Evergrande is the second largest real estate developer in China and was at one point part of the illustrious Fortune 500 companies list put out by the US-based Fortune magazine. The company made its mark during the infrastructure-fuelled growth binge of the Chinese economy back in the 2000s, after the Global Financial Crisis.
So what’s going wrong?
China has told state-owned lenders of Evergrande that the real estate developer was in no position to repay interest that was due on Tuesday. While media reports have suggested that Evergrande was in talks to restructure loans with its banks, the company had previously suggested that it was at risk of default due to stuck receivable and restricted borrowing options.
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Evergrande holds one of the biggest debt piles in all of China and the world. The company’s last recorded debt pile stood at close to $300 billion, including bank loans, short-term borrowings and supplier credit.
According to Ming Zhao, former hedge fund manager, Evergrande has interest payments of 180 million yuan (1 yuan = Rs 11.39) every day as nearly 35 per cent of its debt was interest bearing. According to Evergrande’s annual report, its cash position was merely 150 billion yuan, suggesting that unless the company could raise more money or get extremely favourable restructuring terms, it would go belly up.
Last week, the company was not able to meet a repayment on short-term debt and asked investors to take a haircut and accept a quarterly repayment schedule of the outstanding dues.
How did Evergrande land here?
In China, most real estate developers were able to take up large amounts of short-term debt as they could easily refinance these through their contacts in the shadow banking system. Under Xi Jinping, however, China wants to address the endemic bad loans problem that plague its banking sector by severing backstops like refinancing of short-term debt and imposing credit limits of real estate developers, which constricted their ability to generate revenue from new projects. This was evident when the Chinese authorities allowed Huarong to default — the first banking default in China in more than 20 years — and its crackdown on shadow lenders.
Further, real estate business is a long gestation business with elongated cash conversion cycles. Most of the cash in a real estate business is held up in inventories and receivables that can take months to realise.
Further, Evergrande’s management is known for its largesse. The company invested billions of dollars into the football business, which the Chinese government has started to crackdown on due to it becoming a playground for China’s nouveau riche to exhibit their wealth. On top of that, the real estate company diversified into unrelated fields such as electric cars, streaming media, amusement parks and healthcare. The cash ploughed into these businesses were tantamount to burning them during winter to warm your hands.
Evergande’s operating income has crashed 75 per cent since 2018, while its gross margins have shrunk more than 1,000 basis points in that period. Earlier this month, the company said property sales would fall in September, usually a buoyant month for the real estate sector, due to waning confidence.
So what now?
Evergrande is most likely to default to lenders one by one as weak sales, lack of outlet to monetise existing inventory and credit freeze from lenders leave the company short on cash. However, since state-owned banks are the senior most creditors, they will get their dues first when the fire sale of the real estate developer begins. Everyone else will be left with the skeletons.
The larger issue here is the second order effect it will have on the Chinese credit market. Remember, China is the second largest economy in the world and the largest consumer of commodities and other services. If Evergrande goes down, it will take its millions of suppliers with it to whom it owes billions of yuan. Further, it could cause a lending freeze in the entire credit system, in the manner the Lehman Brothers’ collapse did in the US or IL&FS’ bankruptcy did to the Indian money markets.
The only saving grace could be that Xi may not want a full-blown crisis in his hands, and the emergency liquidity injection by the People’s Bank of China on Saturday suggests the central bank will try to fight the situation to contain wider damage to the financial system.
Oddly enough, just like the Lehman Brothers’ collapse on September 15, 2008, no one genuinely thought Evergrande would crumble until it did.
