A group of state-owned financial institutions will recapitalize Huarong, the state-owned financial conglomerate that fell into distress after the ex- chairman was convicted of bribery and later executed. Though Huarong’s exchange filing did not reveal details of the state bailout, the announcement effectively ends the suspense over whether Beijing would permit a major state- owned financial institution to default on foreign currency bonds. But privately-owned Evergrande, China’s largest property developer by sales revenue, remains under pressure as bond maturities loom and the housing market slows.
A previous note on Huarong and Evergrande forecast that both companies would likely receive bailouts, given their systemic importance and the risk of financial contagion if either one defaulted. The Huarong rescue partly confirms that forecast, but Evergrande’s stock and bonds continue to trade at steep discounts, suggesting that investors doubt if Evergrande will receive comparable treatment. But we still believe an Evergrande default is highly unlikely. For policymakers, the risk-reward calculus of allowing an Evergrande default remains tilted heavily towards risk.
Chinese policymakers believe they can address financial risk and moral hazard in the housing market without running the risk of a disorderly Evergrande default, notably through macroprudential regulation. Regulators have sharply restricted home mortgages and developer loans this year. At the 30 July Politburo meeting, leaders signaled that these restrictions would remain in place and possibly even escalate, despite a general shift towards monetary and fiscal easing. Unofficial data for August showed year-on-year declines in housing and land sales accelerating, while the flow of credit to the sector is still shrinking. Though free-market purists will argue that market discipline is preferable to administrative controls as a tool to address excessive leverage in the housing sector, policymakers are unlikely to be persuaded, given the risks. They may also believe that the losses that some Evergrande bondholders absorbed during this period of uncertainty has already served to instill a degree of market discipline.
To be sure, defaults by smaller property developers are not uncommon in China’s onshore bond market, though not in the Hong Kong dollar bond market. Such defaults have already set an annual record this year, driven by the macroprudential tightening. This trend will similarly serve to reinforce market discipline in Chinese credit markets, but Evergrande’s extraordinary size and geographic scope puts the company in a different category. Evergrande is reportedly already offering discounts on properties to accelerate sales, but an outright fire sale could destabilize the entire housing market. Moreover, allowing Evergrande to default on offshore bonds in Hong Kong would threaten US dollar financing for the broader universe of Chinese developers.
An Evergrande rescue will not necessarily take the form of a discrete, publicly announced recapitalization plan like the one that Huarong disclosed. Instead, Evergrande is reportedly exploring asset sales to improve its capital position and fund debt repayments. Authorities may also quietly nudge potential buyers to assist these disposals, while instructing banks to provide bridge loans to ensure the company remains liquid while restructuring proceeds. The banks most likely to be recruited into such a quasi-bailout are those already exposed to Evergrande. Insofar as these bridge loans are unprofitable, this arrangement can also serve as a form of light-touch market discipline.