Evergrande’s collapse would have ‘profound consequences’ for China’s economy

Investors are bracing for the growing risk that Chinese real estate behemoth Evergrande will collapse under the weight of more than $ 300 billion of debt. But experts say the Communist Party of China will have no choice but to save a company that is so emblematic of its model of economic growth, and whose collapse would send shockwaves through the world economy.

Western financial institutions believe that Evergrande has a bleak future, if any.JP Morgan slashed its share price target for the company on Friday to HK $ 2.80 from HK $ 7.20.

This came after rating agency Fitch downgraded the company’s foreign currency credit rating from triple C plus to double C on Wednesday, saying a form of default “appears likely.” The rating agency Moody’s downgraded Evergrande’s credit rating for the third time in three months, arguing that its creditors faced “weak recovery prospects” if the company defaulted.

Evergrande is the world’s most indebted real estate developer; $ 300 billion is roughly equivalent to all of Portugal’s public debt. Unsurprisingly, top executives admitted in August that they may not be able to meet all of their financial obligations.

‘Debt Dependent Growth Model’

This poses a serious problem for the Communist Party of China, as Evergrande is a long-standing symbol of the country’s economically productive urbanization.

Furthermore, Evergrande’s business model is representative of “China’s highly debt-dependent growth model,” Jean-François Dufour, director of the China-focused French consultancy DCA Chine-Analyze, told FRANCE 24.

The company was founded in 1996, amid the Communist Party’s Herculean effort to move hundreds of millions of Chinese from the countryside to the cities, creating a “very strong growth of the Chinese real estate sector,” Frédéric Rollin, an investment strategy advisor to the multinational Pictet Asset Management, told FRANCE 24.

Evergrande was the main beneficiary of this boom. It followed a very aggressive growth strategy and relied on the goodwill of the banks as it amassed a portfolio of proliferating real estate projects at a rapid pace.

This expansion continued for decades, as evidenced by Evergrande raising $ 722 million in its IPO on the Hong Kong Stock Exchange in 2009. The firm now controls 778 real estate projects in 223 Chinese cities, directly employing nearly 200,000 people. Evergrande has claimed that it has indirectly created more than three million jobs.

Huge pile of debt

But in the early 2010s, in the wake of that successful initial public offering, Evergrande extended its tentacles into a number of other sectors. The company was in a “race against time to diversify its activities, much more than other Chinese real estate groups,” Dufour said. The Communist Party had “made other sectors national priorities,” he continued.

As a result, Evergrande acquired stakes in video streaming companies, health insurers, dairy farmers, and pig farming cooperatives. It also bought Guangzhou FC, a football club in the Guangdong region where it is based, and built amusement parks. Evergrande’s latest diversification project was an attempt in 2019 to start manufacturing electric cars, despite a lack of experience in this field.

Evergrande stuck its fingers in so many cakes because it wanted to be present in “a sufficient number of priority sectors that the state would be more inclined to support it financially when the burden of its debt became too great to bear,” Dufour explained.

The debt is really very heavy. Evergrande will pay $ 15 billion to creditors by the end of 2021; But, at the end of June, he only had $ 13 billion to his name. At the same time, banks have become much more reluctant to lend you money. “It has become more complicated due to the restrictive monetary policy that the government is currently applying,” Rollin said.

Risk of economic contagion

Evergrande has entered a downward spiral in which banks no longer want to give it the funds to finish its real estate projects, depriving the company of new properties to sell and thus fresh funds to repay creditors and reassure the banks.

“In a normal market economy, Evergrande would have gone bankrupt a long time ago,” Dufour said. But the Chinese model of capitalism has long fostered the private debt model.

“The rule was that as long as a company seemed to be moving forward, with many projects in the pipeline, the banks gave it credit on the understanding that the strength of Chinese economic growth would always generate profits,” he continued.

This way of thinking meant that “in 2020, Chinese corporate debt accounted for 160 percent of GDP, compared to just 85 percent in the United States and 115 percent in the eurozone,” Rollin said.

Companies like Evergrande are in a tough spot now that Beijing has pushed heavily indebted countries out of business over the past year.

But the Communist Party also faces a dilemma, as it needs to prevent Evergrande from sinking, to avoid the “profound consequences it would have for the Chinese economy,” Dufour said.

If Evergrande files for bankruptcy, “at least one bank would go under,” Dufour continued. “That may well push other banks to be more reluctant to do away with highly leveraged countries, and that would herald the end of China’s debt-driven growth model.”

The collapse of the real estate giant would send shock waves far beyond China. As the Financial Times noted: “Evergrande counts large international companies among its investors, including Allianz, Ashmore and BlackRock. A default is likely to have spillover effects in global markets, where many investors have historically anticipated Chinese government support in times of trouble. ”

Given the importance of Evergrande to the Chinese economy, “it is very likely that the state will achieve a debt restructuring program,” Rollin said. In other words, Beijing will force the creditors’ hands while organizing the sale of Evergrande’s nonessential assets.

“This probably means putting the company under state control while it finds a buyer; an approach the Chinese government has taken before, ”Dufour said.

But cleaning up a mess as big as a $ 300 billion pile of debt won’t happen overnight.

This article was translated from the original in French.

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