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- Rumors about financial distress at China’s largest property developer have raised questions about which companies Beijing considers too big to fail.
- Policymakers have become more selective about providing bailouts as they seek to discourage moral hazard, but preserving social and financial stability remain top priorities.
- The Chinese government is unlikely to allow a large, systemically important company to collapse, but some investors could still face forced restructuring or haircuts.
Investors are worried about Evergrande Group, China’s largest property developer by sales and its most indebted non-financial listed company after a letter circulated online purporting to show that the company may be unable to meet upcoming repayment obligations to investors.
Evergrande says the purported letter was forged, and this claim is plausible, given that the company’s Hong Kong-listed stock has often been the target of short sellers. Even so, the company’s own official disclosures make clear that Evergrande’s debt risks are significant. Evergrande’s stock and bond prices have largely recovered from sharp falls suffered in late September, after the company announced a deal with investors to relieve some short-term repayment pressure. But the company’s medium-term outlook remains uncertain, and the incident raises broader questions about whether companies like Evergrande are too big to fail.
Market discipline vs. social stability
China has taken significant steps to address moral hazard in the financial system over the last decade. The country’s first domestic bond market default occurred in 2014, and defaults have become common in recent years. Privately-owned companies are the most common defaulters, but several defaults by state-owned enterprises (SOEs) have also occurred. Legal bankruptcies have also soared in recent years, after decades during which insolvencies were mostly handled in extralegal, closed-door negotiations in which local governments exerted a heavy hand.
Nevertheless, the Chinese government is still unwilling to let market forces decide large companies’ fate when officials believe that doing so would ignite financial or social instability. SOEs are most likely to receive bailouts, since allowing one state group to fail can affect the ability of others to obtain financing. But local government-owned SOEs are less likely to receive government support than central government groups, given local governments’ limited fiscal resources.
Property is king
For privately-owned companies like Evergrande, the picture is cloudier. On the one hand, several factors suggest that Beijing would be unlikely to let Evergrande fail. First is the extraordinary role of residential property in China’s overall economy. Including the impact on upstream and downstream sectors like steel and furniture, property contributes somewhere between 15 and 25% of China’s GDP.
For the financial sector, land and buildings are the dominant form of collateral for bank loans of all kinds. For households, property is the main source of wealth, and political and economic elites often own multiple apartments. A disorderly collapse of Evergrande could spark a fall in housing prices, especially of creditors sold off the company’s inventory at fire-sale prices. Evergrande’s size and interconnectedness with the financial system would also make it a likely candidate for a bailout. The company reportedly owes money to 171 banks and 121 other financial institutions, in addition to institutional and retail bondholders.
On the other hand, a bailout for Evergrande would cut against several broader political and policy trends in China. First is an effort to restrain excessive debt among developers. In August, regulators launched a pilot program that would limit borrowing by regulators whose debt ratios exceed several “red line” thresholds. Evergrande is one of 12 developers to whom the regulations will apply initially, before being rolled out industry-wide next year. The company has surpassed the red line for all three ratios – liability-to-asset, net debt-to-equity, and cash-to-short term debt. The policy is designed to reduce financial risks directly related to developers and to restrain increases in housing prices, which rise when developers enjoy easy access to bank financing, enabling them to bid up land prices.
Picking winners and losers
On balance, it remains highly unlikely that the government would permit Evergrande to enter bankruptcy or default on a publicly traded bond. But this stance does not necessarily mean that all the company’s creditors and investors will be shielded from losses. The principle goal of government bailouts and restructurings is to avoid economic and financial contagion. While this goal sometimes requires protecting all investors, in other cases, certain stakeholders may be forced to swallow losses or at least delayed repayment to reduce the fiscal cost of a bailout.
When choosing which creditors stakeholders must absorb losses, legal principles of debt seniority do not always carry the day. Rather, considerations about social and financial stability influence which stakeholders are protected. In terms of social stability, employment is a crucial factor. If maintaining a company as a going concern will protect a substantial number of jobs, the government may choose this option, even if it means forcing creditors to absorb greater losses than they would in a liquidation scenario.
Another priority is protecting retail investors. Officials most fear images on social media of angry mom-and-pop investors demonstrating outside bank and brokerage offices, demanding the return of their “blood and sweat money.” Retail bondholders, therefore, often enjoy greater protection than they would in a legal bankruptcy.
In terms of financial stability, avoiding market contagion and panic selling is a key consideration. Policymakers often prefer to lean on state-owned financial institutions to refinance or restructure loans – or even accept haircuts – rather than to allow a default on a publicly-traded security. Unlike bond defaults, loan defaults do not generally require public disclosure or affect market sentiment.
The case of Baoshang Bank offers a possible model for how a company like Evergrande could be resolved. The Baoshang resolution wiped out equity holders and forced 10% losses onto interbank and corporate creditors, while fully protecting retail depositors. The bank’s assets were sold off to other institutions, who may have faced political pressure to buy at above-market prices. While the government would be less likely to allow a liquidation of Evergrande – which is systemically important to China’s property sector in a way that Baoshang was not to the banking sector – the basic approach of a politicized resolution in which losses are imposed selectively is a plausible model.