Investors could be even further ‘to the left’ after Evergrande as China revamps economic policy


Global financial markets stabilized after debt-laden Chinese developer China Evergrande said it would be able to pay interest owed on the bonds this week. The market volatility underscores the risks associated with Beijing’s debt-heavy development model and has surfaced at a time when foreign investors in overseas-traded tech stocks such as Alibaba and education companies such as New Oriental suffered losses as authorities shifted domestic policy priorities.

“From housing to education to financial services, China is forcefully reorganizing aspects of the economy that the (Communist) Party says have resulted in an unacceptable income division and a dangerous drop in income. birth rate, ”said Drew Bernstein, a Chinese chartered accountant and co-chair of the MBP in New York. “Investors who are caught on the wrong side of these rapid gyrations are being left out. “

What’s next with Evergrande and similar Chinese company bailouts? I spoke to Bernstein by email today to find out more. MBP audits and advises Asian companies. Excerpts follow.

Flannery: Why is China Evergrande important?

Bernstein: A year ago, China Evergrande was famous for being the second largest real estate developer in China, with projects in more than 170 different cities. Today, it is reputed to be the most indebted real estate company in the world, with more than $ 300 billion in debt, or the equivalent of 2% of China’s annual GDP. Evergrande’s tentacles run deep into China’s real estate and banking systems, and owe money to Chinese banks, domestic bondholders, foreign bondholders, suppliers and contractors, and governments. local. And as Evergrande’s cash crunch grew increasingly severe, it got creative in selling high-yielding ‘wealth management’ products to investors, including Evergrande real estate owners and many more. of its 200,000 employees. Evergrande, in short, owes almost everyone money. And although it has engaged in a discount sale of a range of its assets, Evergrande appears to have poor prospects for timely repayment.

Besides its size, Evergrande is important because it highlights China’s dependence on real estate development to boost the growth of its economy and how this has led to unsustainable increases in house prices and debt levels. .

Flannery: What does Evergrande tell us about the wider Chinese real estate market?

Bernstein: In China, a lot of people invest in apartments as a store of speculative value, even if they don’t intend to live or rent them. Land sales associated with new developments are also an important source of income for companies.

Governments and the whole cycle have been lubricated by abundant loans from state banks which often have close ties with government officials. Real estate and related industries account for up to 25% of China’s GDP, giving it a disproportionate impact on both economic growth and the health of the financial system.

The Chinese government is keenly aware of the risks associated with soaring development and has taken active steps to slow debt growth and make housing more affordable. He put in “red lines” last year as to how much leverage developers could exert, and Xi Jinping has repeatedly stressed that homes should be “built to be inhabited, not for speculation.” . In fact, the reforms the government has taken to rule property speculation are likely what exposed the underlying weakness of the Evergrande Empire.

Flannery: Is it China’s “Lehman moment” that is triggering a larger crisis?

Bernstein: Investors who expect a rapid series of implosion like the global financial crisis will likely be disappointed. On the one hand, Chinese regulators are diligent students of how this crisis unfolded and have maintained robust capital controls and a captive state-owned banking system to reduce the risk of institutional panic. China Evergrande is likely to embark on an orderly default process negotiated among its domestic creditors under the watchful eye of the government.

Analysts are now trying to determine to what extent the company could be an indicator of a disease more prevalent among other major Chinese real estate development companies and banks. If further reorganizations and write-downs become necessary, we can expect policymakers to seek to remedy this over time rather than engage in shock therapy.

Flannery: Who wins and who loses as Evergrande unwinds?

Bernstein: If this drama were to unfold in America, there would be a rush to bankruptcy court where expensive lawyers would help creditors position themselves as Evergrande’s assets were sold. The chances that various creditors will collect what is owed to them would be determined by the age of their debt and what secures it. The winners and losers in this case are likely to ultimately reflect the core priorities of the Chinese government. Social stability is paramount, which means that anything that could spark unrest or appear to favor wealthy private investors or foreigners while wiping out the economies of average Chinese citizens is ruled out. It is equally important to avoid any measure that destabilizes the banking system by triggering a chain reaction of insolvencies. If that means bailing out the big state banks, the government will likely find a way to do it.

Evergrande has indicated that it will somehow make a bond payment due to domestic investors on September 23.rd, while not making any mention of the coupon due on foreign bonds, which may be an indicator of the differential treatment to be granted to the different categories of creditors.

Flannery: What lessons should investors learn from the Evergrande affair?

Bernstein: First, China is actively and forcefully trying to shift its economic model from reliance on debt and speculative construction to more sustainable, high-quality growth. These policy measures, while necessary, can have sudden and unpredictable consequences for businesses that got rich under the old model of borrowing, selling apartments and pouring concrete.

Second, when there is a conflict between the social objectives of the (Communist) Party and the interests of the business sector, the businesses will be sacrificed every time. From housing to education to financial services, China is forcefully re-equipping aspects of the economy that the Party says have led to an unacceptable income division and dangerous drop in rates. birth rate. Investors who are caught on the wrong side of these rapid gyrations are being left out.

Third, in China, no one is too big to fail. However, if the company strongly affects the key pillars of the Made in China 2025 plan and / or needs to be involved in the solution, there will likely be a way to survive. As we see more unicorns on a large scale, we can expect more ripple effects in local and global markets.

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