Preventing an Evergrande Crisis of Confidence in China by Shang-Jin Wei
An impending default by Chinese real estate developer Evergrande sent shockwaves through global financial markets. The Chinese government and central bank have the wherewithal to avert a widespread financial crisis, but they need to communicate their strategy now in order to calm nervous investors.
NEW YORK – Many have attributed the recent drop in major global stock indexes to concerns over the heavily indebted Chinese real estate development group Evergrande. To restore investor confidence and minimize the economic damage, the Chinese authorities must eliminate any doubts about their willingness to do what is necessary to contain the potential fallout from an Evergrande default.
Evergrande specializes in the construction and sale of residential apartments in China’s second and third-tier cities, although it is also embarking on other businesses, including the manufacture of electric vehicles. The company’s total liabilities are estimated to be around 2,000 billion yen (around $ 300 billion), which is equivalent to around 2% of China’s GDP in 2020.
On some level, the actual financial problem is considerably smaller than what this number suggests. Evergrande owns many tangible assets, including land (technically the right to build on it), completed apartments that have not yet been sold, and partially constructed apartment buildings. According to the company, the value of its assets exceeds that of its liabilities.
But on another level, the potential negative shock of an Evergrande default to the Chinese economy could amount to far more than a loss of $ 300 billion. For starters, the company has a series of loans and bonds maturing in the weeks and months to come. Meeting these repayments will require cash, not illiquid real estate. If the group is forced to sell assets during a fire sale, it will face a significant financial discount.
Three other sources of uncertainty could greatly amplify the negative impact of an Evergrande default on the rest of the Chinese economy. First, there would be a psychological ripple effect on many other real estate developers who, like Evergrande, use debt to finance their operations. If the potential lenders of these companies are worried about the demise of the real estate industry, many companies may find that their funding is running out. As fears of a chain of bankruptcies in the industry become self-fulfilling, many of these companies will also go bankrupt.
Then there is Evergrande’s spillover into the Chinese financial system. While the extent of the company’s borrowing from banks and non-bank financial institutions is easy to discover and document, the channels and magnitude of the various indirect effects are more uncertain. For example, if Evergrande goes bankrupt, many of its steel, cement and equipment suppliers could also have difficulty repaying their bank loans. Outstanding loans from banks to other real estate companies could also become non-performing.
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Meanwhile, Evergrande has also aggressively tapped into China’s shadow banking sector to fund its operations, and some of that borrowing is managed by unlisted parts of the group who do not fully disclose their balance sheets. There is no transparent and audited report of the amount of these borrowings.
The third and perhaps the most important source of uncertainty is whether Chinese authorities can prevent a widespread financial collapse if the Evergrande problem turns into a systemic crisis. Because China has a much lower public debt-to-GDP ratio (around 70% in 2021) than the United States (133%), Japan (257%) and France (115%), the government still has the fiscal capacity to cope with a potential crisis. And the People’s Bank of China has the tools and the ability to inject liquidity into the economy to deal with any potential credit freeze.
What is less certain is whether the authorities are willing to take such measures. Evergrande is not a public entity, and the government may be reluctant to help the company’s founder and multibillion-dollar majority shareholder, Hui Ka Yan, due to its current “common prosperity” campaign.
Chinese authorities can take two steps to prevent a bank run and calm capital markets. The first is to clearly communicate that they can save the many stakeholders in Evergrande (other than Hui). These include its lenders and employees, as well as households that have paid the company for an apartment but have not yet received one. This can be accomplished by facilitating the purchase by other companies of construction projects and other assets from Evergrande.
Second, the government can announce a contingency plan involving swift and decisive action to stop the various fallout in the event of Evergrande’s bankruptcy. Policymakers should document and disclose each lender’s exposure to the business, and stress the government’s willingness and ability to use a combination of fiscal and monetary measures to ensure that Chinese financial institutions will be able to meet all of their obligations, no matter what.
The authorities may well consider these measures now. But the public announcement of such a plan can remove uncertainty about the government’s readiness and ability to act, and thus can go a long way in ending the market panic.