China’s Black Swan: Is Evergrande the pin that finally pops the bubble?

Earlier this year, Bloomberg Chief Economist – Thomas Orlik – released his laudable research into China’s debt-fuelled growth over the past two decades (China: The Bubble that Never Bursts). In the account he retraces the expansion of lending to private and public companies by China’s banks that has underwritten exponential development in key strategic areas of the country’s domestic economy from advanced technologies to white goods manufacturing.

One key component of Orlik’s investigation is the rapid development of the construction industry in China and the misuse of state lending facilities that led to the rise of so-called ghost cities: vast residential projects established in provincial towns seemingly left vacant upon completion. He goes to great lengths to explain precisely how the central government identified the markings of this property bubble and quickly moved to shift the focus towards somewhat forced urban redevelopment. The plan was intended to create impetus for demand from private individuals in need of new digs as old inhabitancies were demolished to give the ballooning construction industry a raison d’être.

The debt-fuelled rise of these mammoth construction projects has largely been justified by the likes of Orlik and foreign China bulls, such as Bridgewater founder Ray Dalio, on the basis of sound bureaucratic risk management in a proactive response from economic hawks among the Chinese Communist Party’s policymaking apparatus. In any case, they argued, most of China’s enormous debt piles were denominated in renminbi, so if the worst came to pass and large defaults became a reality the People’s Bank of China (PBOC) and other state banks had the capacity to bail out debtors by printing money – inflating away subsequent public debt and otherwise restructuring repayment plans for constructors.

Such thinking seemed entirely reasonable until, that is, the non-state-owned China Evergrande Group property powerhouse began to incur a liquidity crisis earlier this year. Too cash-strapped to pay contractors to complete some 225 construction projects across China and struggling to sell its finished property portfolio despite offering up to 30% discounts, Evergrande has engaged Houlihan Lokey and Admiralty Harbour to advise on bankruptcy and restructuring plans to serve its astronomical $310Bn debt pile.

The reality for Evergrande is that the blatantly obvious discrepancy between the fundamental picture of its finances and sentiment towards its ability to service its obligations are now decoupling. Therein lies the problem with the received wisdom from Orlik and Dalio: Black Swan events occur precisely because they are quite clearly possible, only no one conceives of them actually happening before it is too late.

So if this truly is China’s Black Swan, what happens next?

The first issue is how Evergrande is advised to seek the restructuring of its repayment plans. At present, any attempt to reduce the debt load buy selling off completed property and other tangible assets would likely incur a fire-sale at bargain basement prices. Current discounts have already proved ineffective, so this option would do little to ease the burden. What’s more, the prospect of delaying coupon payments to existing creditors would only serve to narrow Evergrande’s access to sources of extra liquidity further (though this has now been announced). In such a scenario, it is entirely conceivable that lenders would simply pursue a seizure of assets in lieu of repayments.

The next issue is some $14Bn US Dollar-denominated bonds issued by Evergrande to international lenders on the Hong Kong and Shanghai stock exchanges. Such is the dearth of confidence now held towards the company that the bonds are trading at around 35 cents on the dollar, with several analysts expecting foreign lenders to be lucky if they see 25% of their money returned to them. $7.4Bn of this debt is held by high-profile institutional investors such as Allianz and Blackrock. The losses they are likely to incur could have considerable ramifications for Chinese companies seeking to raise capital from international lenders in the very near future.

This leads to the third and perhaps most crucial point of black swan logic: will this lead to contagion and if so, how far will it spread? In some senses, we’re already seeing evidence of contagion in the domestic property market in China. The inability to sell Evergrande’s assets at the marketed price, even with drastic haircuts, will in turn depress property prices in China at large as a race to the bottom ensues. More importantly, it will effectively make Evergrande’s assets underlying their debts worth far less than the debts themselves, ultimately rendering the company’s – and investors’ – equity worthless. The ramifications of which will lead to a downturn in construction, the need for materials and eventually the desire of consumers to consume. August economic data for the third quarter of the year already indicates the latter, with retail sales growing by a mere 2.5% as opposed to the forecast 7% rise.

A slowdown in China’s domestic markets will consequently slow global growth and with it present the possibility of negative sentiment spreading to other markets and the global real economy. At the very least this would spark a correction in global capital markets and at the very worst spark a collapse in demand, leading to a global recession.

But where does the Chinese State Council and its financial institutions find themselves in this scenario? Until recently it was generally anticipated that the Chinese Government would instruct the PBOC to step in as a lender of last resort – purchasing the existing debts where appropriate and establishing a new repayment plan. With Evergrande engaging advisors on bankruptcy and restructuring, all indications suggest that this is unlikely. This was reinforced when the Ministry for Housing and Urban Redevelopment met with the company’s major creditors this week to inform them that interest due this month will not be paid.

Here the contagion gains yet more complexity. If the collapse of Evergrande truly comes to pass, and it depresses prices in the property market, the raft of property-backed wealth management products that were packaged and sold by Chinese banks to savers – effectively transferring the debts from public to private lenders – in the past decade will lose out substantially. Given the general lack of a social security system able to meet with the demands of China’s rapidly changing demographic, the gutting of private savings accounts may lead not only to economic and financial dislocation but social dislocation too.

The riots outside Evergrande’s offices in a country not known for public displays of private dissatisfaction are a striking insight into how the situation is already being perceived. This leads us back to black swan dynamics: what was entirely conceivable lead to something unforeseeable in as much as one company’s inability to manage its affairs appropriately could result in widespread social strife and a global recession. Some have said this may be China’s Lehman Brothers’ moment. It certainly rhymes with that crisis in places. And thus what was unforeseeable is now entirely conceivable, yet what happens next is still ultimately unknowable.