China debt: Evergrande’s fate shows ‘too big to fail’ may no longer apply as crackdown gathers steam

This is the sixth part in a series of stories looking at China’s economic outlook in the second half of 2021 as it continues its recovery from a coronavirus-hit 2020.

On July 1, under cloudy skies in China’s capital, Hui Ka Yan, the 63-year-old billionaire chairman of the nation’s second-largest property developer, walked through Tiananmen Square as part of Beijing’s celebration of the Communist Party’s centenary.

The head of China Evergrande flashed his trademark smile as he posed for photos at one of the nation’s most culturally significant sites, surrounded by some 70,000 onlookers who had gathered at the huge square.

His appearance among China’s ruling elite was seen as a sign of political favour for the country’s most-indebted developer, but it did nothing to prevent his company from falling deeper into a crisis two weeks later after a court froze some of its bank deposits.

The court order caused a sharp slump in the firm’s share and bond prices that hurt overall market sentiment, but it also stoked concern that the company’s toxic debt level would lead to defaults in hundreds of its partner firms and financial institutions, putting the income and jobs of millions of people in danger.

Evergrande is perhaps the most prominent of an expanding list of high-profile companies under threat from extravagant borrowing in recent years. Its financial and political troubles come amid growing concern about systemic financial risks in China, due in part to a sharp rise in corporate debt levels.

Beijing has made reducing debt, or deleveraging, one of its top policy priorities, as extensive credit expansion is seen as a ticking bomb at the heart of the world’s second largest economy.

To keep a lid on rising property prices, Beijing has put pressure on developers like Evergrande.

“Amid credit tightening, financial deleveraging and a decline in liquidity, debt risks in property companies, local government financing vehicles and zombie enterprises have begun to surface, some of them have already been caught in liquidity crises and are on the verge of not surviving,” Ren Zeping, the former head of Evergrande’s research institute, wrote in a note on July 26.

“It is necessary to estimate and prepare for the downward economic pressure” resulting from the government’s deleveraging campaign, said Ren, who now serves as the chief economist at Soochow Securities.

Consequences of the debt-reduction programme are already starting to be felt, with the tighter credit environment leading to more – and larger – corporate bond defaults. This trend is expected to continue, testing how well the country is able to reduce moral hazard without causing significant economic pain.

Indebted companies with only limited profits may be unable or unwilling to invest more in production facilities if they are required to pay old loans to meet regulatory requirements, which could hit the country’s economic momentum in the second half of the year, analysts warned.

China’s ratio of outstanding debt to gross domestic product (GDP), or the so-called macro leverage ratio, declined to 265.4 per cent at the end of June from 267.8 per cent three months earlier, down for the third straight quarter, according to data from the National Institution for Finance and Development (NIFD) under the Chinese Academy of Social Sciences (CASS).

The debt-to-GDP ratio shot up to a record of 285 per cent in the third quarter of 2020 as China pumped money into the economy in response to the pandemic.

The leverage ratio of non-financial corporations had improved for the fourth consecutive quarter as of the end of June, declining to 158.8 per cent, after pandemic-related stimulus sent the figure to a record high of 165.2 per cent a year earlier, the CASS figures showed.

China had temporarily achieved a “beautiful deleveraging”: a scenario in which the debt-to-income ratio goes down without resulting in broad deflation while achieving positive economic growth.

However, behind the seemingly healthier financial picture, the principal amount of onshore corporate bonds defaulted on rose to 62.4 billion yuan (US$9.9 billion) in the first six months of the year, up 18.9 per cent from a year earlier, according to Fitch Ratings.

The value of maturing bonds in China was likely to rise to between 5 trillion yuan and 5.4 trillion yuan in the second half of the year, from 4.9 trillion yuan in the first half, Fitch said.

S&P Global Ratings also sounded the alarm about a possible increase in bond defaults in the second half of the year, given the large size of maturing debt, tighter government policies and the erosion of financial flexibility among local governments due to the impact of the pandemic on their revenue bases.

S&P warned there were more Evergrande-sized conglomerates at risk of default in the future, with average outstanding onshore bonds some 1.6 times the size of last year and nine times that of 2015.

“China is shifting its growth model to focus on efficiency … this means more tolerance for defaults of unfit firms, including SOEs,” the agency said in a note on June 21, referring to state-owned enterprises.

“China’s corporate bond default rate has been rising but remains abnormally low versus global markets.”

Since late 2020, several high-profile bond defaults among SOEs have shaken investor confidence that local governments will always bail out local firms to avoid systemic risks.

This April, China Huarong Asset Management, the nation’s largest bad-debt manager, failed to publish its 2020 results, another wake-up call for investors that even central government-owned institutions might no longer enjoy blanket guarantees from Beijing.

“Increasingly more mainland companies have got into financial problems, which has made the market reconsider whether those that are ‘too big to fail’ may also fail,” analysts at Everbright Sun Hung Kai said in a note on July 27.

Beijing policymakers announced stricter regulation of corporate bond issuance in April, requiring issuers to disclose additional information on debt-servicing capability. Before that, the central government imposed new restrictions on the ability of major property developers like Evergrande to borrow capital.

Property developers suffered the most defaults in the first half of the year, with the sector’s net new financing at a negative 47 billion yuan, meaning it became harder to borrow as companies were forced to repay large amounts of debt, according to data from Zhongtai Securities.

China’s pledge to reach carbon neutrality by 2060 is also likely to put liquidity pressure on metals and mining companies in coming months, with investors less willing to lend given the uncertain outlook for the sector.

Top Chinese decision-makers have shown they are paying attention to the potential negative impacts of deleveraging, repeatedly stressing the need for “cross-cyclical regulation” during recent conferences and surprisingly cutting banks’ reserve requirement ratio last month.

“The key variant for [China’s] monetary policy in the second half of the year is not inflation but debt,” Peng Wensheng, chief economist at prominent investment bank China International Capital Corporation advised in an article at the end of June.

The NFID report warned that if companies rush to repay their debts as soon as they make a profit, and there is no new investment, “it is likely to cause a balance sheet recession.”

While there is concern that private-sector firms have become the major victims of leverage containment, the debt ratio of SOEs has continued to rise, according to Zhang Xiaojing, director of the NFID.

“It can be seen that there is also a serious problem of fairness in deleveraging,” he said at the Qujiang Forum in Xi’an in late May.

Downward economic pressure is expected to mount for China in the second half of the year, as weaker exports and the recent Delta variant outbreaks weigh on activity - a preview of which was seen in the decline of the purchasing managers’ indexes in July.

In the meantime, the impact of the Evergrande drama continues to ripple through financial markets.

Last Friday, S&P downgraded Evergrande and its subsidiaries by two levels to CCC, one of the lowest levels of junk and just two notches above the designation for borrowers that have defaulted, citing an escalating risk of non-payment on debt. The move was the agency’s second cut in under two weeks, and Moody’s and Fitch have taken similar action.

“Unless the government tightens demand severely, the solvency risk [for Evergrande] will remain low,” Raymond Yeung and Xing Zhaopeng, economists at ANZ Banks, said in a note last month.

“However, the mismanagement of its debt maturity may still lead to financial risks.”