What China Must Do to Contain Evergrande Fallout

China’s second-largest real-estate developer by revenue—with liabilities equal to around 2% of the country’s gross domestic product—is in danger of going under. After weeks of ignoring Evergrande’s wobbles, on Monday Wall Street finally stood up and listened: the S&P 500 dropped 2% and global bond funds, some of them invested heavily in Chinese developers’ dollar debt, retreated. Evergrande must pay approx. $115 million in bond interest on Thursday, and is fending off protests and court cases from its domestic suppliers, customers and investors.

A default on dollar debt or at least a deep haircut is likely. Large-scale financial turmoil in China isn’t inevitable. If Evergrande’s woes further infect the broader real-estate market or Beijing doesn’t act quickly enough to restructure the company’s businesses and its onshore debts in an orderly manner, it may not be far behind.

In years past, such a large, important firm would almost certainly have been bailed out. Housing is the third rail of China’s political economy—where most household wealth is parked, a giant liability for China’s banks, and tied to around a fifth of economic activity. But President Xi Jinping has demonstrated a far higher tolerance for economic risk than his immediate predecessors, in part because he has cowed potential rivals so effectively. Evergrande’s woes are a direct result of a new, steely-eyed policy forcing developers to meet tough metrics on debt instituted last year.

As long as onshore financial contagion is manageable, Xi may allow some bondholders—particularly foreign ones—to be wiped out in service of larger policy goals. And so far, signs of that broader onshore contagion are limited. One reason: many of Evergrande’s large domestic creditors like banks are owned by the government, which can both force them to absorb immediate losses and also tide them over with liquidity while working to engineer eventual recapitalizations. Beijing has repeatedly demonstrated its capacity to corral debtors and big creditors and force them to come to an agreement behind the scenes, as in the case of Baoshang Bank’s 2019 crisis.

Evergrande’s offshore bonds are trading at deeply distressed levels. And yields on the dollar bonds of some other large, highly indebted developers like Sunac have shot higher, too: Sunac’s June 2022 issue, which was trading at a 6% yield in early September, now yields 17%, according to FactSet. But, although onshore money-market rates have risen modestly, there are few signs of contagion to key bank funding instruments or to the onshore bond market more broadly outside of real estate.

The real problem isn’t Evergrande’s big creditors but the small ones and the damage to already-weak real-estate sentiment more broadly from an extended, messy reorganisation. That could quickly translate into broader problems for the industry as a whole, the real economy and banks.

Evergrande has massive borrowings but it also owed, as of June, around US$180 billion to individual homeowners, its contractors and others in the form of outstanding accounts payable and so-called contract liabilities—mostly unbuilt homes owed to buyers. More than half of its projects nationwide have been halted, according to local financial media outlet Caixin. And this comes as nationwide housing sales are already down 20% year over year by value in August.

The last thing China’s real-estate market and its financial system need is a buyers’ strike from homeowners watching Evergrande customers get stiffed. To hit new regulatory targets by mid 2023, Chinese developers in aggregate need to shed 18 trillion yuan ($2.78 trillion) of liabilities over the next two years, according to Goldman Sachs. And that assumes no further land purchases over that time period. Robust housing sales will be needed, but unless Beijing acts swiftly to ensure that Evergrande’s customers get their due, arresting the steep drop in national housing sales may prove difficult.

The simplest solution would be a government-mediated takeover of Evergrande’s unfinished projects by a group of other developers in exchange for Evergrande’s existing inventory and massive land bank, lubricated with additional state finance. But with the land market already frozen up—transactions by value were down 90% in the first 12 days of September year over year, according to Nomura—developers are presumably dragging their feet. If the situation drags on and Evergrande has to keep pawning off its existing properties at fire-sale rates, that could also be a further drag on the property market as a whole, given how large the company is. Evergrande alone accounted for around 4% of the residential property market in 2020, according to Fitch Ratings.

The land market itself is another possible route for financial contagion, since land sales form such an important part of local government revenue in China. So-called local government financing vehicle (LGFV) bonds, used by local governments to get around formal budget constraints, account for a significant proportion of the market: around 30% of total outstanding onshore bond debt, after excluding formal government and policy bank bonds, according to Wind.

Clearly much depends on how quickly Beijing is able to assemble a coalition of developers to assume Evergrande’s contract liabilities or find another solution to avoid a disorderly sale of its assets and a big financial hit to its customers and suppliers.

If a solution does appear soon and Beijing acts to further ease overall monetary policy, there are some reasons for cautious optimism that China can still avoid a truly punishing property downturn. Prices in major coastal markets were still mostly rising in August, although many smaller so-called third- and fourth-tier markets are beginning to turn down. And property inventories nationwide are much lower, on average, than at the beginning of the last major housing downturn in 2015, which could help put a floor under prices if sentiment itself recovers a bit: one-and-a-half years of sales, according to ANZ Bank, against two-and-a-half years in 2015. Finally, although Chinese banks have large mortgage exposure, unlike in the U.S. Chinese mortgages are generally “full recourse,” meaning debtors remain on the hook for payments even after losing their home. That may help keep delinquencies in check, even if prices do fall sharply.

A significant hit to growth in late 2021 and early 2022 does seem unavoidable now, but if Beijing acts decisively it could still avoid something worse. The next few weeks—usually the frothiest season in China’s real-estate market—will be crucial.