he ‘managed’ collapse of the Evergrande real estate company is a precarious balancing act for China’s leaders. On the one hand, rushing to the help of the struggling behemoth sends a message that businesses in a similar situation will not be dumped despite their huge debt. This extends the strategy of viewing GDP growth as the ultimate aim for the Chinese leadership—at the expense of a potentially dangerous debt ratio for many enterprises. On the other hand, if Evergrande is made an example of and the government refuses to assist the business, a domino effect might occur, sending the markets into even greater upheaval than in recent weeks.
For many years, the Chinese economy’s overarching purpose has been to satisfy government defined GDP growth targets. It has made little difference whether specific sectors of the economy or businesses are profitable, or whether construction projects provide significant economic advantages. What counts is whether or not there is economic growth, productivity, and debt. Even non-viable zombie businesses are kept going by the government.
This economic approach has resulted in a massive real estate bubble, which is currently revealing itself all too plainly in the instance of Evergrande. Its origins can be traced back to 2008. The global financial crisis of that year not only had a significant impact on developed countries, but it also had a significant impact on Chinese economic performance. The Chinese government attempted to combat this by introducing major economic stimulus packages and making borrowing easier.
As a result, land value increased and the residential construction industry became more appealing. This fueled rapid development activity by real estate developers like Evergrande, whose business strategy was predicated on large debt. Evergrande had not only taken out big bank loans, it had also sold many residential units to customers months, if not years, before completion, collecting hefty advance payments and, in some cases, the full amount. Subcontractors, on the other hand, were not paid in cash, resulting in the accumulation of large receivables from subcontracting companies over time.
The collapse of the real estate giant now poses a threat to other industries. Evergrande’s bankruptcy would also result in the layoff of around three million of the company’s employees, as well as the loss of roughly two million property buyers’ down payments on unfinished homes. Built on an ever-increasing pile of debt, the real estate sector has grown to be a major, if not the most prominent, industry. The industry accounts for around 25% of China’s GDP. Simultaneously, the vacancy rate for houses and flats has reached all-time highs. It is estimated that 20 to 25% of all residences in China’s major cities are empty.
To address the rising dangers, in January the government established three red lines for real estate developers. First, the liabilities to assets ratio must not exceed 70%. Second, the net gearing ratio must not exceed 100%. And third, the ratio of liquid assets to current obligations cannot be less than one. This was designed to reduce the real estate sector’s expanding indebtedness on the one hand, and to combat the speculative mania of real estate developers on the other. The latter, however, has continued to act entirely undisturbed for most of 2021.
This new policy is likely to succeed because China’s political system prides itself on not allowing any ambiguity in government processes. In the long run, this would restore market stability, even if Evergrande would face unpleasant distortions in the short term due to its connections with banks, suppliers, and other institutions in China's credit markets.
Only by removing unproductive activities from national accounts at the expense of GDP growth would China be closer to realistic growth targets. As a result, it will be interesting to observe whatever path the government adopts in the following weeks. At the moment, stabilizing the situation appears to be the most likely path. Government officials may easily exert pressure on bankers and creditors to extend loans to Evergrande. However, in order to address the debt issue genuinely, Beijing will need to adopt more drastic measures.
A worldwide catastrophe on the scale of the one that occurred in 2008-2009, when the bankruptcy of Lehman Brothers precipitated a wave of insolvencies, seems unlikely. Not only because Evergrande conducts 90% of its operations in China, but also because the Chinese financial system remains highly closed, excluding a substantial number of foreign creditors.
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Evergrande Crisis: Cracks in China’s Growth Strategy
Cityscape of modern Hangzhou, China. Photo by Evan Vostro via Adobe Stock.
October 13, 2021
The ‘managed’ collapse of the Evergrande real estate company is a precarious balancing act for China’s leaders. Helping the company sends a message to businesses in a similar situation. And if Evergrande is made an example it may send the markets into even greater upheaval than in recent weeks.
T
he ‘managed’ collapse of the Evergrande real estate company is a precarious balancing act for China’s leaders. On the one hand, rushing to the help of the struggling behemoth sends a message that businesses in a similar situation will not be dumped despite their huge debt. This extends the strategy of viewing GDP growth as the ultimate aim for the Chinese leadership—at the expense of a potentially dangerous debt ratio for many enterprises. On the other hand, if Evergrande is made an example of and the government refuses to assist the business, a domino effect might occur, sending the markets into even greater upheaval than in recent weeks.
For many years, the Chinese economy’s overarching purpose has been to satisfy government defined GDP growth targets. It has made little difference whether specific sectors of the economy or businesses are profitable, or whether construction projects provide significant economic advantages. What counts is whether or not there is economic growth, productivity, and debt. Even non-viable zombie businesses are kept going by the government.
This economic approach has resulted in a massive real estate bubble, which is currently revealing itself all too plainly in the instance of Evergrande. Its origins can be traced back to 2008. The global financial crisis of that year not only had a significant impact on developed countries, but it also had a significant impact on Chinese economic performance. The Chinese government attempted to combat this by introducing major economic stimulus packages and making borrowing easier.
As a result, land value increased and the residential construction industry became more appealing. This fueled rapid development activity by real estate developers like Evergrande, whose business strategy was predicated on large debt. Evergrande had not only taken out big bank loans, it had also sold many residential units to customers months, if not years, before completion, collecting hefty advance payments and, in some cases, the full amount. Subcontractors, on the other hand, were not paid in cash, resulting in the accumulation of large receivables from subcontracting companies over time.
The collapse of the real estate giant now poses a threat to other industries. Evergrande’s bankruptcy would also result in the layoff of around three million of the company’s employees, as well as the loss of roughly two million property buyers’ down payments on unfinished homes. Built on an ever-increasing pile of debt, the real estate sector has grown to be a major, if not the most prominent, industry. The industry accounts for around 25% of China’s GDP. Simultaneously, the vacancy rate for houses and flats has reached all-time highs. It is estimated that 20 to 25% of all residences in China’s major cities are empty.
To address the rising dangers, in January the government established three red lines for real estate developers. First, the liabilities to assets ratio must not exceed 70%. Second, the net gearing ratio must not exceed 100%. And third, the ratio of liquid assets to current obligations cannot be less than one. This was designed to reduce the real estate sector’s expanding indebtedness on the one hand, and to combat the speculative mania of real estate developers on the other. The latter, however, has continued to act entirely undisturbed for most of 2021.
This new policy is likely to succeed because China’s political system prides itself on not allowing any ambiguity in government processes. In the long run, this would restore market stability, even if Evergrande would face unpleasant distortions in the short term due to its connections with banks, suppliers, and other institutions in China's credit markets.
Only by removing unproductive activities from national accounts at the expense of GDP growth would China be closer to realistic growth targets. As a result, it will be interesting to observe whatever path the government adopts in the following weeks. At the moment, stabilizing the situation appears to be the most likely path. Government officials may easily exert pressure on bankers and creditors to extend loans to Evergrande. However, in order to address the debt issue genuinely, Beijing will need to adopt more drastic measures.
A worldwide catastrophe on the scale of the one that occurred in 2008-2009, when the bankruptcy of Lehman Brothers precipitated a wave of insolvencies, seems unlikely. Not only because Evergrande conducts 90% of its operations in China, but also because the Chinese financial system remains highly closed, excluding a substantial number of foreign creditors.
