China’s number two real estate developer, Evergrande, is facing difficulties in making bond interest payments to its investors. Concerns have been raised amongst the financial industry as the company currently stands under US $305 billion worth of debt, and up until now, the company has missed the deadline for two payments, one totaling US $47.5 million and the other US $83.5 million. [1] Among other factors, the large amount of debt and interest payments has led experts to believe that Evergrande is likely to go bankrupt, something which can have a huge impact on the Chinese financial and real estate market and could potentially impact the global economy as well.
Evergrande’s asset value currently stands at US $367 billion and so far the company has been involved in many sectors including finance, health, tourism, automotive, and sports. Like many real estate developers, Evergrande has been using several financing methods to grow. The main method used has been debt financing as opposed to equity financing because in the real estate industry debt interest rates are lower than the rates given in other industries. Evergrande has been mainly borrowing from banks and it important to know is that the Chinese banking system is mainly controlled by the government. Lately, the government has been controlling interest rates, causing the financing cost of real estate enterprises to increase. [2]
Although debt financing is not discouraged amongst the industry, real estate developers are required to maintain a certain debt-to-equity ratio in order to be eligible for receiving further loans. In China, the ratio threshold is less than 0.7. [3] Along with two other requirements, (Net gearing ratio of less being less than 100% and the cash-to-short-term debt ratio being more than 1x) the debt-to-equity requirement was introduced in 2020 by the Chinese government as a part of the deleveraging campaign intending to reduce systemic risks in the financial system. [4] Currently, the debt-to-equity ratio of Evergrande stands far above the 0.7 threshold. [5]
As a result of not being in line with the aforementioned requirements, a year ago Evergrande was placed under debt limits from the banks. This made it difficult for the company to maintain a capital flow and thus attract financing. [6] As a result, the company could not complete its real estate projects and consequently was unable to generate sales and profit. Understandably, this increased Evergrande’s exposure to default risk, and as pointed out in the previous paragraphs, the company is now missing loan and interest payments’ deadlines.
The main problem stands in the fact that the company is too entrenched in China’s economy as it employs 200.000 people and uses 3.8 million contractors to complete its projects. A case of bankruptcy, therefore, would cause huge unemployment. Moreover, the debts extend to several parties such as trust companies, banks, suppliers, and customers. Out of the categories, customers are expected to suffer more directly because the company is not only unable to repay their loans but also unable to deliver the promised houses, which at this point remain unbuilt. As regards banks, Evergrande’s default could lead to cross-defaults due to the nature of the inter-banking system.
Although the balance sheet demonstrates that the asset value exceeds the liability value (the former being US $367 billion and the latter being US $305 billion), the company is not able to pay its debts because out of the current asset value, US $196 billion represent property that is in development. The actual meaning of that category stands for houses that are not built yet, which, unfortunately, cannot be considered to represent real market value or worth of repaying debts.
The question remains, however, in case the Evergrande goes bankrupt will the Chinese government step in to bail it out? For now, it is uncertain whether the government will follow this course of action because of the fear of creating a precedent that might encourage other companies to start borrowing aggressively as well. On the other side, however, Evergrande has been considered too big to fail, therefore inaction from the Chinese government’s end would cause distress in the financial market. Regardless of the alternative that the government chooses, investors have to start preparing for new financial reforms that will follow as a result.
Corax Foundation 