The property sector and its debts are possibly the biggest financial mess in China’s history.
By Wolf Richter. This is the transcript of my podcast of last Sunday, THE WOLF STREET REPORT.
The crackdowns by Chinese authorities on some of the biggest hype-and-hoopla industries have sent investors heading for the exits. There is a crackdown on debt to keep the financial system from imploding. There’s a crackdown on property speculation to tamp down on housing prices and on debt. There’s a crackdown on big tech – mostly internet, social media, and online gaming companies – for their monopolistic size and practices and a slew of other issues.
There’s a crackdown on education tech companies that sell off-campus educational courses that have driven the costs of education into the sky, discouraging Chinese couples from having more than one child. There’s a crackdown on all kinds of other activities that include reporting financial news and analysis in a way that the government doesn’t approve.
There are all kinds of reasons for these crackdowns, including the push by President Xi to create “common prosperity,” which has become a mantra to fight the ballooning wealth disparity linked to the surge in asset prices, including home prices that are now making homes unaffordable for the masses.
The crackdowns already resulted in some spectacular effects.
Wall Street is heavily involved in the stocks and bonds of these companies, both in the US and in China, many of which have dropped sharply, and some have collapsed.
Many Chinese companies have issued American Depositary Receipts, or ADRs, such as Alibaba. These ADRs aren’t actual stocks but were issued by an offshore mailbox entity in the Cayman Islands or wherever, that has a contract with the actual company in China.
Wall Street firms make a fortune setting up these ADRs, selling them to investors, managing them in their mutual funds and ETFs, etc. Wall Street makes money coming and going on these ADRs.
But those ADRs have unraveled. The Golden Dragon China ETF, which tracks these ADRs, has plunged by 46% since February, unwinding the entire pandemic hype-and-hoopla spike.
In the Chinese markets, China’s crackdown has caused the shares of affected companies to plunge by a combined $1.5 trillion in a matter of months at the low point a little while ago.
But now these Wall Street titans that made huge amounts of money from China’s debt bubble, from the wild property speculation, from monopolistic tech companies, from the hype and hoopla, from their dealings in China, well, they’ve had enough of these crackdowns.
A Wall Street delegation composed of top executives from Goldman Sachs, mega-asset manager BlackRock, PE firm Blackstone, Citadel, Fidelity, among others, had a three-hour powwow on Thursday with Chinese regulators that included the vice-chairman of the China Securities Regulatory Commission and the head of the People’s Bank of China.
There was no official announcement, but sources talked to Bloomberg about it. According to these sources, Chinese regulators defended the crackdowns, and said that they were designed to strengthen regulations, improve data privacy – which is an even funnier concept in China than in the US – strengthen national security, and reduce social anxiety.
Some parts of these crackdowns are a combination of silly and scary. But other parts of the crackdowns should have happened a long time ago and would have been a lot less painful then.
Cracking down on monopolistic Big Tech companies, well, hats off – given what we’ve got in the US where Big Tech has run the show for years with monopolistic structures and behaviors, and the government is just now gingerly trying to use antitrust lawsuits to confront them.
But these US companies have now gotten so huge and have unlimited resources, with market capitalizations that exceed $1 trillion or even $2 trillion each, that they can throw money around for lobbying and legal maneuvers, and they will drag this out for years, outgunning the government lawyers at every twist and turn. The US antitrust actions are way late. This should have happened years ago before capital was this concentrated and companies this big and powerful.
Maybe China learned a lesson.
In China, there is nothing gingerly about it. The government has put down its foot to allow for more competition and to shake up the sector, knock down the power of the billionaires a few notches, and reduce wealth inequality from the top down.
And these widespread crackdowns already accomplished one thing: They began to deflate this enormous hype and hoopla apparatus about stocks and IPOs and risky debt and iffy wealth management products.
Most crucial is the crackdown on the property industry, with its mega-amounts of debt. Smaller developers have already defaulted, and others are approaching default.
Evergrande is China’s second largest property developer. It’s opaque and huge. It has 200 offshore subsidiaries and nearly 2,000 onshore subsidiaries that it owns either wholly or partially, according to Goldman Sachs. And it’s on the verge of collapse.
It owes bondholders, banks, shadow banks, suppliers, contractors, homebuyers, and retail investors the equivalent of over $300 billion. A portion of its debts are junk-rated dollar bonds that it sold to international investors in the offshore market.
The property sector and its debts are possibly the biggest financial mess in China’s history.
Last year, Chinese authorities drew the so-called “three red lines” into the sand for real-estate developers. These are leverage ratios that developers cannot exceed. And if they exceed them, they cannot take on new debts.
Evergrande hit those red lines and could not take on new debts. This prevented the company from raising new money to service its existing obligations, and it is now defaulting serially on just about everything that comes due.
Evergrande has already paid suppliers with now worthless corporate paper when it ran out of actual money. These suppliers are now protesting in the streets. It started paying contractors with unfinished apartments instead of with actual money. The contractors are trying to sell those unfinished apartments of dubious value. It has already defaulted on interest payments on loans. Etc. etc.
Evergrande’s debts are tightly woven into the broader financial sectors and derivatives, and that’s one of the avenues by which contagion would spread if Chinese authorities lose control over the process.
But Chinese authorities have some unique tools to prevent a financial panic: The state owns the largest four banks and can tell them to lend. It owns the central bank and can tell it to do whatever it takes. It can lean on large asset managers and brokers to buy shares and bonds. It owns much of the media and can lean on other outlets and thereby controls the message.
On Thursday, September 23rd, interest payments on two onshore bond issues are coming due. If Evergrande doesn’t make those interest payments, it would be in default of these bonds, its first bond defaults, and at some point, creditors are going to attempt to salvage what is left.
The crackdown on debt and the vastly overindebted property sector has hit shareholders, bondholders, and other creditors. It looks like regulators are implementing a forced deleveraging of the sector. And it looks like, finally, bondholders and shareholders will get to eat the losses from this forced deleveraging rather than getting bailed out. And it looks like China will then attempt to prevent the spread of contagion from there.
Evergrande raised money for years by borrowing from banks and issuing bonds, and it borrowed directly from retail investors by preselling them apartments in unfinished projects and by selling them wealth management products, and this worked for years with loads of new money coming in to pay interest and principal to existing investors.
Evergrande has presold over 1.4 million unfinished apartments valued at $200 billion, according to research firm Capital Economics, cited by the Wall Street Journal. It thereby borrowed from its customers to finish the apartments. But now the money is gone and many of those projects aren’t finished. And work has stopped on those projects because Evergrande hasn’t paid contractors and suppliers.
Chinese middle-class investors sink their life savings into apartments like Americans buy stocks. The wealthy buy multiple apartments. They do this not necessarily to be rented out but for capital gains.
Evergrande took some of this money it had raised from these investors and expanded into EV manufacturing, theme parks, healthcare services, and bottled water. It’s now trying to sell those assets.
But that may be tough. The publicly traded portion of the shares of its EV company, China Evergrande New Energy Vehicle Group, trade in Hong Kong. And they totally collapsed, including by an additional 15% on Friday. They’re down 95% from the peak in April.
With Evergrande, regulators were successful in both tamping down on debt and on property speculation. It looks like they will not bail out the bondholders and other major creditors. It looks like they’re trying to make an example of Evergrande.
But then there are the many retail investors that are owed apartments and retail investors that have sunk their life savings into Evergrande’s wealth management products; and the suppliers and contractors that haven’t been paid. And when they’re protesting in the street – which they have started doing – Beijing will likely step in to bail them out in some form, as it has done before in similar situations, because it fears social instability even more than the implosion of the financial system.
And it looks like the government is going to accept the crackdown’s spill-over effects into the broader economy as the lesser cost, and they seem confident that they can keep contagion under control with the tools that they have.
I assume that Evergrande will undergo a debt restructuring in some orderly fashion, rather than a disorderly collapse, with unfinished properties getting handed to other developers to finish, and with creditors, bondholders, and shareholders picking through the debris and taking their losses.
And it looks like shareholders are going to be hit the hardest, as should be the case in a debt restructuring. But there is a twist.
Evergrande’s founder and his wife own the vast majority of the shares. Evergrande has paid out $5.3 billion in dividends to its shareholders since October 2018, according to the Wall Street Journal. The vast majority of these dividends went to the founder and his wife. The dividends and the shares, when they were still worth something, put the founder among the richest people in China.
Even if the company collapses and the shares go to zero, the founder and his wife will still have the billions they received in dividend payments. And they will remain immensely wealthy unless the government decides to crack down on them further.
Taking another pair of billionaires down a few notches fits into the recent theme of clipping the wings of billionaires before they get so rich and powerful that they could threaten the government. Alibaba founder Jack Ma and others have already undergone that treatment. And it would help address the rising wealth inequality that was caused by soaring asset prices, and it would do so by bringing the top down.
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