Huge Credit Stress Starting In China May Easily Rock The Whole World

Evergrande, a real-estate colossus in China is collapsing. Don't expect the collapse to be contained to China. The global macro implications are huge.

Collapse of Evergrande

Many people asked me to comment on Evergrande. 

First let's start with a WSJ article then a closer look at a pair of excellent Tweet threads by Michael Pettis and Girolamo Pandolfi.

Collapse of Evergrande - Background 

The WSJ comments China Evergrande’s looming collapse and its ripple effect on the economy will pose a test for the government’s campaign to keep housing affordable for the masses.

Please consider How Beijing’s Debt Clampdown Shook the Foundation of a Real-Estate Colossus

In a risky race against time that ran for two decades, China Evergrande Group turned billions of dollars in borrowed money into the dream of homeownership for millions of Chinese citizens.

It launched project after project in every Chinese province, selling apartments years before they were completed and scratching together enough cash to stay just ahead of massive interest bills.

The party has ended. Years of aggressive borrowing have collided with Beijing’s crackdown on debt, leaving the giant developer on the brink of collapse. Construction of Evergrande’s projects in many cities has stopped. The company has faced a litany of complaints and protests from suppliers, small investors and home buyers who sank their savings into properties the company promised to deliver.

Cash is so short that this summer, the developer said it began paying bills to contractors and suppliers with unfinished apartments instead of actual money.

A paint supplier based in the southeastern province of Fujian said Evergrande recently paid off the equivalent of $34 million in bills with three unfinished properties, which the supplier is trying to sell. 

The looming collapse is a microcosm of China’s overheated housing market, in which prices have been climbing for years. Evergrande’s problems—and their ripple effects on the economy and social stability—are the biggest test of Beijing’s rejuvenated campaign to end debt-fueled speculation and stop home prices from surging while the government tries to lower inequality and keep housing affordable for the masses.

Pettis on Evergrande 

  1. Even as the chairman was proclaiming that a basic principle of his business is that cash is king, he was pulling cash out of the company. According to WSJ: "As it piled on debt, Evergrande paid out billions in dividends to stockholders, with most of that cash going to Mr. Hui as its largest shareholder."
  2. "The payouts helped him become one of China’s richest men. He has received more than 34 billion yuan, the equivalent of $5.3 billion, in dividends since October 2018."
  3. Someone must have know that this was problematic because, at the same time, Evergrande was doing everything possible to raise cash, not just from banks, but also from employees through wealth management products, from customers through pre-purchases and deposits, and from suppliers and contractors by paying them in commercial paper.
  4. If you have to leverage itself to the hilt — often with very expensive financing — just to keep operating, it isn't a good idea to pay large dividends unless there is, to put it politely, an information asymmetry.

Pettis Evergrande Tweet Thread

Pettis WSJ Evergrande Tweet Thread

China's Lehman Moment

The Guardian comments ‘China’s Lehman Brothers Moment’: Evergrande Crisis Rattles Economy.

As angry protesters occupied the headquarters of the troubled property developer in recent weeks, some analysts have described the Evergrande crisis as “China’s Lehman Brothers moment”. Only this time it’s a credit-fuelled housebuilder that suddenly can’t pay its $300bn debts, rather than a blue-chip investment bank that many assumed was too big to fail but was instead thrown to the wolves 13 years ago.

Although there may be some parallels, the more extreme prophecies of doom for China may be no more correct than the assumption that Beijing will simply step in and bail out Evergrande to make sure the fallout from the failure of a property giant does not spread to other areas of the Chinese economy.

“It seems that we may have already started the financial distress process. As the risk of insolvency increases, the behaviour of sales agents, homebuyers, suppliers and other stakeholders changes in ways that further undermine revenues and raise expenses,” said Michael Pettis, a professor of finance at Peking University. “Once that process begins, conditions can quickly spiral downwards unless someone like the government steps in to guarantee payments.”

Dynamics Started a Decade Ago

Pettis on the Lehman Moment

  1. The former head of the CSRC says that, compared to other countries, too much of China’s household wealth is tied up in real estate, and too little in financial assets. With property accounting for 70-80% of Chinese household wealth, he's right.
  2. But of course with real estate 3-4 times as expensive in China (relative to income) as it is in other major economies, it would be pretty hard for it to be otherwise. Only a sharp and sustained fall in property prices relative to income, or a stock market bubble, can resolve that imbalance.
  3. Japan in the late 1980s had even higher real estate prices and a truly epic stock market bubble, and I think real estate accounted for roughly 65-70% of Japanese savings.

Lehman Moment Tweet Thread

Pettis Lehman Moment Tweet Thread

Pettis on the Problem for Central Bankers

  1. This is an interesting problem for central banking geeks. Many of China Evergrande's suppliers, who were paid not with cash but with Evergrande commercial paper (CP), are now finding it hard to get paid, and so are worried about their own solvency and liquidity.
  2. "The plight of Wu and many others like him has thrown a spotlight on the extensive use of CP in China's property sector. Developers favour it as they prefer to not pay upfront and because it doesn't count as interest-bearing debt."
  3. This is an obvious problem for Evergrande's suppliers, who might not be paid after having delivered products, but, as I plan to explain in my central bank seminar tomorrow, it is in fact also a monetary problem. As long as CP from large property developers was widely accepted as an efficient payments mechanism, it was not much different from other forms of money.
  4. As Hyman Minsky liked to point out, while anyone can make money, the hard part is getting others to accept it, and this CP was widely accepted as money.
  5. As such it formed part of China's money base. Money isn't a "thing" so much as it is a quality inherent — to very different degrees — in all assets. If suppliers now become reluctant to accept CP issued by property developers, this will have two macroeconomic impacts.
  6. First, obviously, it will reduce the efficiency of business transactions — i.e. raise frictional costs — in the property sector. Second, it will cause a contraction in China's "real" money supply as an asset that was once highly "money-like" becomes much less so.
  7. To the extent that the PBoC recognizes this, they should expand the domestic money supply to make up for the partial demonetization of Chinese CP.
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