China: Financial and economic spillovers from bankrupt giant property developer might be contained

Event

Evergrande, the heavily indebted (over USD 300 billion) and second largest private property developer of China, is nearing default on offshore bonds. As a result of its prolonged financial troubles, its shares have been plunging by more than 80% this year. Amid a slowing Chinese property sector, characterised by falling sales and slowing price increases, Evergrande is encountering an insurmountable cash crunch to face domestic and foreign debt servicing and reduce its debt burden in compliance with the tighter credit regulations imposed last year. Evergrande’s collapse is spilling over to global markets, which are fearing contagion to the Chinese economy.

Impact

With Evergrande on the verge of bankruptcy, the Chinese government is facing another potential episode of financial turmoil. What is currently happening results from past government policies, which have fuelled a credit-driven economic activity –  latest policies aiming at putting the brakes on property sector growth. Indeed, several years ago, the authorities committed to reducing the corporate debt mountain (amounting to nearly 160% of GDP in the end of March 2021 according to the Bank of International Settlements). Then, last year, Beijing took various measures in addition to the deleveraging process hindered by the Covid-19 crisis – the so-called “three red lines” policies that set limits on borrowing for property developers based on stricter financial ratios – to slow down mortgage lending, squeeze debt and prevent the creation of an asset bubble in the key and overindebted real estate sector. Evergrande’s troubles have been exacerbated by new regulations launched last year to moderate the sector’s excesses. Among those, banks were limited in their granting of new loans to indebted real estate companies. Selling assets being seen as an insufficient option in the current market conditions, Beijing is expected to come to the rescue as seen in the past with other systemic companies. Selling the most profitable parts and demanding state-owned banks to restructure the debt are thus among the most cited partial solutions. The authorities are likely to intervene once again to avoid contagion to the financial system and limit damages to the economy. Tackling financial instability remains among the top government priorities after the Covid-19 break and three decades of sustained strong GDP growth. However, although state financial support and liquidity injection are likely, Beijing will take care not to feed moral hazard and relax stricter regulations on the property sector. Future financial stability is at stake in debt-laden China and the past couple of years have illustrated Beijing’s increased tolerance vis-à-vis corporate defaults. Looking ahead, domestic banks and other property developers, which are in the line of fire for Evergrande’s fall through their direct and indirect exposure, will be monitored closely in the coming weeks and months.

Although this event is primarily internal – the most important players involved being domestic – it could impact the world’s second largest economy and thus the world economy. The impact would be felt through a resulting economic slowdown in China – as the property sector remains a dominant growth engine – and affect private consumption. Indeed, homeowners are likely to suffer from the property price decline and limits on mortgage loans as real estate is by far the favourite investment for households’ savings. This will represent an extra drag on consumer confidence, which has not yet fully recovered from the Covid-19 crisis. All in all, Chinese demand might moderate in the coming months, hit regional growth and commodity prices. In the absence of significant measures from the authorities, China’s real GDP growth could be less dramatic than expected (+8.1% this year after a low +2.3% in 2020). At this stage and given the uncertain upcoming developments around Evergrande’s crisis, business environment risk is expected to remain in the moderate D/G category. A few months after the Covid-19 shock, the Chinese economy had quickly recovered to a strong economic momentum supported by the sharper global demand. The easing of the Covid-19 impact and a stronger Renminbi had improved the one-year outlook. It remains now to be seen to what extent and how long Evergrande’s expected collapse will affect the economic momentum and forecasts.

Analyst: Raphaël Cecchi – r.cecchi@credendo.com