Victor Shih on the Ramifications of Evergrande

Victor Shih is an associate professor of political economy and has published widely on the politics of Chinese banking policies, fiscal policies and exchange rates. He was the first analyst to identify the risk of massive local government debt, and is the author of “Factions and Finance in China: Elite Conflict and Inflation.” Prior to joining UC San Diego, Shih was a professor of political science at Northwestern University and former principal for The Carlyle Group. Shih is author of the forthcoming book Coalitions of the Weak: Elite Politics in China from Mao’s Stratagem to the Rise of Xi Jinping, which explores how the coalition-formation strategies of founding leaders impacted the evolution of the Chinese Communist Party. He also maintains a large database on biographical information of elites in China. He holds and Ph.D in Goverment from Harvard University and B.A. in East Asian Studies from George Washington University.

Jessie Miller CMC '23 interviewed Dr. Victor Shih on October 8, 2021.
Photograph and biography courtesy of Dr. Victor Shih.

What has triggered the recent crisis at Evergrande? How did Evergrande’s business model differ from other major real estate companies in China?

The immediate trigger was a new regulation published by China's banking regulator, which imposed a set of very harsh ceilings on property developers who tried to borrow money from the major financial institutions in China. These ceilings have to do with debt-asset ratio. If these property developers’ debt exceeds about 70% of their assets, then banks literally cannot lend any more money to them. There are other ceilings, some of which have to do with cash flow ratio and with debt equity ratio, what's called gearing ratio. If a property developer exceeds any one of these metrics, then banks are supposed to be very careful when they lend to them. If they exceed all three of these measures, then banks cannot lend to them anymore.

Evergrande, being a highly levered company, had long exceeded all three of these measures. Therefore, banks in China were not allowed to lend to it anymore. At the same time, it was dependent on new loans to service existing loans and make interest payments. Since it had a lot of debt and had to make billions and billions in monthly payment, it was not able to fully service its debt. As a result, it missed many payments to bondholders. Evergrande had issued a bunch of bonds previously, as well as trust products. Trust products are like a bond, except the yields are really high, around 15 or 20 percent. It missed those payments on the bonds and trust products.

It also couldn't pay its suppliers. To build homes, you need concrete, you need steel, and you need a bunch of construction workers. In many cities where Evergrande had projects, it was not able to pay the suppliers of those goods and services. That leads to another kind of problem: a lot of buyers of Evergrande properties had paid Evergrande for these properties already, years before they were completed. This is the practice called presale in China. Now these people are wondering if they are ever going to get the apartments that they already fully purchased. It's very precarious for all of the creditors of Evergrande. They face big losses. For the suppliers of Evergrande, they already gave a lot of cement and steel to the company, and they don't know if they're ever going to get paid. A lot of people are affected by this.

How is the situation with Evergrande intertwined with and reflective of China’s broader issues with debt? Many people are pointing to parallels with China's use of debt-fueled investments to stimulate economic growth. Is this a fair characterization of Chinese economic strategy, and how does Evergrande illustrate the potential risks of such debt policy?

All of the real estate developers are linked to economic growth at the local level in the provinces of China. These days we talk a lot about Huawei, Alibaba, and Tencent. All of these tech companies are based in a small handful of provinces in China, including Zhejiang, in Beijing, Shanghai and Guangdong Province. Outside of these four places there's actually very little consumer-facing technology; there's additional military technology, which is more dispersed. For a lot of local governments outside of these tech centers, their growth comes from property development.

These property developers don't have a lot of money, and they typically borrow most of the money that they need to build up apartments. Sometimes they borrow twice: they're borrowing from the banks, and at the same time they're borrowing from people who are buying apartments from them, because of this presale practice. They're collecting the buyers’ money years in advance. It's highly, highly levered. This borrowing helps fuel a building boom that has lasted in China for over 20 years, and which has contributed to two or three percent of GDP growth every single year. It has been a very important engine of growth in China, but also very levered. People have been predicting that this would run into some kind of trouble, and it finally is. Still, that doesn't mean that there's going to be a financial crisis.

China has a notably large real estate sector, with estimates from Goldman Sachs valuing the market at $52 trillion in 2019, making it twice the size of the US residential housing market, yet some 20% of homes sit empty. How serious is the issue of overbuilding?  How serious is the overall debt leverage of the real estate sector in general?

There are two linked pieces here. In the United States, we typically think using borrowed money to buy a property. In that case, you have to pay interest every month. If you do that, then you need to generate some income from the property. Otherwise, you're losing money every month, and that's not a very good investment. As a result, many people try to rent out their properties to generate some cash flows. The problem in China is that 20% of the apartments are sitting empty.

If all those people were to try to rent all those units out, rent would decrease dramatically in China and a lot of people who have borrowed money to buy investment properties would not be able to service their debt.

In China, there's a weird phenomenon which has to do with the nature of its financial system.

When people in China invest, especially wealthy people, they don't have a lot of options. They can't really take their money out of China to invest in other capital markets. There are some very, very narrow channels for them to do so, with a tight quota. In the aggregate, the total amount of money that Chinese investors can take out of China legally cannot exceed approximately $100 billion. This sounds like a lot, but it's not, because the Chinese financial system totals trillions and trillions of dollars. Since citizens have to invest in China, they either have very low yield bank accounts, government debt that also has very low yield, the incredibly volatile stock market, or real estate. Real estate has traditionally been seen by high-net-worth investors as a very safe option. Up to this point, real estate has always appreciated. Even if there's some downturns for a few months, within one year it always picks back up. 

A lot of investors in China are happy to buy and hold. They don't even need a mortgage to begin with, so there's no cashflow pressure. They just buy properties and let them sit empty. Even if they don't rent them, they're satisfied with the appreciation, and they didn't borrow money to buy them in the first place. The 20% of property that sits empty is not a huge problem, because the people who own the empty apartments don't need the money. They're just watching the appreciation. It does become a problem, though, if people believe that there's a permanent downshifting in real estate prices. That causes some of the investors to want to sell their property when they believe that it has reached its highest value. 

The longer property prices are depressed, which is currently the case, the more that real estate prices will come down. Usually, after six months of this, prices come back up. If it stays down for another half year or year, then more people are going to want to sell their 20% of empty apartments, or slow down their buying. Then we would have a real kind of price correction on our hands, which will affect a lot of different people. Even if most of the people who owned these empty apartments didn't borrow money, some did, and they're going to sell in a panic. Property developers who borrow a lot of money to build new projects will be in trouble because no one is going to buy them. Their suppliers will be in trouble, and their creditors will be in trouble. As a result, there could be a cascading Japan-style property-led depression in China.

Recent protests outside of the Evergrande headquarters have been in the news. What are the real-world repercussions of the Evergrande crisis?  Are we talking about an inflection point that could set off a series of crises in China?

The people who are protesting are the property buyers who bought apartments from Evergrande.

They don't know if they're going to get them, because construction on the properties that they purchased has stopped. A lot of these people are in the middle class, and even if they're not going to live in these flats themselves, that's their life's investment. The reason why they're protesting is influenced by the idea of rightful resistance described in the literature. Basically, the insight from the literature is that even though political protest is not generally tolerated in China, when people do protest it’s because the law is on their side. If you buy property, you're supposed to get it; the law actually is on your side. When you protest for those sorts of reasons, you're not punished as harshly, and this is what we're seeing. Also, if you protest on these more “legal” issues in China, then the Chinese government will sometimes step in and help you out. 

The protestors are hoping that the government is going to intervene, and going to make sure that their apartments get built. Indeed, we're seeing some effect of this; the central government has ordered the provincial governments to try their best to take over some of these Evergrande projects, and to make sure their completion happens. The problem is that the provincial governments don't have a lot of money, so they have to borrow, and the banks are actually not supposed to lend money to provincial governments to build real estate. That's against regulations. As a result, either the regulations will have to be broken, or these apartments are not going to get built. The provincial governments have these companies called local government financing vehicles. If they're not able to secure the finances, then they also can’t take over Evergrande projects. In that case, the projects are still not going to be built, and these people will have to keep protesting. Right now, we've seen a few cases of these takeovers, and maybe the projects will be completed.

Clearly, the government would like to teach Evergrande a lesson, so that that's another reason why it is tolerating the protests. However, when you have protests, there is always a risk for authoritarian governments that the backlash spreads to other issues. Originally, this is just about Evergrande, but eventually other groups could join in, such as disgruntled workers or pensioners who are not getting paid their due pensions. If those other groups join in, then that's when the government will typically crack down. This would happen through censorship online and by actually arresting the leaders of these protests. When groups join together, even with economic rather than political grievances, that's seen as dangerous to the Chinese government.

Some people are speculating that the Chinese government may step in to restructure Evergrande. What might such a restructuring look like? 

There are two ways this can go. One is the HNA Group example, where the government just took over the entire company. In that case, the initial shareholders lost all of their equity, and they got nothing back in return. It doesn't look like this will happen to Evergrande at this point. If that were going to happen, then the government would have taken over the company already. It's already in deep enough trouble to justify an outright government takeover, but that has not happened.

At this point, it looks like the government will likely force Evergrande to sell up to 50% of its assets, and it will arrange buyers for those assets. If the government simply told Evergrande to sell 50% of its assets, it would heavily discount them, which would trigger an all-out panic in the property market. Then, when Evergrande got the money from heavily discounted sales, it would not be enough to pay back the creditors anyway. When it got into this trouble, Evergrande’s debt was worth 80% of its assets. If it discounts those assets by 50%, it still can't repay its debt.

Instead of allowing Evergrande to discount its assets, the government would prefer to arrange buyers for the asset who will pay a higher percent. This will allow Evergrande to repay its creditors and to shrink its balance sheets at the same time. Of course, the problem is that people don't want to buy those assets at high prices. There are all of these negotiations going on where the government is giving bonuses to incentivize people to buy. These kinds of negotiations take a long time, and a lot of these deals are being worked out right now.

Turning to the effect of the Evergrande situation on global markets, what ramifications are we seeing from this crisis? Thus far, it seems as though Evergrande has focused on repaying domestic debts, leaving foreign investors concerned. How does this affect China’s standing with foreign investors? What recourse do foreign investors have?

Foreign investors don't have a lot of recourse. They can sue in a Chinese court, but historically, they haven't gotten very far. Evergrande has always been in a high-yield category, which is a risky category. Investors who buy high-yield expect a certain degree of risk, but now they're going to be more careful when it comes to Chinese property developers before they buy their bonds, or investors might demand an even higher yield. Still, the yield of Chinese real estate is quite attractive at a time when U.S. Treasury is being issued at around 1.5%. Chinese developers can get 10% or 12%. It's multiple-fold of the returns you can get from a U.S. Treasury bond. 

Even large U.S. corporations like Apple, or even some of the real estate in the U.S., you're getting only 2.5%. Even though it's risky, and Evergrande is going to lead to some losses, investors already anticipate that, and they may demand slightly higher yield. 

At the end of the day, as long as the property market doesn't completely crash, a lot of investors will still want to buy Chinese property bonds. In a world where the yield is so low, they still offer a very attractive return. As an investor, you have to prepare for the day when some of it goes bankrupt, and you lose all your money. But as they say, that's the name of the game. You take some risks for high return. At this point, the market is not going to completely crash. This could change if people see a permanent downward shift in the property market in China. In theory, this has to happen at some point, because the population in China is going to shrink very rapidly in 10 years’ time. Still, for bond investors, 10 years is a long time, and they want their 10% a year return. That's the investment community for you.

Jessie Miller CMC '23Student Journalist

Windmemories, CC BY-SA 4.0 <>, via Wikimedia Commons

Share this:

Leave a Reply

Your email address will not be published. Required fields are marked *