China Evergrande’s massive accounting fraud sheds light on the country’s property troubles
- The company is unlikely to be the only one that has cooked its books, as it’s an open secret that ‘marked-to-market’ assets can be sold at deep discounts
- China Evergrande’s fraud can be traced to its excessive borrowing, which was impossible to sustain after central authorities imposed the ‘three red lines’ in 2019
Massive accounting fraud at China Evergrande, once the country’s largest property developer, is adding insult to injury. While personal greed and the misconduct of its chairman Hui Ka-yan certainly led to the fraud, the saga points to deep troubles in China’s real estate market.
According to the Chinese Securities Regulatory Commission, China Evergrande inflated its sales by 564 billion yuan (US$79 billion) over a two-year period from 2019 to 2020, and fabricated its profits by 92 billion yuan. It is the largest known case of financial fabrication in Chinese history.
The regulator has imposed fines on the group and Hui, as well as banning the former chairman from accessing the capital markets for life. The administrative penalties are expected to be only the start of Hui’s punishment. As he has been placed under investigation but not yet charged, Hui is set to face legal consequences down the road.
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The immediate implication is that China Evergrande did not have the money it once claimed, which has translated into additional costs and burdens for other stakeholders left to clean up the mess. China Evergrande was already a black hole, and the 564 billion yuan fraud revelation has just made it harder to cover up the hole. In a broader sense, the misdeeds at China Evergrande could imply structural problems with China’s property sector. The company is unlikely to be the only one that has cooked its books, and it’s an open secret that “marked-to-market” property assets can often be sold at deep discounts to their book value – if there are any buyers.
Developers, along with local authorities that control the land supply, are supposedly the biggest winners from China’s property market boom, but the reality is that both are badly indebted. On the one hand, Chinese municipal authorities have lavishly and quickly spent their windfall revenues from land sales. While the revenues from selling 70-year use rights for land are supposedly meant to support long-term local development, cadres often rushed to spend the money on airports, subways, museums, stadiums and parks.
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In a similar way, the debt of Chinese property developers has also accumulated due to structural reasons: they have to borrow to maintain operations. China Evergrande’s fraud can be traced to its excessive borrowing, which was impossible to sustain after central Chinese authorities imposed the “three red lines” in 2019, which squeezed credit for developers, making it hard for indebted developers like China Evergrande to survive. It had to lie to creditors to keep going. Had China Evergrande admitted in 2019 that its revenues were halved from 2018, it could have collapsed then.
Under China’s plan for deflating the property bubble, Beijing has given priority to completing in-construction projects. As protests over undelivered flats have mushroomed across China, authorities are under pressure to deliver “purchased” flats to homebuyers. After that, property developers are expected to pay suppliers and contractors, so that contractors will have the money to pay construction workers to ease social pressure. Onshore and offshore financial creditors are the last to be served.
The fraud at China Evergrande has made it less likely it can repay its financial creditors, and the fallout will not be limited. The handling of China Evergrande is just a piece of the puzzle in showing how China manages its property slowdown. The music has stopped and the house is in disarray, but there are no stakeholders willing to step forward to clean up the mess. Beijing has good reason not to rescue any private developer, while banks will certainly be more prudent in lending money to developers and be more selective in accepting collateral. To make matters worse, Chinese consumers have become reluctant to buy property even when prices are on a downward path.
As Hui and China Evergrande face their destiny, it is worth noting that there was a chance over a decade ago to avoid the mess of today. When short-selling agency Citron Research called China Evergrande “essentially an insolvent company” in the summer of 2012, the full-year revenue of the group in 2011 was 62 billion yuan. China Evergrande won the battle then, and critical voices were silenced, but its troubles just got bigger until there was no way to cover them up.
