company's creditors were demanding immediate payment of about $260 million:
“On Friday, the company said in a filing to the Hong Kong stock exchange it had received a demand from creditors to pay about $260 million. It is already late paying $82.5 million in coupons due on Nov. 6. ‘In light of the current liquidity status...there is no guarantee that the group will have sufficient funds to continue to perform its financial obligations,’ Evergrande said, adding that creditors may demand accelerated repayment if it does not.”
This $260 million is in addition to the $82.5 million debt payment that was due on Nov. 6. Unsurprisingly, Evergrande’s admission rattled faith in its stock, as Tiger Faith Asset Management’s Conita Hung pointed out on Dec. 6:
"Evergrande has been trying to sell assets to repay debt, but Friday's statement basically says it is going to 'surrender' and needs help. This sends a very bad signal."
Now, the company is racing to restructure its debt before a cascade of debt obligations come due in the coming months.
Containing contagion
On Dec. 6, Evergrande announced that it had formed a risk management committee to coordinate its emergency restructuring efforts. According to Evergande, this committee will include representatives from government entities whose focus will be on "mitigating and eliminating the future risks" posed by the company.
While Evergrande’s predicament has caught the attention of international investors, its issues are far from unique among large Chinese companies. As the New York Times explained on Oct. 11, many other companies could also be at risk:
“Companies like Evergrande are examples of so-called gray rhinos — large, obvious and highly probable risks that are all too likely to be neglected. Evergrande and companies like it are so large and so entangled in the country’s financial system that the government has an interest in their survival. A failure on the scale of Evergrande would ripple across the economy, and spell financial ruin for ordinary households...Evergrande epitomizes the vulnerability of the world’s No. 2 economy.”
As it turns out, there are many cases of Chinese companies that could follow in Evergrande’s footsteps. Many of the largest, most well-connected domestic companies enjoyed the same light-touch regulatory approach that allowed Evergrande to keep the proverbial music playing long after its debt burden became totally unsustainable.
China’s government under President Xi Jinping has been working to rein in the country’s corporate sector. Xi has asserted the goal of eliminating perverse incentives and moral hazard. Evergrande stands as a stern warning of the price of failure in that endeavor.
My take
Evergrande’s spectacular collapse has exposed a number of potential fault lines in China’s economic and financial system. Should any other gray rhinos start to show signs of financial distress, China’s financial regulators could quickly be overwhelmed.
In my view, investors with exposure to China should follow the Evergrande restructuring story closely. It may hold insight into the future of the world’s second-largest economy.
