China’s Lehman Brothers Moment
On September 24, the Evergrande Group, China’s second-largest property developer, issued a letter that went viral on the Internet. The letter urged the government of Guangdong province, where the company’s headquarters is located, to support its asset restructuring effort and highlighted the tremendous financial crunch that it was facing.
The tone of the letter was ominous, and even threatening.
“If this round of asset restructuring of Hengda Real Estate (an Evergrande subsidiary) cannot be completed on schedule, capital chain rupture may take place, triggering Evergrande’s cross-default on its obligations with related financial institutions and the bond market, including banks, trusts, and funds, causing systematic financial risks.”
Capital chain rupture refers to a company’s inability to pay its debts or its inability to operate normally because of a capital shortage. Cross default is a loan agreement that puts a borrower in default if the borrower defaults on another obligation. In this case, if Evergrande defaults on one bank, then the existence of cross-default puts Evergrande in default on other loans borrowed from other institutions.
“At present, the company cooperates with 8,441 enterprises both upstream and downstream. Evergrande’s cash flow problem will directly impact the operations of those enterprises, and put some of them under the risk of bankruptcy, causing serious disruptions to a steady and healthy economic development.”
“If the cash flow shortfall puts Evergrande in crisis, it will directly affect the jobs of 3.31 million people. At the same time, 2.04 million owners who have purchased 617,000 (unfinished) commercial houses are facing the danger that the ongoing construction projects cannot be completed and delivered. This would seriously undermine social stability.”
Although Evergrande headquarters immediately responded by calling the letter “fabricated and pure defamation” and vowing to take legal action, the stock and bond markets already responded with wild swings.
On September 25, Evergrande’s stock (SEHK: 3333) price on the Hong Kong Stock Exchange (HKSE) at once rose 7 percent after a low opening in the morning. It then plummeted in the afternoon, and closed at HK$13.78 per share, a drop of 9.46 percent. China Evergrande New Energy Vehicle Group Ltd (SEHK: 708), a subsidiary of Evergrande Group and also listed on HKSE, saw its price plunging by 12.76 percent to HK$16.82 per share.
On the same day, prices of all three of the company’s corporate bonds that floated on the Shanghai Stock Exchange (SSE) tumbled more than 20 percent. The exchange had to suspend trading two of the bonds temporarily.
S&P Global cut its outlook on Evergrande’s B+ credit rating from stable to negative. S&P said, “We believe China Evergrande Group’s liquidity is weakening amid the continual increase in short-term debt obligations and potential repayment of a portion of its China domestic ‘A-share’ strategic investments.”
Many people saw that as China’s Lehman Brothers moment and a potential trigger to a widespread financial crisis across the whole economy. The asset restructuring transaction mentioned in the letter was true; much of the data quoted was accurate; and it was also true that the deal didn’t happen.
The Rise of Evergrande
The growth of Evergrande Group coincided with the rapid development of China’s real estate industry. Established in Guangzhou in 1997, it was incorporated in the Cayman Islands in 2006, and listed in Hong Kong in 2009. In 2010, it became the largest real estate company in the country in terms of sales area. In 2018, Evergrande rose to become the world’s most valuable real estate company with a brand value of US$16.2 billion. In 2017, Evergrande’s founder Xu Jiayin’s wealth reached US$39.5 billion and he became China’s richest man.
However, expansion of the company went side by side with an accumulation of debt. Evergrande’s 2016 annual report showed total assets of 1.35 trillion yuan, a total debt as high as 1.27 trillion yuan, and net assets of only 80 billion yuan. The debt-to-assets ratio was as high as 94 percent, and pre-tax profit was only 48.2 billion.
With a 94 percent debt ratio, the company has almost the same amount of debt as assets, implying great financial risk. Mr. Xu’s solution to mitigate the risk has been to raise more capital by having the company listed on mainland China’s stock market, or A-share in the Shanghai or Shenzhen stock exchange.
Many real estate companies have chosen to get listed in the Hong Kong Stock Exchange, and then return to the A-share market after a few years. The reason behind this is the lower qualification for being listed in HKSE than in an A-share market. For example, to be listed in a mainland stock exchange, the company has to be in operation at least three years and stay profitable for three consecutive years, while HKSE requires only one year of operation without a profitability threshold. However, the valuation of the company in A-share exchanges is usually higher. Many real estate companies have chosen to return to A-share listings after gaining a firm foothold in Hong Kong.
Since 2010, the Chinese government, to curb the rapid rise in housing prices, has essentially stopped initial public offerings (IPO) from real estate companies. Evergrande’s path to the mainland stock exchange is through a backdoor listing. A backdoor listing is also known as a reverse takeover, a reverse IPO, or a reverse merger. The firm that wishes to get listed would acquire a majority portion of a publicly listed company which has insignificant assets or little current business activity. Using that public company as a “shell,” the private company gains listed status on a stock exchange. However, the private company can only do this with the consent of the listed company’s stockholders.
Shenzhen SEZ Deal
In 2016, Evergrande had its eye on Shenzhen Special Economic Zone Real Estate & Properties (Shenzhen SEZ), a public company listed on the Shenzhen Stock Exchange (SZSE). A state-owned enterprise (SOE), Shenzhen SEZ’s controlling shareholder is the State-owned Assets Supervision and Administration Commission (SASAC) of theShenzhen municipal government. SASAC is a government entity responsible for managing SOEs, including appointing top executives and approving any mergers or sales of stock or assets.
In October 2016, Evergrande struck an agreement with Shenzhen SEZ. Under the plan, Evergrande proposed to sell its subsidiary Hengda Real Estate to Shenzhen SEZ in exchange for A shares, effectively making it a backdoor listing for the unit, while Evergrande Group will become the controlling shareholder of Shenzhen SEZ.
This is the so-called “asset restructuring” deal mentioned in the letter.
With the prospect of a deal, Evergrande began to raise funds. Between 2016 and 2017, after three rounds of financing, Evergrande was able to raise 130 billion yuan of capital from over a dozen strategic investors. In return, Evergrande gave up 36.54 percent of the future stock shares for when it would get listed. Evergrande also promised a total net profit of 165 billion yuan between 2018 and 2020, and promised to distribute at least 68 percent of the profit to shareholders.
The funds raised enabled Evergrande to pay off its 110 billion perpetual debt and greatly improved the asset structure. It therefore stood a better chance of closing the deal with Shenzhen SEZ.
At the same time, there is a payback clause in the financing agreement with the strategic investors: if Evergrande’s deal with Shenzhen SEZ fails and it cannot be listed, Evergrande must pay back all the funds, including principal and interest, by January 31, 2021.
The COVID-19 epidemic in 2020 delivered a huge blow to the Chinese economy, including the real estate industry. Since the beginning of this year, Evergrande’s share price on the Hong Kong Stock Exchange has fallen more than 30 percent from HK$22.20 at the beginning of the year to HK$15.22 on September 24. In the first half of 2020, Evergrande’s net profit shrank by 50 percent over the same period last year.
In July, a Fujian based luxury villa developer Tahoe Group failed to pay a 1.5 billion yuan (US$214 million) bond. The default underscores the mounting financial stress on the already debt-laden sector hit by the slowing economy. The Chinese government paid high attention to the intensified financial risks due to the epidemic. On August 16, Guo Shuqing, chairman of the country’s banking regulator, the China Banking Regulatory Commission (CBRC), wrote an article on Qiushi, the flagship publication of the Chinese Communist Party, stating, “The real estate bubble is the biggest ‘gray rhino’ threatening financial security.”
To contain the slowdown, more money has to be pumped into the economy. Unsurprisingly, the overall leverage ratio will increase and the bad debts may increase substantially. To prevent the sharp rise in bad debts, the government began to use a heavy handed approach to restrict the debt level of the real estate industry.
On August 20, the Ministry of Housing and Urban-Rural Development and the People’s Bank of China jointly pushed out a new policy, known as “the three red lines,” which outlined caps for debt-to-cash, debt-to-assets and debt-to-equity ratios. The cap for the debt-to-assets ratio will be set at 70 percent, the cap for net debt to equity ratio will be set at 100 percent and the cap for short-term liabilities to cash ratio is also set at 100 percent.
The new policy will strictly limit the scale of interest-bearing debts of real estate companies. The cap for the debt growth rate is set at 15 percent and if any of the three red lines is crossed, the cap for debt growth will be reduced by 5 percent. In other words, if none of the red lines is violated, the interest-bearing debt of a real estate company is allowed to increase by up to 15 percent; if all three are crossed, the interest-bearing debt is not allowed to increase; that is, no more borrowing is allowed. The new policy was set to be fully implemented on January 1, 2021.
For deeply indebted real estate companies, this could not be worse. In the past, they had been borrowing and creating new debts to pay off the existing ones. Now the cash flow problem has become the immediate crisis. How many red lines has Evergrande crossed? Too bad ─ it has crossed all three of them. By 2019, Evergrande was the most indebted real estate developer in the country, with some 835.5 billion yuan ($124 billion) in borrowings, with a debt-to-asset ratio of 83 percent, a net debt to equity ratio of 159.3 percent, and a short-term liabilities to cash ratio of 166 percent.
Starting from September, 12 real estate companies, including Evergrande, were made to participate in a pilot program. Before the 15th of each month, every company must submit a table to the supervisory authority, reporting a list of key financial indicators.
On August 24, Evergrande submitted a report to the Guangdong provincial government soliciting help to facilitate a backdoor listing deal with Shenzhen SEZ, so that it could issue A-shares to raise more capital and improve its debt ratios, avoid paying back the 130 billion yuan from strategic investors, and prevent its financial situation from deteriorating. However, there has been no news since then about the restructuring deal with Shenzhen SEZ. On the contrary, on September 20, Shenzhen SEZ issued an announcement stating, “because the major asset restructuring involves the reform of Shenzhen’s state-owned enterprises, the transaction structure is more complicated. This is a major and unprecedented matter; the restructuring plan needs further communication and study.” What does this mean? If one understands the Chinese-style of bureaucratic discourse, it means the deal is dead.
Evergrande was facing an immediate crisis of no cash flow on hand to pay for the debt of 130 billion yuan plus interest. Under the pressure of the three red lines, it cannot even borrow a penny.
This was the reason behind the circulation of the letter on the Internet, which was actually pressuring the government to rescue Evergrande.
Too Big to Fail
The crisis was real. If nothing were to be done, as mentioned in Evergrande’s report to the Guangdong provincial government, a social crisis would be imminent. As a top real estate company nationwide, Evergrande has 140,000 of its own employees and can impact millions more jobs of companies along the supply chain. 2.04 million home buyers have purchased 617,000 unfinished and undelivered commercial houses. There is also a financial crisis. As of June 30, 2020, the company’s total debt amounted to 835.5 billion yuan, including 232.3 billion yuan from 128 banks, 368.4 billion yuan from 121 nonbanking financial institutions, 49.6 billion yuan in corporate bonds, and 185.2 billion yuan in offshore bonds. Default on any of those debts may trigger a domino effect and lead to more defaults and bankruptcies.
After a turbulent few days during which banks, bondholders and senior government officials became increasingly alarmed about Evergrande’s financial health, on September 29, Evergrande reached an agreement with a group of strategic investors to avoid repayments. Investors holding equity stakes worth about 86.3 billion yuan agreed to keep their shares and not require the company to buy them out. That group represents the majority of the 130 billion yuan in shares held by strategic investors in its Hengda Real Estate unit. Evergrande said it is in talks with the remaining investors on similar deals. The developer has already finished negotiations with investors holding 15.5 billion yuan of equity interests, who are seeking further approvals. Talks with holders of the remaining 28.2 billion yuan are ongoing. Many of these investors are Evergrande suppliers.
The media reported that the deal was reached under pressure from the Chinese regulators. China’s cabinet and its financial stability committee, chaired by Vice Premier Liu He, have discussed risks posed by Evergrande while not making any decisions on whether to intervene.
On September 30, on the Hong Kong Stock Exchange, Evergrande’s stock (SEHK: 3333) price rose by nearly 15 percent, and the China Evergrande New Energy Vehicle Group Ltd (SEHK: 708) rose by 5.26 percent.
Although nothing was mentioned about the government’s involvement in Evergrande’s announcement regarding the September 29th agreement, very likely local and even central authorities brokered the deal. When the strategic investors financed Evergrande in 2016 and 2017, with substantial shares promised by Evergrande, they were expecting a huge profit if the backdoor listing through Shenzhen SEZ was a success. Usually when such an event takes place, the share price will increase significantly and even multiply. Now that the stock listing has failed, at the very least they should demand the payback of principal and interest from Evergrande and make a clean exit. From the perspective of each investor, it was unwise to strike such a deal with Evergrande. Leaving the money in Evergrande was not because they wanted to rescue Evergrande, but because they were told to.
Evergrande’s default on the 130 billion yuan debt would be the last thing that the Chinese government, or at least the Guangdong provincial government, wanted to see. The investors chose to cooperate with the authorities as they could not afford to offend the government when doing business in China.
In 2019, one investor, Anxin Trust & Investment Co., Ltd, itself, was already under restructuring after it failed to repay 2.8 billion yuan to investors in a trust plan followed by a cascade of defaults afterwards. Anxin definitely wanted its money back, but it also needs the government’s intervention to solve its own problem.
The September 29 deal bought Evergrande some time, but hardly solved the problem. According to its mid-year report out of its 835.5 billion yuan debt as of June 30, 47.3 percent will be due within one year. Under the pressure of “three red lines,” Evergrande can no longer borrow and create new debt to pay for the old debts. With the failure of a backdoor listing deal, the options to lower its debt ratio are rather limited.
A New Reality
The Evergrande story is not an isolated one. If one looks at 2019 year-end figures, among the top 50 real estate developers across the country, 15 violated all three red lines, 5 crossed two, and 16 crossed one. In other words, 36 out of the top 50 companies have a serious enough debt problem that the regulator had to put a lid on their potential to borrow. The crisis of Evergrande today can be the crisis of any of them tomorrow. In the past, these companies have been mostly scaling up the by borrowing from banks and financial institutions.
For many years, the real estate boom in China has had more to do with people’s expectations than that demand is in excess of supply. People are buying houses not because they need a place to live in, but because they expect the housing prices will keep going up. In the good old days, it was almost a universal truth in China that a second house in a top-tier city plus ten years equals a millionaire. Meanwhile, the expansionary monetary policy has made lots and lots of cheap money available so that Evergrande and many other developers can borrow and grow.
Things are different now. Guo Shuqing’s August 16 article signals an important policy change toward the sector. In the past, the government was more receptive to the real estate building sprees because of their pivotal role in the Chinese economy. Starting from a couple years ago, when the economy entered into a lower growth territory, compounded by the U.S. – China trade war, the other side of the coin – the risk of high leverage – has been getting more and more attention. The epidemic in 2020, and the hostile international environment, further dampen the outlook of the economy and people’s expectations. It is true that whenever things went south, the government would print money and stimulate the economy with more real estate and infrastructure building. With the industry already on a high-risk path, policy makers have to tread carefully to make a subtle balance: allow the sector to grow but bring down the high debt ratio at the same time. In other words, money will not flood into the real estate business as before.
The Evergrande story presents the new reality that the industry faces. It is starting to be felt throughout the whole sector. Under the debt pressure, some companies have already started to cut prices so as to increase sales. Although it is still too early to tell whether and how those companies will cope and survive, one thing is for sure: the old game will no longer work.
Endnotes: Phoenix New Media. (2020, September 24) Evergrande run into debt crisis.
https://i.ifeng.com/c/801tKeVEttm  Security Time. (2020, September 26) Facing double kill of equity and debt, Evergrande fight back with emergency announcement. https://news.stcn.com/sd/202009/t20200926_2391851.html  Reuters Chinese. (2020, September 24) Plunging by more than 20%, Evergrande’s three corporate bonds temporarily suspended by the Shanghai Stock Exchange.
https://cn.reuters.com/article/china-evergrande-bonds-0925-fri-idCNKCS26G0B8  Bloomberg News. (2020, September 24) Evergrande Warns of Looming Cash Crunch, Spooking Investors
https://www.bloomberg.com/news/articles/2020-09-24/evergrande-warns-of-looming-liquidity-crunch-spooking-investors  Xinhua. (2018, September 5) China’s Evergrande tops world’s most valuable real estate brand: report
http://www.xinhuanet.com/english/2018-09/05/c_137446988.htm  Evergrande’s 2016 annual report.
https://doc.irasia.com/listco/hk/evergrande/annual/2016/car2016.pdf  Bird, Mike. (2020, July 8) The Other Chinese Property Debt to Worry About. Wall Street Journal.
https://www.wsj.com/articles/the-other-chinese-property-debt-to-worry-about-11594198858  Guo, Shuqing. (2020, August 16) Unswervingly fight the tough battle to prevent and resolve financial risks. Qiushi.http://www.qstheory.cn/dukan/qs/2020-08/16/c_1126366413.htm  Sohu.com. (2020, September 4) New “three red lines” financing regulations for key real estate companies introduced, Ni Pengfei: The era of rapid expansion relying on debt is coming to an end
https://www.sohu.com/a/416378417_100160903  Phoenix New Media. (2020, September 29) Under the “three red lines,” can we see a round of economic recovery without real estate?
https://jn.ihouse.ifeng.com/news/2020_09_29-53245962_0.shtml  Lianhe Zaobao. (2020, September 30) Evergrande and strategic investors signed a supplementary agreement, 86.3 billion yuan converted into ordinary shares
http://www.uzaobao.com/time/20200930/78654.html  Bloomberg News. (2020, September 29) Evergrande Soars After Taming Risks That Alarmed Regulators
https://www.bloomberg.com/news/articles/2020-09-29/evergrande-investors-agree-to-keep-shares-avoiding-repayment  Sina.com. (2020, September 30) Crisis resolved, Evergrande rebounded nearly 40% within three days.
https://finance.sina.com.cn/roll/2020-09-30/doc-iivhvpwy9720056.shtml  Nikkei Asia. (2020, July 8) Anxin Trust’s $7bn investment black hole
https://asia.nikkei.com/Spotlight/Caixin/Anxin-Trust-s-7bn-investment-black-hole  Evergrande’s 2020 interim report.
https://doc.irasia.com/listco/hk/evergrande/interim/2020/intc.pdf  Sina.com. (2020, September 18) Under the “Three Red Lines,” the creditworthiness of real estate companies further differentiated