China’s Japan, not Lehman, Moment

By Ichiro Suzuki This is what has been expected for a very long time. Too much debt in the overextended real estate sector would inflict serious blows to the Chinese economy one day. China Evergrande, the second largest real estate developer in the country, is facing a growing chance of default of its fixed income securities. The size of liabilities is estimated at $300 billion that is 2% of China’s GDP. Driven by China’s loose credits as well as the lure of strong growth potential, real estate developers borrowed aggressively to fund projects that were designed to change the face of large cities. Competition among local governments also fueled land speculations as they offered cheap finances and opaque structures to solicit investors, or speculators. It has been speculated that failures of large scale real estate developers were going to bring down the Chinese economy, possibly taking down banks wth it. After decades of strong, sometimes spectacular, growth, there is no shortage of excesses in the economy. Only several weeks ago, China Huarong Asset Management was bailed out. A possible financial market upheaval that Huarong’s collapse might have brought is bad enough, of course. It is even worse, if it was caused by a state-owned institution, that has been controlled by the Ministry of Finance all the time. The authority managed to arrange a rescue through Citic, another state-owned institutions. The authority does not seem to be interested in bailing out every private sector real estate developer or financial institution that runs into difficulties. There are many of them, for sure. However, those who have been waiting for China’s Lehman moment are already disappointed. A panicky implosion of the financial system witnessed in the fall of 2008 is not assigned a high probability in the framework of China’s real estate problems. A financial vehicle called collateralized debt obligations (CDO) became a centerpiece in bringing down the financial system in the U.S. and elsewhere. CDO is a package of mortgage loans of a variety of credit qualities. Tranches of good quality mortgages loans consisted the vast majority of a CDO as a package. Below investment grade loans represented a small portion, and a whole package was still of good quality on a weighted average basis. So they were stamped AAA. As it turned out, defaulted low quality mortgage loans eroded the value of what were originally good quality tranches, eventually bringing down the value of the entire package totally. This utterly unexpected development severely damaged banks’ capital base. A variety of investors owned CDOs lured by a combination of high yields and quality, and Lehman Brothers and other banks were loaded with unsold inventories. All of them witnessed value of their CDOs evaporate. This was dubbed as the 21st century’s financial crisis because of an unprecedented way it happened. In contrast to the development that led to Lehman Brothers’ collapse, Evergrande is facing a very classic, plain vanilla crisis. They simply borrowed too much. Of the $300 billion+ liabilities, over a half consists of bank loans, with most of the rest being fixed income securities, essentially in RMB. The company also sold its employees high yield investment products whose principals are not guaranteed. As opposed to the nightmarish experience of the 2007-09 Global Financial Crisis in which no one was able to tell precisely who had CDOs by how much, it is relatively simple to pinpoint where the risks are even if there are over 2,000 lenders to Evergrande. If Evergrande fails, its stockholders are going to be wiped out, of course. Investment products holders are going to suffer the same fate as stock holders, however loudly they shout at Evergrande’s headquarters. Holders of dollar denominated bonds would get 25 cents out of a dollar, according to the valuation the market is giving these securities. Holders of RMB bonds and lenders might receive more than 25, especially if the communist party decides to bail out Evergrande through a backdoor. Despite official denial, the CCP might choose to do it secretly in the face of risks to the financial system that Evergrande’s failure poses. Most likely, banks would be forced to live with Evergrande for the foreseeable future. They would have to work out Evergrande loans sometimes extending fresh loans to keep the company afloat in one way or the other. Credits to Evergrande would not be non-performing, but could be low-performing that hardly contributes to banks’ profitability. There is a chance that loans of sub-par performances become industry-wide problems, since other developers than Evergrande are likely to suffer the same plight, to a certain extent at least. Working out Evergrande debts would be unproductive use of bank capital and could adversely affect long-term health of the economy. In the U.S. subprime crisis, less-than-creditworthy people were allowed to borrow aggressively to buy a dream house without much down payments, and then defaulted the loans easily, to start all over again. This conduct exacerbated the quality of the lowest tranches of CDOs, but prevented households from greater pains of being tied to debt for a very long time, possibly for life. In contrast in China, homebuyers overwhelmingly make deposits with a developer, essentially out of their savings, and then wait for their condo to be completed. While banks don’t suffer through mortgage defaults, house buyers are deeply hurt if their houses are not delivered as promised. According to the Evergrande website, there are 12 million owners in 1,300 projects around China. If the company fails to deliver houses on time, or delivers nothing at all, a spectacular number of owners would be stuck with unfinished condos, and be under severe financial strains. And Evergrande might not be the only one to renege on their obligation to deliver condos. House prices would find it hard to rise as once hoped, and most likely fall in the event of a wider crisis. Since houses represent the bulk of household wealth, macroeconomic implications of weak house prices could be huge, making a significant dent in private sector consumption. Deterioration of household balance sheet due to house prices’ fall was one of the main reasons behind the Japanese economy’s stagnation in the 1990s and beyond, along with the crippled banking sector and lost competitiveness of the electronics industry. A broadly defined real estate sector accounts for 29% of the Chinese economy and about a half of the sector is represented by private corporations. In a hypothetical situation in which all sectors in the economy grow 6%, and then the private real estate sector (15% of the economy) comes to a standstill to register a zero growth rate, then the growth rate of the economy as a whole would fall to 5.1%. On top of the real estate sector, China’s frenzy on fixed asset investments has been well documented, be they railways, airports, roads, bridges, dams. As the economy’s growth rates peak out, returns from these investments fall. Such over-dependence needs to be corrected, and President Xi Jinping is well aware of the necessity. It is right to let an over-extended developer struggle or reduce fixed asset investments to achieve a structural shift. Reducing over-dependence on fixed asset investments can come with costs, unless other sectors fill a slack left by shrinking sectors. Private sector consumption is a prime candidate to pick up such a slack, and that is the wish of President Xi. However, already over-leveraged households are likely to suffer from deterioration of their balance sheets due to weak house prices. They may find income stagnating due to struggles of heretofore growth engine. Punishing billionaires doesn’t make an average man on the street richer. The Chinese Communist Party and the People’s Bank of China have carefully studied the process the Japanese economy fell into stagnation after the late 1980s bubble, so as not to repeat the same policy mistake. The key lesson for the PBOC was never to over-tighten money in the fashion of the Bank of Japan at around 1990. So the PBOC kept money relatively loose, and this was consistent with a global trend of the time. Loose monetary policy in turn kept brewing mini-bubbles in the real estate market, adding up further debt up to a point not even the second largest developer have found it hard to service it. The CCP and the PBOC would make sure to prevent a panic from erupting. Working out a mountain of debt would be a long and painful process. After all, China is on the brink of falling into a slow-burn, protracted crisis that Japan had to live with for years. About the author: Mr. Suzuki is a retired banking executive based in Tokyo, Japan.

Is China’s Evergrande Group too big to fail? Huarong bailout