China Evergrande Group (HKSE:03333, Financial) has been making financial media headlines worldwide in recent months. Unfortunately, the coverage has been almost universally negative, being focused on the mounting debt crisis gripping China’s largest commercial property developer.
As I have discussed previously, Evergrande’s debt pile, which now exceeds $300 billion, has become wholly unsustainable. With President Xi Jinping continuing to stand firm in his policy of stamping out moral hazard from China’s financial markets in recent weeks, investors’ hopes of a government bailout have faded precipitously.
With Evergrande circling the proverbial drain, some investors have shifted their focus to another question: Could Evergrande’s collapse precipitate a wider financial crisis in China?
Escalating corporate debt crisis
Evergrande’s debt crisis has proven rather reminiscent of a classic – and oft cited – quotation from Ernest Hemingway’s novel "The Sun Also Rises":
“How did you go bankrupt? Two ways. Gradually, then suddenly.”
As Evergrande has teetered ever closer to insolvency, its crisis has only accelerated. A number of major events have transpired in August alone. Evergrande agreed to sell off its stake in HengTen Networks Group Ltd. (HKSE:00136, Financial) for just over $400 million and has started the process of selling off additional assets, such as its stakes in subsidiaries Evergrande Property Services Group Ltd. (HKSE:06666, Financial) and China Evergrande New Energy Vehicle Group Ltd. (HKSE:00708, Financial).
Evergrande conducted yet another fundraising gambit this month, selling off a portion of its residential property portfolio at a steep discount to some of its unpaid suppliers and contractors. While such a firesale could hardly hope to plug the yawning gap in the company's finances, it did have the positive effect of assuaging ornery creditors to the tune of $3.9 billion.
With its balance sheet in shambles, Evergrande has effectively halted construction work on a number of development projects. While such actions may help staunch the bleeding, they cannot heal the gaping financial wound. With net earnings set to drop by as much as 39% in the first half of 2021 compared to the same period last year, there seems to be little prospect of a meaningful turnaround anytime soon.
Given its deteriorating financial position, it should come as no surprise that Evergrande's corporate bonds faced another round of downgrades from debt ratings agencies in August. Moody’s Corp. (MCO, Financial) clipped the ailing property developer’s rating from B2 to Caa1, a move that was quickly followed by S&P, which dropped its rating of Evergrande’s bonds from B- to CCC.
Rising contagion risk in focus
For many years, China’s industry titans benefited from a tacit guarantee from the central government and ruling Chinese Communist Party that, should they run into financial trouble, China Inc. would have their back. The Xi administration has sought to do away with this guarantee, which it sees as a source of dangerous moral hazard. This effort to draw a line in the sand could cost Evergrande dearly, but the Xi administration appears confident in its ability to manage the property giant’s potential failure, which it does not see as posing a systemic risk to China’s broader economy.
It may behoove Xi and his team to reflect on recent history. Afterall, the George W. Bush administration was confident in its ability to manage the fallout from the collapse of Lehman Brothers in 2008, only to discover that what it assumed would be a controlled bankruptcy had quickly spiraled out of anyone’s control. The contagion that followed spread throughout the financial system, precipitating a domino effect that threatened to shake the very foundations of the American economy.
The issues China’s economy and financial system are facing today are unquestionably different from those of the U.S. in 2008, but they are of a similar kind in a number of respects. The Chinese government’s confidence in its ability to manage may be misplaced, as Bloomberg warned on July 19:
“The risk is that a major payment failure at Evergrande ripples through China’s financial system, eroding confidence in other highly leveraged property companies, shadow lenders and even some banks.”
Confidence can be a good thing, when it is justified. But there is always the risk that healthy confidence will turn to dangerous hubris, as Proverbs 16:18 warns:
“Pride goeth before destruction, and an haughty spirit before a fall.”
The Chinese government has managed to orchestrate an unprecedented economic miracle over the course of several decades. That is undoubtedly an achievement to be proud of, but I fear that that success also risks blinding China’s policymakers to the dangers that individual companies can pose to a financial system – especially one as massive as Evergrande.