Evergrande offers an ugly view into China’s property woes

The release, finally, of China Evergrande’s results for the past two financial years provides disconcerting insights into the scale of distress within China’s property development sector and the challenge authorities will have in stabilising it.

Evergrande, dubbed the world’s most indebted property company when it defaulted on its debts in 2021, was one of the earliest, largest and most high-profile casualties of the “three red lines” policy China introduced in 2020 to restrict the degree of debt within an over-leveraged property sector.

Since its default, there has been a wave of developer defaults that is still continuing. The crisis has left tens, if not hundreds, of billions of dollars of debts unpaid and vast numbers of apartments unfinished, leaving buyers with mortgages but no homes and putting a massive drag on the economy from a sector that was once a core growth engine.

China’s authorities have only two options for dealing with its distressed property sector: They can let it bleed out over time, or accept a nasty hit to the economy.Credit: Getty

Evergrande’s financial statements, released this week, were ugly, showing that the company incurred losses of $US81 billion ($120 billion) over the past two years. It has total liabilities of $US335 billion and a deficiency in its shareholders funds of $US83 billion.

The only reason it still exists is that the hopelessness of its position provides no incentive for its creditors to bury it.

Evergrande has proposed a restructuring of its $US20 billion of offshore bonds in which bondholders would be given new long-term bonds (with coupons that could be paid with the proceeds from selling new bonds) that could convert into debt or perhaps equity in Evergrande’s Hong Kong-listed property maintenance and electric car subsidiaries. (The electric vehicle subsidiary, which has sold only a handful of cars, has about $US9 billion of debt of its own and has said it is at risk itself if it can’t raise substantial new funding).

Even if the creditors agree to the restructuring, with 75 per cent majority approval required, Evergrande would need to borrow more – tens of billions of dollars – to complete the $US158 billion or so of uncompleted developments it still has on its books and to service that new debt until it can get some cash flowing.

What’s disturbing about Evergrande’s financials is that they are representative of the way the entire sector operated, using a pre-sales model for developments that enabled the companies to employ massive levels of leverage while the music was still playing.

At the end of December 2021, Evergrande had total assets of almost $US300 billion and total liabilities of $US358 billion. A year later, after it had sold anything it could sell, total assets were still about $US255 billion and its liabilities totalled $US339 billion.

Most of the Chinese property developers that have defaulted show that same picture of liabilities substantially exceeding assets, big stocks of incomplete or undeveloped apartment projects, huge amounts owed to trade creditors and apartment buyers, and minuscule cash flows.

There are no signs of any light on the horizon. Property prices and sales have been falling since the crisis developed.

The longer the authorities try to prop up the sector, the more daunting the equation becomes.

The economic data China has released this month showed that property sales by floor area in June were more than 28 per cent below those in June last year. Property investment was down 20.6 per cent year-on-year. The declines in both sales and investment accelerated between May and June.

So far, it has been the offshore holders of the developers’ US dollar-denominated bonds that have borne the worst of the crisis, with their holdings trading at a hopeful few cents in the dollar and because they generally lent to holdings companies, few real assets from which to recover any funds.

The authorities in Beijing have taken some actions, largely to avoid liquidation of the big developers. They’ve assigned local authorities, which are highly exposed to the developers because property sales account for much of their income, to oversee some of them.

China Evergrande’s finances are emblematic of the debt-fuelled property boom, which the government in Beijing is trying to rein in without derailing the entire economy.Credit: Bloomberg

State-owned banks have avoided acting against insolvent developers and, indeed, have provided some funding. (Evergrande’s borrowings increased $US5 billion in the last financial year). There has been some concessional funding for the more trusted developers and lower interest rates and some incentives for prospective apartment buyers.

Keeping the larger developers on life support, however, doesn’t address the problem, and without a change in approach will probably mean the property sector – once generating about 30 per cent of China’s GDP – will weigh on the country’s economic growth for years, if not decades.

The challenge confronting the developers – their hopeless financial position combined with the weakness of demand, which means that even if they could complete the developments, they would struggle to find buyers – makes for a near-insoluble equation.

Indeed, the longer the authorities try to prop up the sector, the more daunting the equation becomes.

At best, China is effectively going to have a host of zombie companies populating a key part of its economy for years to come. But it’s probably worse than that – zombie companies can at least service the interest costs on their debts. And the demographics – China’s shrinking population – means that buying time won’t provide a longer-term solution.

Shrinking the sector by degrees in the hope that it might find stability raises the risk of the kind of protracted impact on financial capacity and risk aversion that led to the decades-long malaise and stagnation experienced by Japan after its property bubble burst in the 1990s. This risk is enhanced by the property sector’s pervasive relationships with the rest of China’s economy and financial system.

China’s economy overall is relatively robust, albeit growth has slowed significantly in this post zero-COVID era, but having such a large sector remaining in a distressed state for the forseeable future threatens to lower the country’s growth potential significantly.

There is no apparent solution to the property distress in China which doesn’t involve massive losses and significant economic pain. The question for the authorities is whether it will be less painful to let the sector bleed out over years or decades, or whether they should cauterise it now.

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