China's rescue of Evergrande has to happen really fast

In the last few years, China has emerged stronger from bigger challenges like the US trade sanctions and COVID pandemic. It is hoped, in the larger interest of financial stability, that China gets over Evergrande smoothly.

Sep 22, 2021 08:09 IST India Infoline News Service

Over the last 25 years, there have been number of implosions that brought financial markets close to a crisis. There was the fall of Barings in 1995, LTCM in 1998 and of course, the Bear Sterns and Lehman implosions in the US in 2008, which triggered the global financial crisis. India had its own Lehman moment when IL&FS triggered a crisis in Indian financial markets. The question is whether an implosion of Evergrande of China could create a similar crisis?

What exactly went wrong with Evergrande

At the peak of the 2008 crisis, a CNBC journalist had asked Hank Paulson if it was a crisis of trust. His pithy response was that all financial crises are effectively a crisis of trust. It is only when stakeholders lose trust in the company that it implodes. That was the case with LTCM, Bear Sterns, Lehman and India’s own IL&FS. Of course, there are sub-plots like unnecessary diversification, too much debt, weak governance etc. But the trigger is loss of trust.

Evergrande is no different. One of the most successful and aggressive realty stories in China, Evergrande made the best of the real estate boom over last 2 decades. It is China’s second largest realty company and has developed more than 1300 projects across China. Home ownership accounts for 90% of Chinese household wealth so the Chinese government just cannot afford a housing crisis.

But Evergrande crisis is manifesting in various forms. Thousands of investors and depositors are queueing up outside the offices of Evergrande to claim their money. There are hundreds of unfinished apartments where the life savings of the Chinese middle class is stuck. But the big worry is for the banks as Evergrande is struggling with debt of $304 billion with little cash flows to service this debt.

But, how did things get so bad for Evergrande?

Evergrande was always living on the edge. It was borrowing to grow and the growth allowed it to borrow more. To be able to service the borrowings and roll over the debt, Evergrande had to maintain a frenetic pace of selling apartments and properties. That was done by closing the sale on wafer-thin margins. They even compromised on the margin amount to be brought in by the borrowers making negative equity a big risk on unsold properties.

Two factors triggered the crisis at Evergrande. The pandemic resulted in thousands of job losses across China seriously impacting purchasing power and repaying capacity of people. The pressure was evident in the slowdown in home sales. The Communist Chinese regime was far from happy that people had to pay steep prices for homes due to the land inflation triggered by developers. That is when the China government came down hard.

Since easy debt and low cost leverage were the reasons for the realty boom and high prices, the Chinese government came down hard on debt levels of realty companies. It came up with a multi-point formula with analytical variables including leverage ratio, short term debt ratio, interest coverage, debt service coverage etc.

Each real estate company was audited and assessed on each of these parameters. They were asked to reduce debt progressively more if they scored low on more parameters. Evergrande scored low on most parameters and had to substantially cut debt. That is where the crisis spiralled out of control.

Chinese government will rescue Evergrande, but markets are impatient

People are confident of the crisis at Evergrande not snowballing owing to the financial muscle of China. Arranging a few billion dollars to help Evergrande repay loans or even infusing equity and taking over the company are easy options. The Chinese authorities have already indicated that they would pull all strings to save the company and avert a crisis. But, markets are impatient!

The stock of Evergrande lost 92% in the last 1 year and has lost nearly 85% from the recent peak of Feb-21. That is big price damage. The trading on most Evergrande bonds had to be halted multiple times due to junk bond-type yield spikes. With these intimidating market triggers; lenders, investors, depositors and home buyers are awfully jittery. The rescue plan needs to happen really fast to prevent a collapse.

What does the Evergrande saga mean for India?

There are 3 reasons India could see red flags due to the Evergrande saga.

• A hard landing in China means a sharp fall in demand for almost every commodity. That could disrupt the metal story, which is already evident.

• A hard landing would mean the Yuan is weakened to spur the recovery. That would force the INR to also weaken to stay competitive, impacting FPI flows.

• Lastly, a crisis of this magnitude will impact sentiments around emerging markets and India will also feel the impact.

In the last few years, China has emerged stronger from bigger challenges like the US trade sanctions and COVID pandemic. It is hoped, in the larger interest of financial stability, that China gets over Evergrande smoothly.

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