China’s Evergrande

Last Monday markets slipped on concerns that the Chinese firm Evergrande was facing a debt default. Though the S&P 500 recovered its losses over the rest of the week, the story of Evergrande is still unfolding. 

Michael Pettis at the Carnegie Endowment for International Peace provides an excellent overview of the Evergrande meltdown. Evergrande is China’s most indebted developer, with over $300 billion in debt, amidst an economy already awash in debt from business enterprises, local governments, and households. Chinese regulators, who have struggled to curb excessive reliance on debt financing, implemented 3 new rules last year, capping a company’s debt to asset ratio, debt to equity ratio, and cash to short term debt ratio. The impact of these hard limits cascaded rapidly through the economy. Many firms could no longer borrow and, in order to pay down debt, sold assets at fire sale prices, which in turn led to losses that worsened their debt ratios, necessitating further debt payments.

Further complications have arisen from the fact that the property development market is enormous in China (accounting for up to 25% of GDP), and that the country is in the midst of a housing bubble in which housing prices are much larger relative to household income than they were in the US during its housing bubble, and over 20% of properties are uninhabited and held by speculators. Chinese regulators were thus hoping to reduce debt while cooling the housing market.

Moreover, the Chinese government was simultaneously seeking to address the moral hazard problem in Chinese development. Borrowing had always been easy for large Chinese companies because it was assumed that these companies would never be allowed to default, and so credit markets showed very little differentiation. Not surprisingly, companies that expected government to cover their losses need have no qualms about risky speculation.

So, the Chinese government is trying to avoid a bailout of Evergrande while also not allowing Evergrande’s financial difficulties to spread throughout the economy. In other words, China is trying to restructure the entirety of its credit markets from a “too big to fail” philosophy to…well, we’re not sure what, and neither are Chinese companies. Who will be able to access credit, at what prices, and with what guarantees, if any? And can Chinese credit markets be restructured without too much downstream damage to home sales, construction, and employment? Chinese regulators are attempting what appears to be critical adjustments to credit markets, but the devil will be in the details.

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