My subscription
...
Filters
My Subscription All Publications

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

Download
Save
Mark Williams Chief Asia Economist
Continue reading

More from China

China Activity Monitor

CAP: Output to stagnate in 2022 despite latest bounce

Our China Activity Proxy suggests that around half of the drop in output during the recent virus wave reversed in May. This recovery looks to have continued in June. But a lot of damage has already been done and we now doubt that China’s economy will grow at all this year. Asia Drop-In (30th June, 09:00 BST/16:00 SGT): Are Asia’s central banks behind the curve? Can the Bank of Japan and People’s Bank of China continue to go against the grain? Find out in our special session on what global monetary tightening looks like in Asia. Register now.  

22 June 2022

China Economics Weekly

GDP target unattainable, shipping disruption

China’s statistics office is adept at massaging GDP data. But with many of the indicators that feed into GDP showing year-on-year contractions in April and May, even it won’t be able to deliver published growth at the rate the government wants this year. Meanwhile, the latest port throughput data suggest that Shanghai’s lockdown had a much smaller impact on shipping than commonly supposed.

17 June 2022

China Data Response

China Activity & Spending (May)

The May data suggest that a post-lockdown recovery got underway across most parts of the economy last month. It is likely to have progressed further in June. But the recent resurgence in infections in both Shanghai and Beijing means that the risk of relapse remains. And the latest data also underline that the recovery in consumer activity still has a longer way to go than that in industry.

15 June 2022

More from Mark Williams

China Economics Update

Property crunch will be followed by lasting decline

The root of Evergrande’s troubles – and those of other highly-leveraged developers – is that residential property demand in China is entering an era of sustained decline. Relaxation of regulatory controls on the sector wouldn’t change this fundamental constraint. Construction, a key engine of China’s growth and commodity demand, will slow substantially over the next few years, whether or not the economy escapes the current crunch unscathed.

15 September 2021

China Economics Weekly

Regulatory crackdown or ideological campaign?

What looked like a tech crackdown, broadened to a crackdown on large private firms, then to a wider regulatory push. This week it started to resemble a society-wide ideological campaign aimed at fortifying the nation’s people and economy. K-Pop fandoms are out. Xi Jinping Thought is in. Meanwhile, there’s growing talk that property tax plans are being revived.

3 September 2021

China Economics Weekly

Delta wave may have peaked but it won’t be the last

Aggressive containment measures, mass testing and quarantine appear already to be bringing China’s Delta outbreak under control. The economic cost should be fleeting – but it will be felt beyond China’s shores due to the closure of another major port terminal. And it won’t be the last bout of disruption. Meanwhile, the People’s Bank is likely to deliver a policy signal early next week in the form of an MLF operation.

13 August 2021
↑ Back to top