Can Evergrande make it through another year?

The bigger they are, the harder they fall.
The bigger they are, the harder they fall.
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As bad as 2021 was for Evergrande, the Chinese real-estate giant floundering in debt, it was at least still around as the year drew to a close. By the end of 2022, Evergrande as we knew it may altogether cease to exist.

That is, admittedly, the most dire prognosis, but it isn’t an outlandish one. After Evergrande defaulted on an $82.5 million coupon payment to bondholders overseas in early December, it stood on the precipice of becoming China’s biggest-ever defaulter, its offshore bonds worth $19.2 billion. A total collapse will ignite a market crisis in China and also—per the Federal Reserve—in the US.

Whether that happens or not depends on the Chinese government, and on what it decides to do with Evergrande. So far, the state has been reluctant to bail the company out altogether, lest it seem as if it will always rescue businesses that behave recklessly. But the fallout of collapse is likely to be so vast that China will feel compelled to intervene. How that happens will reveal volumes about the near future of China’s economy—and the world’s economy as well.

How Evergrande got to the point of collapse

The story of Evergrande feels like some kind of parable, but it’s hard to know what to learn from it. The lesson could be about another instance of capitalism gone rogue. Or it could be about the consequences of a capitalist experiment within a statist economy. Or it could be about a slow but certain pivot in what China wants from its economic future.

Close observers had seen this coming. Like many other developers, Evergrande fed on easy debt for decades to build and sell residential and commercial towers. These were speculative assets rather than places in which to live and work, so a glut of overpriced real estate flooded the market. Anne Stevenson-Yang, the co-founder of J Capital Research, which publishes reports on Chinese listed companies, recalled seeing the results of this bubble as she traveled through China: ghost towns, “an endless inventory of office parks and apartments, all empty.”

Evergrande was among the biggest of these developers, racking up roughly $300 billion in debt. The company counted its inventory of homes and offices as assets, so its books looked healthy, Stevenson-Yang said. Such practices worried the Chinese government so much that, last year, it issued a policy compelling property firms to clean up their books and be more stringent about the debt they took on. The policy came to be known as the Three Red Lines, after the three conditions it set down.

The policy worked, in a way. “Last summer, 21 of the top 30 real estate firms breached at least one of the three red lines,” Julian Evans-Pritchard, a senior economist at Capital Economics, said in September. “Now that is down to eight.” But the policy also served as a ruinous corrective to an over-leveraged giant like Evergrande. Through the latter half of 2021, it teetered from crisis to crisis, missing one bond payment after another, watched apprehensively by those who feared a collapse. At least 10 smaller companies suffered as well; the luxury developer Fantasia Holdings, for instance, started missing bond payments in October.

The course of these companies in 2022, and of Evergrande above all, will determine how China resolves this festering real-estate crisis: whether the government has the appetite for a bailout, or whether it can find other ways to prevent Evergrande’s risky debt from infecting the world’s financial markets.

What an Evergrande implosion could look like

It isn’t evident that Evergrande’s collapse will be akin to the bankruptcy of Lehman Brothers in 2008. Evans-Pritchard said that he wasn’t overly worried about the contagion risk to China’s banking system. He did say, though, that the wider housing market could suffer badly. Evergrande owes 1.7 million people apartments they’ve already paid for. If those homes cannot be delivered, housing prices could plunge in an already-slumping market.

Worse still, for the Chinese government, severe social unrest could ensue—among homebuyers who feel cheated by Evergrande, or among citizens watching the erosion of their real estate’s value in a market dip, or among investors suffering the effects of a wider financial shock. China has always been wary of such discontent, lest it translate into broader anger against the Communist Party.

But Evergrande may not necessarily unravel in quite so alarming a fashion. On the brink of defaulting on its December bond payment, Evergrande formed a seven-member committee to deal with its risk levels; the committee includes four officials from government agencies in Guangdong, the province in which Evergrande is headquartered. The default itself forced Evergrande to announce that it would “actively engage with offshore creditors” in a debt restructuring exercise—one that would automatically involve government authorities.

A slow, stable restructuring might stave off a sudden implosion, but it will doubtless be long and controversial—particularly as nearly $3.5 billion of its dollar debt will be due for repayment in the first half of 2022. Regulators will have to establish a “waterfall”: a hierarchy by which the various lenders to Evergrande get preferentially repaid. Bondholders overseas—including BlackRock, UBS, and Allianz—are likely to find themselves near the very bottom of the waterfall, because the government will probably prioritize Chinese lenders, investors, and homeowners in a bid to contain domestic damage from Evergrande’s struggles.

The restructuring will also signal the government’s determination to prop up the financial system and housing market. Ensuring that homebuyers receive the apartments they were promised or their money back, for instance, would settle jitters in housing; periodic injections of liquidity will allay financial markets; a full-fledged bailout, if one becomes necessary, will be the strongest sign of reassurance. In turn, these moves may revive confidence in an economy that is starting to decelerate; in the third quarter of 2021, the economy grew by a little less than 5% compared to a year earlier, a slide from nearly 8% the previous quarter. In addition to its real estate crisis, China was hit by energy shortages as well as a prolonged slowdown in consumer spending.

China may be aiming consciously for slower but more stable and equitable growth, analysts think. Nonetheless, the government will want to avoid a pronounced loss of investor confidence in its economy—the kind that will doubtless follow a cataclysmic default by Evergrande, setting off shock waves at home and overseas. For Evergrande, 2022 will therefore be a year of discipline and dramatic restructuring—of slimming down even to the point of unrecognizability, where Evergrande becomes a different company altogether.