You know a finance story is big when it migrates from the business section to the front page and associated social media tags take off. That's what's going on here in Asia right now with the potential collapse of China Evergrande Group (HK:3333, EGRNY), China's largest property developer.
TV cameras and smartphones are trained on the company's headquarters in Shenzhen, just across the border from me here in Hong Kong, where hundreds of protestors have gathered this week to harangue the poor executives who step forward to address them. A squadron of police officers held hands to form a human chain to hold the baying masses back. There have been crowds for three straight days now, people fainting in the lobby from the stress and sweltering late-summer heat.
It's a mess. The property company's woes are being compared to the collapse of Lehman Brothers, which froze up the finance industry during the crisis of 2007-08.
You know a finance problem is dire when the company is forced to file a confession of sorts to the stock exchange. Evergrande did so with a missive to the Hong Kong bourse on Tuesday, stating that it faces "tremendous pressure" on its cash flow and liquidity.
The company blames "ongoing negative media reports" for dampening confidence in the group among potential property purchasers. Sales plunged 38.9% from June to July and another 13% from July to August. September is normally a bumper month for developers, it notes. Instead, Evergrande expects "significant continuing decline" in contract sales this month.
With C¥1.97 trillion (US$306 billion) in liabilities, Evergrande's overseas bond owners and shareholders are likely looking to recoup cents on the dollar, if there's anything left at all. Then there's the systemic risk of a knock-on effect on other developers, all of which are under intense pressure from Beijing to cut back on credit.
China's housing ministry has told major banks that Evergrande will not be able to make loan interest payments due on Sept. 20, Bloomberg reports here on Wednesday.
Ironically, it is the likely lack of government intervention that is of greatest concern. Beijing has inserted itself into a lengthening list of industries -- digital payments, videogames, e-cigarettes, for-profit tutoring, ride hailing, grocery delivery, to name just a few -- with market-moving regulatory changes, sprung without warning. But it is adopting a hands-off approach to the property industry that may see the Chinese leadership willing to let Evergrande go under.
It would be a warning to property tycoons across China, at a time Chinese President Xi Jinping says it is time to redistribute China's wealth away from the rich. Evergrande's founder, Hui Ka-yan (who goes by Xu Jiayin), was in 2017 rated the richest man not just in China but all of Asia. Forbes pegged his wealth at US$42.2 billion, which has now fallen to US$11.4 billion in its real-time ranking.
Evergrande has the kind of cross-holding structure that involves multiple subsidiaries, some of them listed separately. It has 1,300 projects in some 170 Chinese cities, has borrowed extensively abroad with high-yield bonds, has offered high-return wealth management funds to fund its construction, is holding deposits on apartments it has yet to build, counts businesses in its stable as diverse as a Chinese top-flight soccer club, theme parks and a bottled-water business, and risks leaving reams of shareholders holding little more than the thin air in which it promises to build its multistory residential towers.
Its downfall sounds a little like that of Mike in Ernest Hemingway's "The Sun Also Rises." When asked how he went bankrupt, the character says it happened "Two ways. Gradually, then suddenly."
Downgrades kick in
It may sound familiar to anyone who has seen a business collapse. Credit is good, until it's gone. It dwindles and dwindles as the problems mount up. And then it disappears all at once.
The ratings agency Fitch said on Tuesday that any default by Evergrande would bring heightened credit risk to "numerous sectors," is already intensifying credit polarization among property developers, and could create headwinds for some smaller banks.
It downgraded Evergrande's debt on Sept. 7, saying it considers a default of some kind as "probable."
Standard & Poor's followed suit here on Wednesday, with its own downgrade of Evergrande and subsidiaries Hengda Real Estate and Tianji Holding, and rating their outlook "negative."
"We believe nonpayment risk is extremely high and could ultimately lead to debt restructuring - meaning a default scenario is a virtual certainty," S&P says.
Evergrande shares in Hong Kong are down 5.4% today in Hong Kong, bringing its year-to-date decline to 80%. The stock in this umbrella holding company has fallen 89% since a recent peak in July 2020.
These are decade-long lows last tested in September 2011. Evergrande's bonds are trading around 65% below par value.
Hengda is its operating business that does the actual development in mainland China and was the company's original name when Hui founded it in southern China in 1996. Contract sales are its main source of liquidity. It is slashing prices to encourage discount sales but still can't shift its stock fast enough. Tianji is purely a financial vehicle that transacts its overseas financing.
The company is trying to sell two separately listed subsidiaries without success. Those are its electric-vehicle business, which has yet to produce a sellable car. China Evergrande New Energy Vehicle HK:0708, which began life as a company developing and running hospitals when healthcare was cool, has seen its shares fall 87% in 2021.
It also has a business that manages properties that the developer builds. Evergrande Property Services HK:6666 has only shed the 50% of its value this year. So far.
Evergrande's single-largest asset is its Hong Kong office building. It bought the 26-floor trophy office tower in 2015 for US$1.6 billion. Despite talks to sell it for US$2 billion to another mainland developer, Yuexiu Property HK:0123, no deal has gone through.
Lehman declared debt of US$768 billion against US$639 billion in assets when it went belly-up in September 2008. Its downfall locked up the entire financial system as everyone worked out their counterparty risk.
So one of some 100,000 property developers, even the biggest, going belly-up won't directly have anything like the same effect. But it is symbolic. Buyers of homes are highly sentiment-driven in a way that the Wall Street system is not.
Tons of obligations
Evergrande not only has its high "official" debt load but also a hefty burden in off-balance-sheet liabilities in the form of "wealth management products." The company offered high-yield investments that it used in part to fund its operations. People holding some of those are among the furious protestors.
The company has interest-bearing debt of C¥572 billion (US$89 billion). In its stock market statement, Evergrande admitted that its subsidiaries have stopped making C¥934 million (US$145 million) in guaranteed payments that it is obliged to deliver on wealth management products.
Evergrande also owes its suppliers in the construction trade C¥667 billion (US$104 billion). These corporate promissory notes have been another popular way for developers to raise funds. The notes are more or less an "IOU" and may not involve any actual parts or products changing hands.
When it stopped paying the "real" bills, some suppliers stopped delivering their wares, forcing construction to halt on certain projects. For instance, piping supplier Yonggao in August said it stopped deliveries of pipes in May due to unpaid past-due invoices. A lender in Guangzhou, Guangfa Bank, successfully had a US$20 million bank deposit frozen when it said an Evergrande subsidiary stopped making payments. Several Hong Kong banks have stopped offering mortgages on Evergrande's projects here.
Evergrande is attempting to keep up payments on US$850 million in U.S. dollar bonds due by the end of this year. Its huge debt load leaves it facing an annual interest bill alone of C¥60 billion (US$9.3 billion), according to S&P.
China Evergrande owns plenty of non-property businesses and has a 50% stake in Evergrande Life Assurance, which offers life insurance, annuities and health coverage. It also holds 36% of Shengjing Bank HK:2066, a regional bank in northeast China. Those would be illiquid and hard to shift, Fitch states.
The Evergrande Group now says that "cross-default" may result if it is unable to meet its obligations or repay debt to creditors of any one subsidiary. It's in discussions with everyone: banks, bondholders, retail homebuyers, the wealth management investors, potential buyers for its Hong Kong offices, corporate buyout specialists.
The group has brought in restructuring and M&A specialists Houlihan Lokey and the debt capital-markets specialists Admiralty Harbour Capital to craft a turnaround. Those joint financial advisers are looking at the group's capital structure and liquidity. Clearly, asset sales and negotiations with creditors will be key.
Broader impact looms
Although Evergrande is a top-tier developer that leads the industry by 2020 total sales, it only constitutes around 4% of the residential-property market in a highly fragmented industry. However, its travails are causing a crisis of confidence in Chinese developers in general.
Any problems that Evergrande has in completing projects will leave it holding deposits on pre-sale off-plan properties. Fears that it will not honor those sales or return the deposits have driven some members of the crowd besieging Evergrande's headquarters as well as offices in other cities where it is currently under construction. Other protestors own its wealth management funds and want that money back; Evergrande has told them that might happen in five years, the best it can do right now.
Property is the largest private-sector industry in China, accounting for about 14% of the entire economy. If buyers stop buying there, it poses a real macroeconomic risk.
In August 2020, Chinese regulators introduced a policy of the "three red lines," limiting how much developers are allowed to borrow. Developers have to maintain a liability-to-asset ratio of less than 70%, a net gearing ratio of less than 100%, and a cash to short-term debt ratio of more than 1x.
Only 6.3% of Chinese developers could satisfy all three red lines, S&P said at the time of their introduction. Evergrande could satisfy none, forcing it to deleverage when its business plan demands heavy levels of borrowing. It has cut leverage from 35% in 2020 to 27% now, in terms of net debt versus adjusted inventory, Fitch calculates, but is still squeezed by a lack of liquidity.
Lenders are unwilling to throw what's likely bad money at Evergrande, because they can't recoup the good stuff. If they grow suspicious of the entire property industry, watching for dominos to fall, the entire sector will feel a squeeze. There could be a self-fulfilling vicious cycle of property buyers and banks doubting developers, which then can't shift the properties that would provide the cash flow they need to stay afloat.
China said on Wednesday that new-home prices rose only 0.2% in August compared with July and 4.2% year over year. Both are the slowest pace of growth since January, and prices continue to slow.
Evergrande may have borrowed to excess, but that financed its success. Where it heads next may hint at the direction of the property industry, and by extension the Chinese economy as a whole.