Evergrande circling the plughole

  • Evergrande’s collapse would be the biggest test that China’s financial system has faced in years. Policymakers’ main priority would be the households that have handed over deposits for properties that haven’t yet been finished. The company’s other creditors would suffer. Markets don’t seem concerned about the potential for financial contagion at the moment. That would change in the event of large-scale default, though the PBOC would step in with liquidity support if fears intensified.
  • The immediate cause of Evergrande’s problems is the imposition of the “Three Red Line” limits on borrowing in August last year which forced the company to reduce its interesting-bearing liabilities and to offer increasingly steep discounts on properties to keep cash flowing. (See Chart 1.)
  • The most likely endgame is now a managed restructuring in which other developers take over Evergrande’s uncompleted projects in exchange for a share of its land bank. Commitments to households and suppliers to deliver pre-sold properties now account for the bulk of the company’s liabilities (see Note below). (See Chart 2.) We estimate that Evergrande had RMB1.3trn in presale liabilities at the end of June, equivalent to roughly 1.4 million individual properties that it has committed to complete.
  • A restructuring that prioritized homebuyers might not leave much for other creditors. A Huarong-style rescue can’t be ruled out. But we expect Evergrande to be treated differently: Huarong is a majority state-owned firm with a policy-like mandate to digest state-owned banks’ distressed debt. Evergrande is private and the poster child for excess leverage in a sector in which policymakers want to instill more discipline.
  • There is no sign at present that Evergrande’s problems are leading to any contagion. Indeed, spreads on developer bonds have been falling. (See Chart 3.) Spreads on the negotiable certificates of deposit issued by lower-rated banks have been skirting all-time lows. (See Chart 4.)
  • But we’ve thought for a while that a banking failure triggered by the collapse of major property developers was the single most likely scenario that could lead to a hard landing in China. And the fact that financial markets aren’t currently signaling alarm doesn’t mean they won’t. For example, it was only three weeks after the People’s Bank took over Baoshang Bank in 2019 that credit conditions suddenly tightened. (See Chart 4 again.)
  • That episode provides some clues to how large-scale default by Evergrande – or other developers – could reverberate through the banking system. China’s banks in aggregate report large loan-loss buffers, but there are a couple of caveats. There is wide variation between banks; and published measures of bank health may not tell the whole story: on paper, Baoshang comfortably met regulatory requirements for NPLs and capital adequacy before its collapse.
  • Contagion in 2019 was triggered not by the takeover itself but by the subsequent repricing of counterparty risk as markets reassessed the reliability of the assumed state backstop. The PBOC let this repricing run for a while – after all, imposing more discipline was a key goal. But it backed down as strains grew. It then provided liquidity directly to the smaller banks that depend more heavily on the interbank market. And it organized emergency funding for non-financial firms unable to borrow because banks had adopted more stringent rules on collateral. We would expect a similar response to Evergrande’s failure.
  • Baoshang provides a model for the Evergrande case in another way too: creditors suffered a haircut while the equity stakes of the bank’s private sector owners were ultimately liquidated by the PBOC.

Note: This sentence originally read “Pre-completion deposits from households now account for the bulk of the company’s liabilities.”

Chart 1: Evergrande – Property Sales (12m ave.)

Chart 2: Evergrande – Liabilities (RMBbn)

Chart 3: Real Estate Developer Spreads

Chart 4: Negotiable Certificate of Deposit (NCD) Credit Spread (AA minus AAA+)

Sources: Wind Financial, CEIC, Capital Economics

Mark Williams, Chief Asia Economist, mark.williams@capitaleconomics.com
Julian Evans-Pritchard, Senior China Economist, julian.evans@capitaleconomics.com

Mark Williams Chief Asia Economist
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