News of burgeoning debt problems at China’s largest property developer, Evergrande, has become the number one topic in China’s financial markets. While we see the immediate problems at Evergrande as solvable, the news is significant because the company’s woes have not emerged in a vacuum. Property sector financial risks are becoming more central to market discussions of overall credit risks in China. Even if Beijing can figure out how to alleviate the immediate pressure on Evergrande, the problems related to China’s excessive debt and credit growth in recent years will not go away.

The Evergrande news arrived at a time of growing credit risks in China. In recent months, we have seen more frequent runs on smaller banks, defaults on shadow banking investment products issued by trusts, and defaults by major local government companies, when localgovernments themselves were unable to provide support to firms within their jurisdictions (Tianjin in particular).  We have written about these developments throughout the year, including in our June 22 note “China’s Slow-Motion Banking Crisis is Picking Up Speed” and our September 9 note “Geographic Counterparty Risks.”

First, the background on Evergrande’s situation. Late last week, a letter from Evergrande to the Guangdong provincial government started circulating among market participants. In it, the company asked provincial authorities to provide assistance in relation to a 130 billion yuan ($19 billion) debt owed to private investors. The letter says the only way to resolve the issue is to restructure and allow a backdoor listing of the firm by January 31. If the A-share listing does not happen by this date, the letter warns, Evergrande would face severe debt pressure and its liquidity chain could break, hurting financial stability, employment, and social stability. It is important to note that Evergrande has denied the authenticity of the letter. But circumstantial evidence suggests it is real. Beijing has been tightening policy toward property developers and does not generally encourage developer listings. Evergrande’s letter was filed one month ago. If there had been a positive response from the provincial government, this letter would probably have never seen the light of day, and Evergrande would not have launched more aggressive price cuts this month.

The Evergrande news is significant for three reasons, in our view.

Property Risks Take Center Stage

First, property sector risks are now being discussed as the key risks within China’s financial markets. Evergrande is the largest property developer in China, and may not be systemically important or too big to fail, but it will not be viewed by markets as an outlier.  Property developers are likely to receive more scrutiny from markets in the future.  Investors will be pricing in additional risks for other property developers as well since Evergrande’s equity buy-back structure is a common method for developers to borrow money.  Bonds and stocks of other property developers may come under pressure, and commodities may react as well. Domestic Chinese markets have been overly optimistic in recent months, encouraged by the recovery in headline data and production-side improvements. Investors have largely ignored the fact that most produced goods are sitting as inventories and will increase debt burdens without buyers. Now the Evergrande news threatens a critical component of the recovery itself, which has been property construction.

Evergrande has been leading the market with the sector’s most aggressive price cuts in September, but the impact of price cuts is diminishing in a market where supply in the form of new starts is still near all-time highs and demand is heavily dependent upon investors and speculators. Property investors will expect Evergrande to offer even deeper price cuts in order to recover cash faster.  Other developers are already complaining about Evergrande’s price cuts because these moves hurt their sales. The environment is now in place for a price war as developers face tighter financial conditions, and increasingly depend upon sales to generate revenues.  Speculators are more likely to postpone housing purchases to wait for a better entry point, and overall sales will take a hit.

Evergrande’s creditors and suppliers will also be hurt. It is expected that financial institutions will be checking their exposure to Evergrande in order to limit further lending, if not recover cash early. Among them, the most vulnerable are the strategic investors for the original 130 billion yuan investment. Some of these firms may be counting on these funds to improve their own cash flows. Suppliers and contractors will be affected through corporate acceptances that they have received from Evergrande. Suppliers are now likely to start declining Evergrande’s acceptances, which may intensify pressure on the firm.

The Guangdong provincial government may simply permit Evergrande’s listing to solve the problem—no resources are required.  But this would undermine the significance of the new tightening measures that have just been implemented (See September 1, “Game-Changing Property Tightening”) and other developers would certainly seek listings citing Evergrande as a precedent.  As a result, an immediate solution along these lines seems unlikely.

Slowing Credit Growth

Second, overall credit growth is likely to slow in the coming months.  The Evergrande news occurred at a time when the property sector was already under pressure from the new tightening rules (and Evergrande is certainly the first victim of these rules). The property sector represents a significant source of credit demand in the market, and developers now face concerns about credit risks as well as regulatory restrictions on leverage growth.

Over the past week, there have been media reports concerning two trust firms selling products based on non-existent assets and raising money to repay other investors, in typical Ponzi structures. Tianjin has been plagued by defaults at two large local SOEs, Tianjin Real Estate and Tewoo, and market discussion is starting to focus on problems at Teda, a flagship SOE (although it appears that online and WeChat discussion of these problems has been censored). Any one of these developments would be enough to slow credit momentum, but they are all occurring at the same time.

Testing Beijing’s Credibility

Third, and perhaps most significantly, the credibility of China’s implicit and explicit guarantees is breaking down. Evergrande is important not because it is systemically important, but because if a firm like Evergrande can fail, then many other weaker firms can fail.  And if Beijing is unable or unwilling to support Evergrande, where do these guarantees stop?  Beijing may be able to provide support to Evergrande, but even explicit local government guarantees are being questioned elsewhere within the system.  The property sector as a whole is too large for the government to support.  This has been a slow-moving development as Chinese households, corporates, and investors appear to be losing faith in government support for individual asset markets and financial institutions.  Defaults have gradually moved from the periphery to the center of the financial system, from peer-to-peer lending networks to trust products, to corporate bonds, to LGFVs, and even to banks.

We have written in Credit and Credibility that the key reason China has avoided a financial crisis so far despite its rapid credit growth has been the credibility of government guarantees.  Last week, in a new report, The China Economic Risk Matrix, we developed that argument further and evaluated the conditions and markets in which Beijing’s credibility was most likely to change or its state capacity would struggle to respond, because those were the most likely paths to crisis.

The Evergrande event by itself does not challenge Beijing’s capacity to respond to financial stress.  But it is the type of event that can cause investors to question Beijing’s capacity to maintain financial stability, along with the slow-burning build-up of debt and defaults within the financial system.  China’s rapid debt accumulation over the past decade is now showing its teeth and is increasingly unmanageable, particularly in some localities where credit growth has already slowed sharply. Beijing can manage the Evergrande problem, but it will struggle to tackle China’s broader debt burden. We see this event, along with debt distress developing elsewhere, as a meaningful risk to the health of the property sector and overall credit and investment growth.  If badly managed, it could endanger financial stability more broadly. Beijing needs interest rate cuts to reduce funding costs and corporate debt servicing burdens, and to boost the confidence of consumers and investors within a more comprehensive effort to manage China’s growing debt problems.

Disclosure Appendix

This material was produced by Rhodium Group LLC solely for the recipient. No part of the content may be copied, photocopied or duplicated in any form by any means without the prior written consent of Rhodium Group. Redistribution, forwarding, translation, or republication of this material in any form by you to anyone else is prohibited. Rhodium Group LLC is not an investment advisor. Any information contained herein not intended to be relied on as investment advice and this information is not purported to be tailored advice to the individual needs, objectives or financial situation of a recipient of this information. This report is intended for informational purposes only and does not constitute a recommendation, or an offer, to buy or sell any securities or related financial instruments. The information contained herein accurately reflects the opinion of Rhodium Group at the time the report was released. The opinions of Rhodium Group are subject to change at any time without notice and without obligation of notification. Rhodium Group does not receive any compensation from companies that may be mentioned in this report. No warranty is made as to the accuracy of the information contained herein.

© 2020 Rhodium Group LLC, 5 Columbus Circle, New York, NY 10019. All rights reserved.