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Evergrande Explained | One-off crisis or China’s version of Lehman Brothers?

MUMBAI: While the global equity markets have decided only today that they want to acknowledge the existence of a crumbling real estate giant in one of the largest property markets in the world, the Evergrande crisis has been brewing for a long time.

Evergrande is the second largest real estate developer in China and was at one point part of the illustrious Fortune 500 companies list dished out by the US-based
Fortune magazine. The company made its mark during the infrastructur-fuelled growth binge of the Chinese economy back in the 2000s and post Global Financial Crisis.

So what’s going wrong?

China has told state-owned lenders of Evergrande that the real estate developer is in no position to repay interest that was due on Tuesday.

While media reports have suggested that Evergrande is in talks to restructure loans with its banks, the company had previously suggested that it was at risk of defaulting due to stuck receivables and restricted borrowing options.

Tell me more…

Evergrande holds one of the biggest debt pile in all of China and globally. The company’s last recorded debt pile stood at close to $300 billion, including bank loans, short-term borrowings and supplier credit.

According to Ming Zhao, former hedge fund manager, Evergrande has interest payments to the tune of 180 million yuan (1 yuan = Rs 11.39) every day as nearly 35 per cent of its debt is interest bearing. As per Evergrande’s own annual report, its cash position was merely 150 billion yuan, suggesting that unless the company could raise more money or get extremely favourable restructuring terms it is going belly up.

Last week, the company was not able to meet a repayment on short-term debt and asked investors to take a haircut and accept a quarterly repayment schedule of the outstanding dues.

How did Evergrande land here?

In China, most real estate developers were able to take up large amounts of short-term debt as they could easily refinance it through their contacts in the shadow banking system.

Under Xi Jinping, however, China wants to address the endemic bad loans problem plaguing its banking sector by severing backstops like refinancing of short-term debt and imposing credit limits of real estate developers, which constricted their ability to generate revenue from new projects.

This was evident when Chinese authorities allowed Huarong to default, the first banking default in China in more than 20 years, and its crackdown on shadow lenders.

Further, real estate business is a long gestation business with elongated cash conversion cycles. Most of the cash of a real estate business is held up in inventories and receivables that can take months to realize.

Further, the Evergrande’s management is known for its largesse. The company invested billions of dollars into the football business, which the Chinese government has started to crackdown on due to it becoming a playground for China’s nouveau riche to exhibit their wealth.

On top of that, the real estate company diversified into unrelated fields such as electric cars, streaming media, amusement parks and healthcare. The cash ploughed into these businesses were tantamount to burning them during winter to warm your hands.

Evergande’s operating income has crashed 75 per cent since 2018 while its gross margins have shrunk more than 1,000 basis points in that period. Earlier this month, the company said property sales will fall in September, usually a buoyant month for the real estate sector, due to waning confidence.

So, what now?

Evergrande is most likely to default to lenders one by one as weak sales, lack of outlet for monetization existing inventory and credit freeze from lenders leave the company short on cash. However, since state-owned banks are the senior most creditors they will get first when the fire sale of the real estate developer begins, everyone else will be left with the skeletons.

The larger issue here is the second order effect it will have on the Chinese credit market. Remember China is the second largest economy in the world and largest consumer of commodities and other services. If Evergrande goes down, it will take its millions of suppliers with it to whom it owes billions of yuan.

Further, it could cause a lending freeze in the entire credit system in the manner that Lehman Brothers’ collapse did in the US or IL&FS’ bankruptcy did to the Indian money markets.

The only saving grace could be that Xinping may not want a full blown crisis in his hands, and the emergency liquidity injection by PBoC on Saturday suggests the central bank will try to fight the situation to contain wider damage to the financial system.

Oddly enough, just like the Lehman Brothers’ collapse on September 15, 2008, no one genuinely thought Evergrande will crumble until it did.

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