All eyes on whether China will bail out Evergrande or allow controlled detonation

Singapore

CHINA Evergrande may have temporarily averted a default on its coupon payment last Thursday, but all eyes are on how Beijing intends to handle the country's most indebted property developer whose fate it has partly orchestrated as it clamps down on debt-fuelled growth: will it be a bailout or a controlled detonation?

After all, in a bid to force deleveraging among property developers, China imposed a "three red lines" guidance last year to improve the financial health of the sector which is facing growing debt levels, rising land prices and booming sales.

Evergrande, one of the fastest-growing developers in China, missed all three red lines: liability-to-asset ratio (excluding advance receipts) of less than 70 per cent; net gearing ratio of less than 100 per cent as well as cash-to-short-term debt ratio of more than one time. Naturally, it has suffered intense pressure from the new borrowing constraints.

Martin Hennecke, head of Asia Investment Advisory and Communications at St James's Place, said the biggest focus is still on Evergrande's bond interest payments (a second payment of US$47.5 million on another bond is due on Wednesday).

But over time, attention may shift to other areas such as repayments on financial products and the situation of unfinished properties. Evergrande has already sought to deleverage through sale of assets, among others, in the run-up to the recent crisis, but these did not materialise fast enough.

"Therefore, at this stage, the question should be more about what the Beijing central government's options are, because it seems likely that a degree of government intervention and or support will be needed to manage the situation," Mr Hennecke told The Business Times.

Alfredo Montufar-Helu, a director at The Economist Intelligence Corporate Network in Beijing, noted that Evergrande has 240 billion yuan of interest bearing debts that are due within one year.

"Without any indications from the Chinese government of a possible bailout, creditors' hopes are likely on a debt restructuring plan which liquidates non-core assets and allows the profitable, real estate part of the business to continue operating in order to minimise losses," he said.

Goldman Sachs experts have been urging Beijing to communicate its plans to help diffuse uncertainties surrounding Evergrande from spreading to the broader property market.

"In our view, the current level of uncertainty is contributing to unsustainably high funding costs for developers, very low levels of sales activity, and a halt in activity at many of Evergrande's current projects," they said, adding that a sharp deceleration in the property market could exacerbate and amplify the downward pressure on China's economic growth and labor market.

Light the bomb or defuse?

Beijing is basically torn between two different, and at times, conflicting agendas; namely the reduction of speculation, debt and moral hazard on the one hand, and the preservation of social and financial stability on the other, Mr Hennecke said.

"It should be clear that it was the former 'clean-up drive' that triggered the present crisis in the first place," he said.

While investors are debating whether Beijing will let Evergrande fail, analysts have highlighted that the non-performing loans (NPLs) in the banking sector have been cleaned up, with NPL ratios averaging1.76 per cent, which is very low by global standards.

Shadow banking has also been reduced steadily during the past five years to 55.4 per cent of gross domestic product (GDP) today, from 123 per cent of GDP in 2016. Reserve requirement ratios are still high, compared with most other markets.

At a macro-level, China's fiscal position and financial reserves are strong, which means China has the financial resources to deal with potential fallouts.

Mr Hennecke reckoned Beijing wants unfinished properties to be completed and investment monies on financial products returned to retail investors, to avoid major contagion risks.

"A full bailout however does seem unlikely, ie, I would anticipate some form of haircut for some investors as part of the crisis management process," he said.

China will not allow Evergrande to collapse as it risks triggering systemic contagion and social instability, Mr Montufar-Helu said. A collapse could weaken further consumer confidence and lead to a fall in housing prices, which would severely impact people's wealth. Some have estimated that housing makes up three-quarters of household wealth in China.

Evergrande is estimated to owe up to 1.6 million unfinished apartments to home buyers, as well as billions of yuan in wealth management products sold to credit investors without providing complete information on the risks, and without paying due consideration to their credit profiles and financial literacy.

"But this certainly does not mean that Evergrande will be nationalised, which would amount to bailing it out," Mr Montufar-Helu said.

He reckoned the Chinese government is wary about exacerbating moral hazards in the property sector, which would run opposite to its efforts to deleverage and reduce financial risks, stop speculation and make housing more affordable.

"Instead the government is likely to broker a partial bail-out for assets most connected with social stability," he said.

Examples of other financially-troubled companies suggest that the government could ultimately take control over the company and a creditor committee would be established to help restructure its debt, which will include liquidating the company's non-core assets; and instructing state-owned companies to absorb the salvageable parts of its business and take over unfinished real estate projects, he said.

Goldman Sachs'experts reckoned one possibility could be to find third parties, or "white knights", to take over Evergrande's onshore property business as part of a debt and equity restructuring.

"This could be done nationally or at the provincial or city level, potentially involving a consortium, and could include government-linked entities," its experts said.

The latest media reports have pointed to some involvement of local governments and state-owned enterprises (SOEs) although the situation is fluid and uncertainty is great.

They warned that the outcomes of previous China SOE defaults were not consistent across cases, and with 800 property projects in over 200 cities, any resolution for Evergrande is also likely to be significantly different from the government's approach with regional banks such as Baoshang Bank, which was taken over by Chinese authorities in May 2019. Approvals have been given for the troubled bank to start bankruptcy proceedings in the final clean-up of China's first bank failure in decades.