A basic law of physics is that the higher an object is propelled into the atmosphere, the faster it returns to the ground – unless there is enough velocity to help it escape the earth’s gravity.
This principle can be applied to businesses also. A business propelled by the fuel of debt risks crashing if the model is not strong enough to place it in the orbit of sustainability.
In the past decade, there have been many examples of this crashlanding phenomenon in India – among them Infrastructure Leasing & Financial Services and Dewan Housing Finance Corporation. Globally, it was Lehman Brothers in 2008.
Just as Lehman symbolised the affliction in the US financial sector, property giant Evergrande has come to represent the malaise in China.
China’s real estate development sector has been at the core of phenomenal growth in the country’s economy in general and the financial sector in particular for the past two decades. Nonetheless, fables of ghost towns, unsustainable debt and window-dressing of lenders’ books have become quite common.
While most bankers, investors and money managers have been worrying about this, not many may have taken steps to hedge against a potential crash, confident, perhaps, that no large business will be allowed to fail lest it deter global investors.
However, things began changing dramatically over the past year, with the Chinese authorities making a paradigm shift in business policy. Amid the actions taken against Alibaba, food delivery leader Meituan, ride hailing app Didi, popular micro blogging app Weibo and numerous private tuition entities, the potential failure of Evergrande has attracted global attention.
For Indian investors, it is pertinent to understand the Evergrande episode and its likely implications for the economy and the markets in the right perspective.
What is Evergrande?
Evergrande, founded in Guangzhou in 1996, is one of the largest real estate developers in China. According to the group’s website, it owns more than 1,300 projects (780 under construction) in about 300 Chinese cities and has interests in other businesses including sports, media and electric mobility.
Evergrande is also one of the world’s most indebted developers, with more than $300 billion in dues to lenders and operating creditors. About $129 million in interest is due for payment immediately and $850 million of principal repayments are due in the next three months.
What’s the problem?
Fitch Ratings recently downgraded Chinese developers including Evergrande. The US rating company said that Evergrande may default on payment of interest due in the near term. The action sent shock waves across markets, which anticipated a default by Evergrande would impact China’s real estate development and financial sectors directly and the commodities and consumer sectors indirectly.
The stocks and bonds of Evergrande and other major real estate developers have since crashed by 35 percent to 80 percent. While Chinese homebuyers stand to lose money if Evergrande projects are not completed in time or are abandoned, global entities that invested in stocks and bonds of Chinese developers have already lost substantial money.
What caused the problem?
Prima facie, managing $1 billion of Evergrande’s payments due in the near term should not be a problem for the Chinese government. India, with a much smaller banking sector, managed the IL&FS and Yes Bank crises with relative ease. The problem lies in the changing policy paradigm in China.
China outlined three parameters to be followed by all developers – their liabilities must not exceed 70 percent of their asset value; their net debt must not be greater than their net worth, and all developers must have cash in excess of their short-term debt.
Apparently, the objective was to pre-empt the financial system from being dragged into a deep crisis. Last year, a large number of entities failed the test.
The bigger problem was identified in the business model followed by developers like Evergrande. They bid for land at very high prices, which were passed on to homebuyers in the form of inflated property prices.
This made bankers happy as they could lend more to homebuyers due to the higher notional value of the collateral property, but that resulted in substantially higher household debt and unaffordable home prices.
Household savings were diverted to an inflated housing sector rather than to the capital-starved high technology sector which had to increasingly rely on foreign capital. It also frustrated efforts to make domestic consumption – and not exports – drive China’s economy.
To correct these issues, the Chinese authorities took measures, including curbs on venture capital investment in real estate and checking corrupt practices.
Consequently, real estate developers saddled with unsustainable debt and inflated assets are feeling the pressure. It’s important to note that it is not real estate alone, but the entire high-yielding Chinese debt that is feeling the pain. Also, Evergrande may have become the face of the problem, but it is certainly not the only one in trouble.
What are the implications?
A series of defaults in China’s real estate sector could have multidimensional implications:
(a) It could lead to wealth erosion for Chinese home buyers. To mitigate some of this impact, the authorities are transferring the assets of troubled real estate developers to lenders, which will complete and sell them. A variant of this model is being tried in India. Besides, the Chinese authorities are ensuring adequate liquidity in the market to stem a repeat of the post-Lehman market freeze and global contagion.
(b) Bond and stock prices of troubled developers have already seen severe losses. Global investors holding these securities have already weathered the loss. However, it is hard to believe that after the Lehman collapse, these investors had not hedged their risk.
(c) There could be a material slowdown in the Chinese economy and therefore, the global economy, threatening the fragile recovery from the pandemic. Demand for commodities could collapse and lead to a sharp correction in prices.
Implications for Indian investors
Indian investors must see the developments in China as a continuation of the trend that started with the Trump-Xi trade war. This will only accelerate the move towards a China+1 policy of global businesses, which is expected to benefit India.
In the near term, there may be minor outflows from the Indian markets as global investors with significant exposure to Chinese developers seek to rebalance their portfolios due to losses and redemption pressure. However, in the mid to long term, this could result in higher allocation to India by investors.
The most visible impact for Indian investors would be the likely easing of inflationary pressures.
Overall, the Indian markets have little to worry from the recent developments in the Chinese real estate and financial markets, although they may have their own walls of worry to climb. But that’s a story for another time.