An overarching illusion about China’s prosperity concerns the “construction boom” of China’s real estate bubble. Of course, the bubble will eventually burst, still, no one expected the first casualty of the Asian real estate industry to be Evergrande Group (or Heng Da Group).
Despite Evergrande boasting it was “too big to fail,” the storm has already hit Wall Street and undermined China’s economic blueprint. As the Chinese call it, the “eventful fall” has begun and will continue for some time.
A big hole in China’s real estate bubble
For years, the entire world seemed to believe that China’s economic boom was an inevitable trend that would just keep going. However, Dr. Cheng Xiaonong, a former policy researcher who served as an aide to late Chinese statesman Zhao Ziyang when the latter served as premier, has argued that China’s economic growth over the past 20 years or so has been built on one-time opportunities such as the “export boom” and the “construction boom” that are unlikely to replicate and therefore are not sustainable.
The Chinese economy has amassed a series of severe, almost unsolvable problems that make it challenging for the Chinese government to seek further economic prosperity. One of the worst economic challenges is the real estate bubble that it has to sustain.
Although many people in China know that the real estate bubble will burst sooner or later, few people want to believe that it will come so fast. So, the Chinese Communist Party (CCP) has been trying to regulate real estate activity by restraining it from continuous expansion and sustaining it from suddenly bursting at the same time.
Recently, Evergrande Group experienced a break in its capital chain and began defaulting on its maturing financial products. To deal with the crisis, it began to sell off its residential properties under construction and even used unfinished projects to pay off debts owed to other companies. Its impact can be felt on the Hong Kong stock market and Wall Street.
So it is under close watch by the international financial media. Some people think that Evergrande is only a drop in the ocean despite its size, and its collapse will not damage China’s massive economy. So how did the Evergrande storm start, and what does it mean for China’s economy?
Eight jars with only seven lids
Evergrande has been using various financing tactics to raise money for expansion, creating an impression that everything was going smoothly. Evergrande headquarters transferred the capital collected by Evergrande Wealth, through financial products, to fill the capital hole of its construction projects, while failing to return the principal and interest to Evergrande Wealth. As a result, the financial products of Evergrande could not be redeemed at maturity, revealing the actual status of Evergrande.
How many holes does Evergrande have, and when did it start to have problems?
The Chinese media Caixin Weekly published two investigative reports on its WeChat page recently, revealing much insider information. These two articles are titled How Evergrande Got Here ( Part 1 ) — Crisis Hits and How Evergrande Got Here ( Part 2 ) — Tracing the Root of the Crisis. However, under pressure from the CCP, Caixin had to delete the articles. Here are the key points from these two articles.
A few years ago, Evergrande’s fund-raising branch “promoted its own financial products to all employees within the company, even allocated sales targets, and later conducted regular work performance reviews based on the sales,” forcing employees to invest and seek out external connections in order to meet the sales quotas.
When its subcontractors requested payments, Evergrande asked them to purchase Evergrande’s financial products. “The amount is about 10 percent of the project payment. Although it is not mandatory, construction companies often purchase the products to maintain a good relationship with Evergrande.” Despite various means of raising funds to finance construction projects, Evergrande was still unable to maintain the regular operation of its construction sites. In August 2021, “more than 500 of Evergrande’s more than 800 projects nationwide were in a state of standstill.”
Secondly, Evergrande owed vast amounts of money to construction companies. By August 2020, Evergrande had 8,441 upstream and downstream partners, the majority of whom had payments defaulted on by Evergrande. Evergrande used its unsecured short-term bills — also known as commercial bills — to pay these debts. As found in Evergrande’s financial report, “trade payables and other payables amounted to 951.133 billion RMB or 147.21 billion USD” as of 30 June 2021.
Thirdly, while the debt is mounting, Evergrande’s assets are shrinking. “As of the end of June 2021, Evergrande has total assets of 2,377.5 billion RMB and total liabilities of 1,966.5 billion RMB. Among these nearly 2,000 billion RMB in liabilities, the interest-bearing liabilities are 571.7 billion RMB.”
The so-called interest-bearing liabilities are the sums borrowed by Evergrande. After deducting the interest-bearing liabilities, the main body of the total liabilities is the payables and pre-receipts, nearly US$219 billion. The payables are the construction money owed by Evergrande, while the pre-receipts are the purchase money from the pre-sale of homes, which have not yet been constructed or completed. From the book, it seems that Evergrande has more than US$62 billion net assets after deducting total liabilities, the central part of which is purchased land and construction in progress. However, such a net asset figure is not reliable.
Why isn’t it reliable? On the one hand, the acquisition price of the land is much lower than the market price from which the real estate company can profit. However, if the land is not developed during the term, according to the land sale contract of the local government — usually a few years — the local government may take back the land, resulting in Evergrande’s vacant land disappearing from the net assets. Furthermore, if there is no capital available for projects under construction, the value of uncompleted buildings is virtually zero.
On the other hand, Evergrande also has a large amount of debt hidden outside its financial statements. “It is a well-known secret that real estate companies have a lot of off-balance sheet liabilities. It remains a mystery how much off-balance-sheet debt Evergrande has, and whether it exceeds the current net assets of Evergrande.”
The Evergrande storm dispels three myths of China’s real estate industry
The reason why China’s real estate bubble has grown over the years without bursting is that, in addition to the local government’s efforts to protect it, by all means, three myths have been holding up the housing bubble psychologically.
The first myth is that “real estate companies won’t collapse if they are big.” Evergrande has been expanding because one of its tenets is “if it is big, it will not fail,” convinced that the government will not let it fall. Homebuyers in China also believe it.
On August 2, 2021, Fortune magazine announced the world’s 500 largest companies. Evergrande Group ranked 122nd in the world. Among the eight Chinese real estate companies on the list, Evergrande ranked first. However, the top real estate company in China is now in trouble. The reality that Evergrande might not survive has destroyed the myth of “too big to fail,” not to mention small and medium-sized companies failing.
The second myth is that “pre-sale homes are safe.” Many homebuyers in China are now buying homes and placing orders after seeing a model home or a blueprint. The real estate companies take advantage of home buyers’ eagerness to get a new home and use the prepayment as the capital for construction. However, the lesson Evergrande tells the Chinese people is that if the turnover of a real estate company’s capital fails, the pre-sale homes may become undeliverable or a “tower in the air.” The buyers might end up with nothing despite having made the payment.
According to a report sent by Evergrande Group to the Guangdong Provincial Government in August 2021, in Guangdong Province alone, “the number of commercial properties sold by Evergrande Group without delivery as of 30 June 2020 is 617,000 sets. If Evergrande Group falls into crisis, 2.04 million owners will face the risk of uncompleted projects or failure to take possession of their properties.”
The third myth is that “China’s housing prices won’t drop.” To repay the debts, Evergrande started to discount the residential units under construction, which impacted the whole real estate market. For individual customers of financial products, Evergrande headquarters uses physical assets to pay off cash debts. Du Liang, the person in charge of Evergrande Wealth, said: “When offsetting physical assets, residential homes and apartments are discounted by 7.2 percent and 5.4 percent respectively according to the current selling price, while retail shops and parking spaces are discounted by 4.8 percent according to the current selling price.” At the same time: “For the overdue commercial bills, Evergrande offered a solution of ‘offsetting the debt with properties.’”
For example, in the past two months, Evergrande, due to the cash shortage, has paid off the debts of a painting company named “Three Trees” “by using the three properties located in the city of Wuhan, Ezhou, and Shenzhen, with the expected completion and delivery dates of 2022, 2024 and 2023 respectively. It is possible that the properties used to offset the debts will flow to the market.” The creditors will sell the properties at low prices regardless of the local real estate market prices to recover the cash as soon as possible. “The company Three Trees has already started to dispose of these properties.”
The debunking of these three myths will, on the one hand, have a massive impact on the nationwide home buyers’ psychology. Many people who originally intended to buy a home will have to consider it more carefully. On the other hand, Evergrande’s discounting action will cause a “ripple effect” of falling home prices, bringing down prices faster in many cities.
New and more restrictive government policies for real estate financing will devastate real estate companies in China
For more than a decade, local governments in China have relied heavily on land sales for revenue. Many banks have invested in real estate projects or provided mortgages to home buyers. The central government is increasingly worried about the possibility of a bursting real estate bubble and its implications for local governments and banks. If the real estate bubble bursts, there will be many bad debts, resulting in a crisis in the banking sector. With the high dependence of local finances on real estate, local finances could collapse along with it. Therefore, since 2017, Beijing has been trying to stop the feverish development of the real estate industry by gently squeezing the real estate bubble through multiple means such as restrictions on purchases, prices, and loans.
In the aftermath of the pandemic, the central government has become even more concerned that the real estate sector, or “the flagship sector in China,” is drawing too many financial resources from society and causing consumer spending to shrink and the economy to lose momentum. So it started to further clamp down on the sector. In August 2020, the CCP drew “3 red lines” for real estate companies to limit their bank loans. The three lines are: the balance sheet ratio (i.e., liabilities divided by assets), excluding pre-receipts, must not be higher than 70 percent; the net debt ratio of real estate companies must not be greater than 100 percent; the cash short-term debt (i.e., cash divided by short term debt) ratio must not be less than 1.
The new policy stipulates that if a real estate company steps on all three “red lines,” it can no longer borrow from banks; if it steps on two “red lines,” its annual growth rate of interest-bearing debt shall not exceed 5 percent; if it steps on only one “red line,” its annual growth rate of interest-bearing debt shall not exceed 10 percent; if none of the three “red lines” are crossed, its annual increase in an interest-bearing debt shall be 15 percent at most. In this way, the common practice of borrowing new debts to repay old ones can no longer work for real estate companies. When they can’t get enough in loans and old debts must be repaid, these companies will fall into insolvency.
Evergrande is not the only unlucky one under the new policy of real estate financing. Since its implementation at the beginning of 2021, real estate companies have struggled in deep water for eight months. By September 5, 274 real estate companies nationwide had declared bankruptcy, an average of one a day. The first to go bankrupt was small real estate companies with weak capital strength, and then it was Evergrande. As long as the new policy is in place, the financial pressure on real estate companies will just become immense.
Significance of the Evergrande storm for China’s economy
It can be said that the Evergrande storm has informed the CCP of the necessity of a new financing policy for real estate companies and the danger of the accelerated deflation of the real estate bubble. Although Evergrande alone is unlikely to drag the whole real estate industry into the abyss right away, the storm it started has proven that the real estate-based growth in China has come to an end. Furthermore, the real estate bubble has become a heavy burden on the whole economy. Praise for the “construction boom” is unlikely to be heard in China again.
The CCP’s new financing policy for real estate companies focuses on preserving banks at the expense of real estate companies, which is somewhat equivalent to “breaking the arm to survive.” As for Evergrande, the authorities would like to see it manage its complicated debts and rapidly shrinking assets on its own. By doing so, they also want to understand how bad the Evergrande storm could turn out to be.
The Evergrande storm represents the beginning of China’s real estate bubble bursting, probably the first “domino” to trigger the domino effect that will soon appear in the real estate industry. How other real estate companies will hold up does not depend entirely on their efforts alone, but to a greater extent on the general economic environment in China. If home prices continue to drop, the government is bound to sacrifice more real estate companies to save the banks. Such a situation would exacerbate China’s economy, which is already struggling with sluggish domestic spending and rising industrial prices. Moreover, it would overshadow the Communist Party’s trumpeting of an economic recovery. The Wall Street Journal devoted several articles on September 22 to analyzing the negative impact of the Evergrande storm on China’s economy, including one with the headline Evergrande Is China’s Economy in a Nutshell.
The international society already feels the Evergrande storm. Media from all over the world, including the financial media in the U.S., have continuously reported its impact. After Evergrande’s predicament became public, it hit the Hong Kong and New York stock markets.
Chinese concept stocks and Chinese bond funds were hit together with U.S. companies on the New York exchange. For example, the two most significant downturns are Caterpillar Inc., which makes and sells construction machinery in China, and Goldman Sachs Group Inc., an avid dealer and investor in bonds of Chinese companies involved in housing.
Although Evergrande is not so big as to change the direction of the global economy, it has exposed the economic risks of China, which are so big that the worldwide investment community will re-evaluate it. Investors will become more cautious in their future investments in China and may even withdraw some. Such an international trend is bound to add pressure on China. Desperate to raise funds by selling bonds to Western countries, Chinese companies may lose their ‘charm’ of attracting foreign capital. Moreover, the increasing caution of foreign investors will make the Chinese economy less able to count on foreign capital.
Regardless of Evergrande’s fate, it has already left its name in history. In the future, when experts in world economic history describe the decline of China’s economy, they will probably start their chapters with phrases like “Since the Evergrande incident…”, which is the significance of paying attention to the Evergrande storm today.
Commentary by Cheng Xiaonong, which has been edited for length.
Dr. Cheng Xiaonong is a scholar of China’s politics and economy based in New Jersey. Cheng was a policy researcher and aide to late Chinese statesman Zhao Ziyang when the latter served as premier. Cheng has also been chief editor of the journal Modern China Studies.
