Tag Archive for: Evergrande

China’s Hidden Debt Crisis

Estimated Reading Time: 5 minutes

Editors’ Note: It is estimated that 70% of the household worth of the Chinese people is invested in the property market. This market is largely run by the government, the Communist Party, and its state-owned banks. We have covered this ongoing story for some time but indications are the situation is getting worse and has spread well beyond the collapse of Evergrande. In part, this is because of the global economic slowdown, and it further has been aggravated by draconian Covid-related lockdown policies in China. The most recent Economist suggests the problem is now political, with widespread unrest. President Xi is up for”reelection” at what could be a very difficult time. Furthermore, the crisis has taken the form of banks freezing accounts, which has created riots, as well as property owners going on strike and refusing to make their payments. As the article below indicates, China is not only highly centralized, which creates concentrated economic error on a vast scale, it is incredibly over-leveraged. Falling asset prices endanger the loans used to support the particular asset in question, which runs the risk of a cascading scramble to get out and get liquid. This, in turn, runs the risk of a deflationary bust, and then particularly in authoritarian governments, a response by governments to try to stem deflationary pressures. Knowing the timing of such events is largely impossible, but history certainly provides ample examples of the general process. What is very clear is that you can’t have the world’s second-largest economy get into such trouble, Europe lurch into trouble because of energy mistakes, and Japan experience a currency crisis (Yen is down nearly 30%); without raising the risk of global economic trauma. Meanwhile here in the US, the FED is raising rates against our own asset bubble, increasing the risk of recession here as well.

Beijing’s centralized planning has created a massive bubble of obligations.

China’s ongoing debt crisis has experienced yet another twist of fortune. Some Chinese, fearful that their savings are in jeopardy, have protested so actively in front of banks that the Peoples’ Liberation Army has intervened. Others who had bought apartments before now-troubled developers could construct them—what the Chinese refer to as presales—have threatened to withhold payments on their mortgages. These latest aspects of China’s financial troubles have captured the media’s immediate attention, but they change nothing substantive in China’s underlying problem. Significant debt overhang points to fundamental, even systemic flaws in the Chinese Communist Party’s approach to economic organization.

China’s rolling debt crisis broke in 2021, when the huge property developer, Evergrande, announced that it could no longer support some $300 billion in liabilities. Evergrande, and other developers who have since made similar if less grand announcements have left bondholders and lending banks—both private and state-owned—with assets that are now worthless, causing some to try to lock down deposits, and bringing on protests from anxious savers. Would-be homeowners who paid for and floated mortgages for apartments that do not exist have been left holding the bag. In a pattern common to financial crises everywhere, these mortgagees and lenders may now fail on other obligations, imposing losses on others who had nothing to do with the initial failure.

The government in Beijing, as well as media outlets—both Chinese and western—have so far laid the blame for these debt problems on the profligacy of Chinese developers. There can be little doubt that many of these firms had flamboyant managements that borrowed too heavily and spent too freely. But if imprudent management can take some of the blame, the lion’s share belongs to policymakers in Beijing. It was, after all, they who gave property development pride of place in the nation’s growth model. Beijing used special bonds to encourage provincial governments to work with private developers to raise whole cities from what were previously farmers’ fields.

Early on, these rapid developments formed the basis of glowing western media reports. Property development became a huge part of China’s gross domestic product (GDP). But Beijing’s planners, insensitive to facts on the ground, as central planners frequently are, went far beyond the nation’s needs. Today, Beijing estimates that some 20 percent of China’s housing stock is unoccupied and paying no return on the huge debt load incurred to produce these units. It should be no mystery, then, that the developers cannot service those obligations.

If the real estate problem were the whole story, it would be dangerous enough, but the problem is more fundamental. Beijing’s top-down, centrally planned approach to economics has multiplied these kinds of mistakes across the economy. True, this centrally planned system once worked well, but China has changed since those halcyon days, making the centralized approach increasingly wasteful and debt-prone.

When China began its decades-long growth surge, its underdeveloped state made central planning easy. All Beijing needed to do was look at the developed world and see that China lacked roads, ports, rail links, housing, and other such obvious essentials. That emphasis paid off handsomely as the nation filled in its blanks. But as China’s economy has developed and, in many ways, caught up to the developed west and Japan, future avenues for sustained growth have become harder and harder to identify. China’s planners have accordingly begun to make more and more mistakes, setting priorities that, like residential development, have increasingly missed the economy’s needs—bridges, rail links, roads to nowhere, and impressive transit systems in cities with relatively few residents. Even as such fundamentally wasteful projects are abandoned or razed, the debt incurred to build them remains.

Of course, unplanned, market-based systems also make mistakes about future needs.  No one can see the future. But the mistakes of market systems are seldom as massive or pharaonic as in China’s centrally planned system. Market-based participants, typically more sensitive than are central planners to signals from buyers, adjust more quickly before going too far down the wrong road. Because the decentralization in market-based approaches implicitly creates a great diversity of efforts to capture the future, each mistake happens on a smaller scale than when central planners marshal national economic and financial resources toward relatively few priorities. The same diversity of market-based systems means that one of the many efforts to capture the uncertain future will likely be right, thereby generating great returns for the firms and individuals involved, but also crucially for the economy at large. Central planners, on the other hand, place relatively few but very large bets, and suffer commensurately when they fail to pay off. It is noteworthy that America’s market-based system has suffered its worst collapses when government intervenes, as for instance when Washington pressured banks to lend mortgage money to lesser credits, fostered dubious financial practices, and encouraged the overbuilding that culminated in the 2008 and 2009 financial crisis.

A comparison of relative debt loads in China and the United States can quantify this crucial difference and assay China’s essential problem. To be sure, Beijing has kept a lid on government debt issuance—certainly much better than Washington has. But central government debt is an inadequate measure of this effect. The financial legacy of failed projects lies with China’s provincial and local governments and the state-owned enterprises (SOEs) that control the bulk of the nation’s industry. To see the errors wrought by China’s system and make a valid comparison to the United States, the debt to track is a combination of central government obligations, provincial (or state) and local obligations, and the debt of the corporate sector.

During the ten years from 2009 to 2019, aggregate debt in China grew at a 23 percent annual rate, far in excess of the nominal economy’s otherwise impressive 8 percent growth rate. This difference offers a rough (admittedly very rough) estimate of the burden of waste left by the mistakes of the top-down planners. The equivalent debt aggregate for the United States shows a legacy of error, but on a much less grand scale. In America, this measure of debt has grown at about 5.6 percent a year over the ten years ended in 2019, faster to be sure than the 4 percent average growth of the nominal economy, but a much narrower gap than in China. The relative burden of these legacies is apparent in debt levels relative to the overall economy. In the United States, this composite of debt outstanding amounts to just over 190 percent of GDP. In China, aggregate debt verges on 270 percent.

None of this is to forecast a collapse in China or eventual American triumph. To paraphrase Adam Smith, counties can withstand a lot of ruin. What it does say is that China’s underlying economic system will for the foreseeable future create an ever-larger debt overhang. The planners may still get lucky from time to time, but the odds point in the direction of more mistakes, raise questions about easy and popular forecasts of eternal Chinese dominance and should take the edge off equally popular fear-mongering over China.


This article was published by The American Mind and is reproduced with permission.

Will Evergrande Go Bankrupt?

Estimated Reading Time: 5 minutes

The largest real estate developer in China—and one of the largest in the world—is on the brink of bankruptcy. The problems this could create in the Chinese financial sector, and in turn in other parts of the world, are convulsing capital markets around the globe. The news is not encouraging. Evergrande has already defaulted on several interest coupons on its dollar debt, and recently the listing of its shares was suspended on the Hong Kong Stock Exchange.

What Is Evergrande?

Evergrande became the largest Chinese real estate developer through turnover. It is currently engaged in about eight hundred active real estate developments, mostly in 230 secondary and tertiary Chinese cities. While it is a giant company that has been extending its business model to other economic activities, more than 97 percent of its income derives from real estate development.

Evergrande reached its peak valuation at the end of 2017. At the time, it was worth almost $51 billion, ranking it among the 350 largest companies in the world and among the 40 largest companies in China. Since then, its value has been sinking, and today it is worth just $5 billion. At today’s valuation, it is only the 2,650th-largest company in the world.

Why has Evergrande’s value dropped so much? Is this a sign of an inevitable bankruptcy?  And what is the state of Evergrande’s finances? Let us begin with an analysis of its income and profitability.

The Business Model: Is Evergrande Making Money?

Evergrande was already the largest Chinese real estate developer in 2011. Since then, the company’s sales have soared, particularly since 2016.

Evergrande’s earnings statements show that profits have dropped significantly since 2018. However, its earnings remain positive even in 2021 (January–June). Earnings are currently close to those seen in 2016, and while the share value is lower today than it was in 2016, the difference is small.

The problem with this approach is that all of Evergrande’s profit figures are contaminated by non-recurring events (such as accounting profit realized from the sale of subsidiaries to increase liquidity). Considering only Evergrande’s main business, real estate sales, and excluding the non-recurring events, we arrive at a much bleaker picture of the Asian real estate giant’s finances.

Evergrande’s profits are below those recorded in 2010 when its turnover was one-tenth of what it is today. To make matters worse, the construction of new housing is practically paralyzed because of a lack of supplies, due in no small part to Evergrande’s defaults on payments to suppliers. Evergrande’s earnings are thus not what the company claims; it likely incurred losses in the second half of 2021.

Evergrande’s margins have plummeted since 2018 and currently are not even enough to pay the interest on its debt.

The Elephant in the Room: Evergrande’s Debt

Most of the discussion surrounding Evergrande is about its debt problems, which is logical, as the market is waiting for the company to default. The company’s problems with assets are as serious as those associated with its debt.

Evergrande’s debt/asset ratio reached 41.6 percent in 2017. In 2021, it dropped to 24 percent. This makes it seem as though Evergrande has significantly reduced its debt, but nothing could be further from the truth. All the company has done is exchange formal debt for debt to its suppliers. In other words, to meet debt-reduction commitments, Evergrande has accumulated unpaid bills to its suppliers.

Once debt to suppliers is introduced, it becomes clear that the company’s real debt-to-asset ratio has remained almost constant. The official ratio is nothing more than accounting smoke and mirrors.

The accumulation of debt to suppliers has caused serious problems for Evergrande. Most vendors have decided to stop supplying the company, so many real estate projects are completely paralyzed for lack of supplies. Evergrande’s ability to deliver new housing projects (crucial for the company’s survival) has been seriously compromised, as the company itself acknowledges in its latest quarterly financial report.

Perhaps as (or even more) important as the accumulation of debt is the company’s temporary profile. Evergrande did not know how to plan for its enormous growth. Since 2014, half of Evergrande’s debt has been constantly renegotiated and renewed, making the company vulnerable when faced with any event that would prevent or hinder the renewal, and 78 percent of Evergrande’s debt needs to be renewed every year.

An unexpected change came at the beginning of 2021 when the Chinese government decided to burst the country’s real estate bubble. It required the country’s real estate developers to comply with relatively demanding financial ratios and prevented companies that didn’t comply from increasing their debt. This decision was the spark; the financial irresponsibility of Evergrande’s directors was the dynamite.

The Last Piece of the Puzzle: The Assets Evergrande Could Sell

There is no doubt that Evergrande is a disaster on the debt side, but what about its assets? Although it’s not ideal, every company has the option of selling assets in order to pay off debts. This is precisely what Evergrande has been doing in recent months. They have jettisoned the assets that are not central to their business, such as holdings in banks and other companies. But most of the company’s assets are housing developments.

The company has two problems here. The first is that the company’s sales price (by square meter) has begun to plummet. The second is that the bulk of Evergrande’s real estate assets are unbuilt houses. Approximately 90 percent of Evergrande’s real estate developments are homes that are under construction (the other 10 percent is finished housing). According to Evergrande, the houses under development will be finished within a year, but housing sales are far below the number of properties in the company’s inventory.

There are two possible explanations:

  1. It takes much more than a year to construct the houses. In this case, selling the houses to pay the company’s debts will be impossible.
  2. Houses under construction are actually unsold houses. In this case, they will have to be sold at significantly reduced prices (which will tend to create a huge loss on the asset side and could lead to the company going bankrupt).

In both cases, Evergrande will not be able to use its assets to pay its debts and avoid bankruptcy.

Conclusion: Evergrande’s Inevitable Bankruptcy

If Evergrande’s liabilities are a disaster and its assets are too, and the latter are in a bursting market bubble, the company’s chances of survival are low.

Perhaps the clearest indicator that Evergrande cannot survive on its own is the interest-coverage ratio. This measures a company’s ability to pay its debt and is calculated by dividing earnings before interest and taxes by interest expenses on debt. A ratio higher than one indicates that profits are greater than interest expenses. A ratio lower than one indicates that profits are insufficient to pay the interest on the debt (and the company must sell assets or increase debt just to pay interest on previous debt). Evergrande’s interest-coverage ratio dropped below one in 2020.

The chances of Evergrande’s survival without public aid or without the massive injection of cash from some unsuspecting investor are therefore nil.


This article was published on November 23, 2021, and is reproduced with permission from AIER,  American Institute for Economic Research.