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Too ‘Grande’ to Fail


From being the world’s most indebted property developer to the frustration of its lenders and stakeholders, there are many peculiar things about Evergrande and the $300bn mountain of debt that it is currently sitting on. What worries economists and financial experts is the potential for havoc across all sectors that the collapse of this mountain possesses. But should we be worried?

Evergrande began as the Hengda Group and was founded by Xu Jiayin, now its current chairman, in Guangzhou back in 1996 during a period of widespread urbanisation across China. The firm went public in October 2009 and raised US$772m in its first IPO on the Stock Exchange of Hong Kong.

Since then, it has grown to become the second-largest property developer in China by sales revenue and has acquired stakes in firms across various sectors, ranging from entertainment to automobile.

Beyond all of this, what Evergrande is perhaps best known for is the current liquidity crisis engulfing the company. It has $300bn of debt to repay to various stakeholders which takes various forms such as $20bn in dollar-denominated bonds.

Recently, the firm has regularly been missing interest payments on its US corporate bond debt. For example, it
missed a $83.5m interest payment last week and has more recently missed a second payment too.

What sparked this debt crisis was the decision by the Chinese government to reduce the amount of debt that companies could take on. Given the opacity of China’s financial system that previously allowed firms to recklessly borrow and amass sizeable liabilities on their balance sheets, these new regulations have hit Evergrande and its peers who have undertaken significant loans and are now required to pay them back.

For those who lived through the subprime mortgage bubble that triggered the 2007/08 financial crisis, there are many parallels that can be drawn here.

Firstly, both involve the reckless exchange of financial capital, in one case through lending and the other through borrowing. Secondly, both involve asymmetries within the financial markets where the lender had little information regarding the financial profile of the borrower. Finally, both stem from the real estate and housing market.

The significance of the real estate sector in China cannot be understated; it forms 29% of China’s GDP and employs 20% of China’s entire labour force which is considerable compared to Western economies such as the UK and US where real estate forms only 7% of their respective GDPs.

Source: Reserve Bank of Australia

Despite it being so fundamental to the output of the world’s second largest economy, China’s housing sector is victim to numerous inefficiencies that have contributed to the images of empty apartment and ghost towns across China of unfathomable magnitude; China has enough spare housing to accommodate the entire populations of the UK or Canada.

Chinese property developers often sell residential properties to homebuyers before their completion, allowing them to invest this cash in the purchase of new construction plots despite the final product not yet being traded, in other words an accrued liability on the part of these property developers. This provides local governments with much-needed revenue which is why there is little objection to this practice from an authoritative standpoint.

Being able to raise significant amounts of capital through borrowing is what has driven this immense surplus of supply in China’s housing market and so far has gone unchecked, until the recent intervention by the Chinese government detailed above.

By forcing companies such as Evergrande to repay their liabilities to lenders, the company has been unable to finance current construction and forced to postpone projects, that is if it is able to see itself through this crisis.

By terminating the construction of properties, clients are now demanding refunds on products that they have paid for but now seem unlikely to receive. The combination of these effects now constitute the $300 billion pile of debt that perilously looms over not only Evergrande but asset managers across the world.

Much like the collapse of Lehman Brothers 14 years ago, this turbulence and uncertainty within the credit and fixed income markets has gripped investors around the world who now fear that their portfolios are at risk of ‘contagion’ from Evergrande’s financial insolvency.

Source: Shutterstock

You would expect that the Chinese government would be considering stepping in to prevent the Evergrande crisis spilling over into other sectors of the Chinese economy in addition to the economies of its key global trading partners. However, its inert response to this crisis has shocked many and instead it has urged state-owned enterprises to acquire Evergrande’s assets.

The firm is now considering available financial solutions and offshore bondholders have hired the US law firm Kirkland & Ellis and the boutique investment bank Moelis to advise ahead of what could become the largest corporate debt restructuring in China’s history.

Evergrande has also divested part of its stake in Shenjiang Bank, one of its lenders, to a state-owned firm, retaining only a 15% stake in the bank that now demands that all proceeds be used to repay Evergrande’s liabilities to the bank.

Many question marks hang over Evergrande’s liquidity crisis; what will be the global repercussions if Evergrande was to fail? Or will the Chinese government bail them out and contain this developing upheaval? And if it was to do so, will this set the precedent for Evergrande’s peers to continue to recklessly borrow and inflate their balance sheets by leveraging extortionate amounts of debt?

The final question brings to mind a phrase coined during the 2007/08 financial crisis and the title of a film: “Too Big to Fail”. Perhaps “Too ‘Grande to Fail” would be more appropriate for a future documentary on the current woes of Evergrande.

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