It looks like Evergrande, the great-grandaddy of China’s property bubble, is finally going to collapse. What will that look like?

The short answer is that investors, lenders, and apartment owners lose. Insiders win. China’s financial system remains standing. Governments at every level ramp up repression.

Evergrande project in Guangdong Province in 2018
Photo by Anne Stevenson-Yang

Evergrande is now swirling the drain, and the world is waiting for it to go down. The share price of the parent, 3333 HK, is down 76% from where it started the year. In August, Xu Jiayin, Evergrande’s founder and one of China’s wealthiest men, stepped down as chairman of the property group. Trading in the company’s bonds has been suspended in Shanghai. Police descended on Evergrande’s office building in Shenzhen Monday when individual investors in the company’s myriad “wealth-management” products gathered to demand repayment.

There are two things that make this company’s distress extremely dangerous to the Chinese government: its scale and its effect on Chinese individuals who thought they had bought a ticket to the middle class.

First, scale. Publicly acknowledged debt is $300 bln. That is 2.4X the $123.8 bln cost of the bailout of the savings and loan industry to the U.S. government in 1998-99 and twice the $169 bln direct cost of the 2000-2001 Chinese bank bailout, both of which had enormous consequences for their respective economies.

Second, number of people affected. Evergrande is essentially a Ponzi, collecting cash from the pre-sale of an ever-growing number of apartments, plus hundreds of thousands of individual investors, and using the cash to fund further sales by accelerating construction in progress and funding down-payments. Like any Ponzi, this works as long as it’s accelerating. When the market slows, those incoming streams of cash start to fall behind the growing arc of cash demands. Evergrande now has about 800 unfinished projects, and there are about 1.2 million people waiting to move in, according to press reports.

MORE FOR YOU

Construction abandoned at Evergrande Harbin in 2018
Photo by Anne Stevenson-Yang

But worse than that, few buyers purchase an Evergrande apartment as their primary residence. Apartments in China are like mutual funds in the U.S.–the investment vehicle of choice for people aspiring to the middle class who–with good reason–do not trust the banks. And Evergrande has explicitly catered to these people, choosing locations that fall just outside of areas that restrict the number of units a person may buy and advertising the developments as second homes. All over China, salesclerks and factory workers are sitting on empty Evergrande apartments and dreaming of selling them at a big mark-up to fund their children’s study abroad or their own retirement.

Personally, despite 25 years living there, the greatest public outrage I have seen in China is not over random arrest and abuse, bribery, or shakedowns: it is over property values. Hell has no fury like that of Chinese investors who have lost money in Evergrande loan derivatives or apartments that have declined in value. Indeed, WeChat and TikTok are filled with videos–posted faster than they can be deleted–of protests at Evergrande offices. Evergrande reportedly told employees in Shenyang, Liaoning to work from home to avoid the protests.

To cauterize the bleeding, the Chinese government is likely to force a restructuring. What will that look like?

Let’s look at some historical cases. First, the bailout of wealth-management products or WMPs, the Chinese version of mortgage-backed securities, the financial sausage casings that banks and brokers stuff with mortgage loans, equity and bond derivatives, private equity investments, and all sorts of other financial products. These are the vehicles through which the Chinese public has invested in Evergrande. And they clearly are not paying out even on principal, much less return.

The last publicly disclosed WMP bailout was in 2014, when a consortium of banks was required to refinance the roughly $500 million hole left by the default of the Credit Equals Gold WMP, which had been used to fund a dead coal company. The original trust behind the product got its money back. Losses were absorbed by the banks. After that, Chinese bank regulators threw a snit fit and tried to force banks to reduce their off-balance-sheet exposure–which by some accounts had reached around 90% of GDP. The new regulations forced a number of bank mergers and saw many small regional banks quietly go bust. But in many cases, the banks have reacted as banks do, by recategorizing their off-balance-sheet obligations. This may be part of what’s behind the government’s determination to gut Ant Financial.

Cranes are seen at the construction site of an Evergrande housing complex in Beijing on September … [+] 13, 2021. (Photo by GREG BAKER / AFP) (Photo by GREG BAKER/AFP via Getty Images)
AFP via Getty Images

A few restructuring cases:

1. Kaisa Group: This developer defaulted on about $2.5 billion in bonds in 2015 and was accused of fabricating financial reports that claimed a big cash balance. In the restructuring deal, neither the founder’s family’s 49% nor the 30% of shares owned by Sino Life were diluted. Bondholders received a choice of a deep haircut or refinancing with high-yield bonds. Local governments, though their property arms, quietly took over many of the projects.

2. Dalian Wanda: This developer restructured in 2017 by selling assets in the U.S., Europe, and Australia, including the AMC theater chain and the Spanish football club Atletico Madrid. In 2021, Wanda was still struggling to pay off $56 bln in debt. Forbes in 2013 rated founder Wang Jianlin as the richest man in China. He is still worth nearly $15 bln.

3. HNA Group: The Chinese government forced a consolidation of this company’s hundreds of affiliates, leading to widespread defaults by HNA affiliates like Bohai Leasing, the Irish company Avolon Holdings, and Hainan Airline Holdings. A Chinese bankruptcy court said that 67,400 creditors had filed JPY1.2 trillion of claims. Losers have included shareholders of Hilton Grand Vacations (HGV
HGV
), Temasek (shares in Hainan Airlines), shareholders in Park Hotels and Resorts (PK), but not, as far as we can tell, owners of HNA Group.

Wanda Theme Park. Harbin Wanda Cultural Tourism City opens on Jun. 30, 2017, in the city of Harbin … [+] in north-eastern China. With a 20 million yuan investment, it features attractions, most notably the word’s largest indoor ski resort, Wanda Snow Park which allows ski-lovers to ski all year round. The project also includes Wanda Theme Park, Wanda Movie Park, Central Grand Theatre, Wanda Mall etc. Mr. Wang Jianlin, Chairman of Dalian Wanda Group gave a speech at the opening ceremony. 30JUN17 SCMP/Simon Song (Photo by Simon Song/South China Morning Post via Getty Images)
South China Morning Post via Getty Images

Message:

1. Non-core and especially overseas assets will be hived off and sold at whatever the market will bear.

2. Public market investors will lose out.

3. Chinese individual investors in Evergrande’s wealth management products and empty apartments will lose their shirts. When they object, they will be silenced.

4. Unfinished developments will become the responsibility of local governments.

5. Evergrande founder Xu Jiayin will remain very wealthy until domestic protests reach a crescendo requiring that heads roll. Then he will either go to jail or remain a fugitive overseas.

The end of the dream that ever-rising property values will bring prosperity to the average family in China is a politically combustible phenomenon, yet Evergrande is of a scale that indicates it cannot be completely bailed out and debts hidden. As owners of the apartments and the debt come out into the streets, rubbing their eyes, everyone should steel themselves for brutal repression.

A worker cleans a display area next to the construction site of an Evergrande housing complex in … [+] Beijing on September 13, 2021. (Photo by GREG BAKER / AFP) (Photo by GREG BAKER/AFP via Getty Images)
AFP via Getty Images

Read More