Is China’s Evergrande Crisis a Global Systemic Risk?

The real estate developer is teetering on the brink of collapse, but what might it bring with it?

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This episode is sponsored by NYDIG.

Today’s show is a look at one of the most important but under-discussed macro events in the world today: the crisis surrounding China’s massive real estate developer Evergrande. The company’s share price has fallen more than 85% this year and around the country, people are protesting as more than 1.5 million deposits for homes were taken without fulfillment. In this episode, NLW looks at whether the risk is limited to just Evergrande, or whether it represents a larger systemic risk for China or the world as a whole.

“The Breakdown” is written, produced by and features NLW, with editing by Rob Mitchell and additional production support by Eleanor Pahl. Adam B. Levine is our executive producer and our theme music is “Countdown” by Neon Beach. The music you heard today behind our sponsor is “Tidal Wave” by BRASKO. Image credit: Qilai Shen/Bloomberg/Getty Images, modified by CoinDesk.

Transcript

What’s going on guys, it is Friday, September 17 and today, we are talking about something where even by my normal, “I’m not an expert standards,” this I am truly not an expert in. We’re talking about the potential nightmare scenario emerging in China with Evergrande. Given that this is not crypto, and is even a different international dimension of macro, I’m going to give an extra caveat that this is something that I am learning about just alongside you guys, and so what I wanted to do is actually be much more curatorial. So I’m going to give a little bit of setup, then I’m going to rely on a number of Twitter threads, threads that I think offer two very different takes, at least, on this situation, to give you the ability to try to discern between them, to figure out what seems real. I hope that this episode serves as a primer of something that seems like an important situation in the world to be watching, if not being completely comprehensive. So to give you a flavor of what’s going on, let’s start with the first couple paragraphs of a piece from Bloomberg.

“Protests intensify in China Evergrande group offices around the country as the developer falls further behind on promises to more than 70,000 investors. Construction of unfinished properties with enough floor space to cover three-fourths of Manhattan grinds to a halt, leaving more than a million homebuyers in limbo. Fire sales pummel on already shaky real estate market, squeezing other developers and rippling through a supply chain that accounts for more than a quarter of Chinese economic output. COVID-weary consumers retrench even further and the risk of popular discontent rises during a politically sensitive transition period for President Xi Jinping. Credit market stress spreads from lower rated property companies to stronger peers and banks. global investors who bought $527 billion of Chinese stocks and bonds in the 15 months through June, begin to sell.”

So, let’s back up. Evergrande was once China’s second largest real estate developer. Now, it is drowning in debt. Something like 1.5 million people have put deposits down on homes that haven’t been built. And everyone is wondering if, and when, the Chinese government is going to step in. Evergrande was founded in 1997 by Xu Jiayin. It is completed something like 1,300 commercial, residential and infrastructure projects and supposedly employs something like 200,000 people. It has expanded into other economic areas as well, including entertainment sports, food, leisure, but its big thing is, and remains, real estate. The company’s success came because it was so perfectly positioned for the absolute boom in real estate that has been driven by the last two decades of staggering Chinese growth, a growth for a country that is unparalleled in all of modern human history.

Evergrande’s founder is one of the 10 richest billionaires in China, although he was all the way up to three last March before falling to 10 in December. Evergrande’s story is one of too much debt. The company has been fueling its growth with borrowing and they have liabilities currently in excess of $300 billion. They’ve also been on an acquisition frenzy, and on top of all this, they use pre-sales to finance themselves. As I said, about 1.5 million properties have down payments on them, without any activity so far. Their issues started in August of last year, after Beijing introduced new measures to monitor and control the debt level of major property developers. Subsequently, their stock price has seen an 85% drop, their corporate bonds have fallen 30%, so much that trading was halted at the beginning of this week. Evergrande in the last two weeks has been downgraded by two credit agencies and in the last few days, as the Bloomberg story intimated above, there have been massive protests outside their offices around the country. Real estate represents 29% of economic output in China and bankruptcy could have a major financial and psychological impact. The question, though, is how endemic this problem would be? Does it have spillover potential into other real estate developers, into other sectors of the Chinese economy or even beyond?

To understand a couple different takes of that, like I said, let’s turn to two different threads. And by the way, I think just to take a moment here, this is where Twitter is such an amazing resource. On the one hand, of course, you have to have the caveat that Twitter threads don’t have the sort of fact checking that you would assume from a major publication. But at the same time, in a time when major American publications have been largely ignoring this issue, we have these really in Interesting, considered perspectives to take as at least a starting point, if nothing else. So with that, let’s start with Adam Cochran. And Adam Cochran, you’ve probably heard me mention him before. He is a crypto investor. He’s had experience in a number of different industries and he is an ever thoughtful commenter on many things, as you’ll see. This thread was written on September 13. That’s Monday.

“Evergrande and other Chinese developer stocks dropping off a cliff in the Hong Kong morning session today. Here’s what you need to know about why Chinese real estate may impact crypto, and even U.S. markets. Evergande is a major Chinese real estate developer, who, through leveraged properties and issuing U.S. denominated junk bonds, built up a real estate empire, making it the second biggest in the country. Assets and equity boomed over the past decade, but net income struggled. The reason is debated, but it seems they were over leveraging properties that were getting very little actual revenue to grow their empire. This worked, right up until the pandemic really began to hurt the few commercial and tourism properties that were actually driving revenue for them. It’s estimated that they’ve now managed to rack up more than $300 billion dollars in debt. To put that in perspective, $300 billion is the entire GDP of countries like Ireland, Denmark, Hong Kong or Portugal. And that’s just the debt that Evergrande has. Currently, rumors are swirling that Evergrande may not have enough remaining capital to service the interest payments on their loans, nevermind paying down their principals.”

Editor’s note: in America, we call that a “zombie company” and a huge portion of the U.S.’s top 2000 companies are, in fact, zombie companies. So, as terrifying as that sounds, it’s less abnormal than it seems like it should be. Back to Adam now.

“Now, the real estate developer claims that they’re going to liquidate property to get operations back on track. But, those of us in the crypto market understand how liquidations work. If you’re liquidating because your collateral asset (real estate property), has sunk in value and you have to sell that asset to pay back, then every time you sell it, the asset drops further. Evergrande is so large that they will be in a race to the bottom as they’ll be selling properties which will lower the average price of properties in the region, thus lowering their asset value and entering into a spiral. Evergrande currently owns a whopping 2% of all Chinese real estate and so this has led Chinese issued bonds from nearly all real estate developers to sink. But Evergrande itself has been diving off a cliff all year and has reached a critical point. Now creditors are unwilling to accept their bonds and demanding payments made and aggressive restructuring options are being reviewed. So, why should you care? On September 15th 2008, the Lehman Brothers collapsed, dissolving $600 billion in U.S. assets, leading us to the worst market crash since the Great Depression, $600 billion in assets.

Right now, Evergrande has around $200 billion dollars in assets and $300 billion in unserviced debt, $500 billion total. So it’s entirely on the same level as the assets that Lehman Brothers had. But Lehman Brothers was a U.S. bank, broadly diversified across many industries. Evergrande is not. Evergrande is in one industry and only one industry. And its debt is held by banks across China, the U.S., Canada, U.K., Australia and others. This also comes at a time when markets have been on an artificial, inflation-driven quantitative-easing-fueled run-up like no other. So, when the hammer does drop, it will drop hard. This will not only cause default on bonds, but it will also mean billions of dollars unpaid to Chinese contractors and goods suppliers. And it will mean the largest ever bulk real estate liquidation ever, if evergrande goes under. That real estate collapse would mean the assets sheets of other real estate developers, banks and mortgage companies in China would all crumble. Remember the big empty houses in the U.S. in 2008? That times 100x. Then we have to remember that China owns 15% of all global debt. So what happens when they have an internal crisis? They’re likely to start aggressively pursuing some of that external debt, much of which is likely with the same overseas banks and funds that own Evergrande bonds in the first place.

Now, there’s a chance that the CCP step in and find a way to bail out or unwind Evergrande. With China’s internal policies, that seems quite likely, although it will still likely be a pennies on the dollar bailout. But if they don’t, then market conditions are primed for a god damn meltdown. We’re sitting on a powder keg of weak economic involvement and yet all time high stocks, huge inflation and disconnected markets. The question of a large correction is not a matter of if, it’s a matter of when and how bad. That correction could be soon, it could be years from now, but it will happen. The longer it takes, the worse it gets. But there are some unique events that could make it far, far worse, and the collapse of Evergrande is certainly one of them. The shockwaves could be felt in markets around the world, including crypto. While we can hope that crypto one day becomes a flight from the TradFi markets, right now, it’s sufficiently intertwined to its movements. Plus, there’s the stark reality that this will have a huge impact on the commercial paper markets. Regardless of what commercial paper you hold, bonds and commercial paper would take a hit and some issuers may even fold. Currently, both Tether and Circle hold commercial paper. And while I think it’s unlikely that either would have large swaths of Evergrande bonds, the whole market will relive it.

For what it’s worth, I do think both of those will still have more than enough wiggle room to prevent any actual meltdown. But if we have a meltdown that gets really bad, they certainly could get a bit off peg. If either Tether or USDC did meltdown in a global collapse, though it actually be bullish for crypto, as you couldn’t use them to cash out, people would start bulk converting them into BTC, or ETC, regardless of price. Either way, Evergrande is a huge story that most Western media is entirely oblivious to. I hope they get to stay that way and never have a reason to learn their name, but there’s a chance that we’re currently staring down the barrel of the next financial meltdown. It all comes down to what the Chinese government will do, and if the Chinese real estate market really has enough demand to keep those assets afloat, but it’s damn dicey.

So I want to, before I read the second and kind of different opinion thread, point out that there is a huge amount of Tether FUD going on right now related to this. And I don’t think Adam here is Tether FUDding, I think he’s pointing out that stablecoins currently, in the crypto ecosystem, hold a bunch of commercial paper. And if there’s a ripple effect, knock on effects to the commercial paper industry as a whole, it’s going to have impact for stablecoins which hold them. That, to me, is a completely reasonable point of view that’s not fueling some conspiracy theory that Tether has a bunch of Evergrande commercial paper and its roster. Tether’s team has come out explicitly and said that they don’t, but Tether Truthers are going to use whatever they have, always, as is clear. And unfortunately, by the way, if you’re a Tether Truthers who’s listening to this, I would suggest that perhaps not latching on to any stupid conspiracy theory would make everyone take your arguments just a little bit more seriously. But I digress. That is not really the point of the show.

I want to give that perspective, I think, obviously, this shows the global ramifications. But it’s not the only take on what the Evergrande story is going to be or how it’s going to play out. Let me give you another thread that kind of gives the other side. This is from an anon on Twitter, which at this point, you should probably know that I clearly think has a ton of value. I think that our idea of using our own likenesses on social media may, in the long run, be a historical accident rather than the norm. And either way, this comes from @hodlKRYPTONITE who goes by degentradin, whether you decide to give it more or less value, because it’s anonymous, that’s up to you. I think it is a different take than Adam’s and I think it’s worth sharing.

“FUD blasting thread about Evergrande, the Asian property developer that everybody is talking about and yet nobody really knows about. I dealt in Asia credit and I have seen some particularly bad takes on this whole situation. First of all, let’s get this out of the way. Evergrande will go into liquidation without government help. However, even if it goes into liquidation, the impact on the external world would be very limited. The total value of USD and HKD bonds that it has outstanding is only about $21.2 billion. These bonds are trading at 25 cents to the dollar, so even if we have a total default, the impact to investors will only be about $5.3 billion. The biggest holders of Evergrande bonds are high net worth clients, these junk bonds are retail favorite. And no, because Evergrande is a junk rated Chinese developer, it cannot issue commercial paper, i.e., Circle and Tether probably are not exposed to Evergrande risk. The biggest impact of an Evergrande default is actually within the whole Chinese ecosystem, which one, purged crypto in May; and two, the Chinese government has a mandate of social stability, which probably means that they will bail out Evergrande. Evergrande is not facing a profitability crisis, it’s facing a liquidity crisis. If you look at the balance sheet, it is shored up with land, the only reason why it hasn’t managed to dispose of land assets is because competitors are waiting to pounce. This is reflected in the share price. Even at three Hong Kong dollars per share, Evergrande still has a $5 billion USD market cap. Doesn’t really sound like a company on the brink of bankruptcy, does it? The genesis of Evergrande’s troubles began with the three red lines campaign for deleveraging. Getting a massively levered company to deliver quickly is like asking a 900 pound man to lose 200 pounds instantly. Obesity is not what kills you, but the weight loss. For all the crypto natives who are familiar with liquidations, in the real world, liquidations work differently. Crypto can drop 90% in one hour. Land drops 5% in a year and that is a lot, and, there is a prospect of a government bailout, the bigger you are. Conclusion: this entire Evergrande saga is a race to see when the CCP will blink. The impact of an Evergrande default will be huge in China but otherwise muted outside of China. The offshore bonds are freely traded, and investors have already taken that 75% mark to market losses.”

I wanted to share that different perspective with you because it’s so easy, especially in this line of podcasting work, to give you just the most sensational, nervous kind of take, and I certainly don’t think Adam’s threat is sensationalized, but it is a “here’s what happens in the worst case scenario.” and we should at least be prepared and thinking about it. This alternative take from degentrading doesn’t deny the Evergrande issues, but argues that the impact will be more limited. I think for me, I’m still learning about this situation wut what’s clear is that it’s going to come down to China. Frankly, I don’t think China has the ability to do anything less than whatever it takes to have this not be a systemic failure. Today, one of the lead headlines in Bloomberg markets is  “China Adds $14 Billion Cash as Evergrande’s Pain Roils Markets.” Here’s how one economist quoted in the article puts it: “Avoiding a systemic liquidity squeeze is the absolute priority for the PBOC and it has means to do so. A Lehman-style financial market meltdown is not our top concern, but an extended and severe economic slowdown seems more probable.”

Another commenter: “It’s fair to say that the evergrande situation and its repercussions on the broader property market will have a far greater direct impact on Chinese growth than any of the other regulatory crackdowns, I would not be surprised at the PBOC is acting to contain the fallout in the money markets.” So, like I said, it’s clearly in the hands of the Chinese government at this point and the question is whether markets will respond to stimulus, and to their efforts to keep this under control. For you, the listener, for me, doing this research and learning myself, I think the key thing is just keeping an eye on this, understanding what’s happening in the world, understanding that our markets are deeply interconnected, both globally and in terms of different asset classes, and trying to stay informed about what might happen even if it doesn’t come to pass. I hope this has been a useful primer on the topic. I appreciate Adam Cochran and degentrading for these threads that I’ve leaned on heavily for this show. And I appreciate you listening. Until tomorrow, guys, be safe and take care of each other. Peace!