- Evergrande appears highly likely to default on US dollar bonds, contrary to our previous forecast that the company would receive a government bailout.
- But the government is not adopting a pure laissez-faire approach and will participate in the restructuring, which may include bailouts of selected creditors to preserve social stability.
- A politicized hierarchy of creditors will likely prioritize homebuyers, suppliers and construction contractors, and retail investors ahead of institutional investors.
The earliest maturity on Evergrande dollar bond is not until March 2022, but default now appears virtually inevitable. Such a default would be unprecedented and runs counter to the Chinese government's long history of bailing out systemically important companies. But in the end, the sheer scale of Evergrande debt rendered a full-scale bailout prohibitively expensive. Moreover, despite Evergrande controlling shareholder Hui Ka Yan's 25 years of savvy government relations, the company is still privately owned, which limits the relevance of precedents like the recent bailout of state-owned Huarong.
With the benefit of hindsight, our earlier forecast also relied too heavily on Evergrande's long history of escaping from debt distress, due in large part to Hui's deep relationships with other Guangdong and Hong Kong property tycoons, who have repeatedly stepped in with financial support at crucial moments in the company's history. Hui typically returned the favor later by investing in those tycoons' equity or debt when needed. But Hui's resignation as chairman in mid-August was a sign that his old magic had worn off.
Policymakers have apparently weighed the high fiscal cost of an Evergrande bailout against the likelihood that limited credit defaults and selloffs of unfinished Evergrande housing projects will not spark systemic contagion in either the housing market or the banking system. Though Evergrande was China's largest developer by sales revenue in 2020, the company still maintained only a 4% market share in the country's highly fragmented housing market.
In the banking system, a central bank stress test published on 3 September concluded that even in a scenario of severe housing market stress – in which defaults on both home mortgages and developer loans exceed the likely impact of an Evergrande collapse – the banking system's overall capital adequacy ratio would only fall by about 2 percentage points. This finding probably helped persuade regulators that a full-scale bailout is unnecessary.
Neither bailout nor laissez-faire
Still, the dilemma between protecting market stability and avoiding moral hazard (and the corresponding fiscal cost of a bailout) remains a difficult balancing act, given that a disorderly Evergrande default and liquidation still poses significant risks to the broader housing and credit markets. Beijing's apparent decision to allow some defaults does not mean that policymakers are adopting a pure laissez-faire approach.
Evergrande remains unlikely to enter formal bankruptcy, and regulators will be deeply involved in the company's restructuring. Guangdong provincial officials have reportedly hired lawyers, accountants, and financial advisors to assist with Evergrande's restructuring. As previously discussed, regulators will likely still recruit state-owned banks and property developers to participate in Evergrande's restructuring, including through asset purchases and loan re- financings that do not reflect pure market pricing. One prominent rumor suggests that state-owned Poly Property will participate in the restructuring.
Housing market impact
Broader conditions in China's housing market will influence policymakers' decisions on Evergrande. The company's troubles track a broader downturn in China's housing market, where sales fell 20% year-on-year in value terms in August, while prices in the secondary market inched lower month-on-month for the first time since February 2020. This slowdown is the intended result of policies enacted since late 2020 to restrict mortgages and developer loans. Still, the nightmare scenario is a fire sale of Evergrande assets that transforms a healthy market correction into a rout.
For Evergrande, the market-wide slowdown was compounded by the flow of negative news about the company, which destroyed homebuyers' confidence that the company could complete unfinished projects offered for pre-sale. This collapse in confidence sparked a vicious cycle in which Evergrande's falling sales destroyed banks' willingness to provide the additional loans needed to complete those projects. The good news for regulators is that most of Evergrande's unfinished projects are probably still viable based on market fundamentals. Restructuring Evergrande -by wiping out existing shareholders – and/or selling unfinished projects to healthier developers – would likely revive the marketability of those stalled projects.
A politicized creditor hierarchy
The government's involvement means that political decisions about which creditors should be repaid first will take precedence over legal principles of debt seniority. Beyond its RMB 572bn (USD 89bn) in financial debt, Evergrande also owed RMB 951bn in payables at the end of the second quarter. The latter figure includes homebuyers who have placed down payments on unfinished flats as well as suppliers and construction contractors.
With social stability and the political imperative to protect workers and small businesses in mind, regulators are likely to prioritize those groups over other stakeholders. Homebuyers have already engaged in protests around the country, demanding refunds, while suppliers and contractors have filed lawsuits. A third group, retail investors in Evergrande wealth management products, has staged protests demanding their promised investment payouts. Policymakers are likely to prioritize all three of these groups ahead of banks and institutional bond investors.
A key question is where offshore dollar-bond investors sit in this politicized creditor hierarchy. Prices on offshore dollar bonds now imply haircuts of more than 70%. Still, dollar-bond investors may ultimately fare better than onshore financial creditors, though worse than the other groups mentioned above. The reason is that policymakers want to ensure that the broader universe of Chinese dollar-bond issuers maintains access to the offshore market. While the Evergrande fiasco will increase onshore financial institutions' sensitivity to credit risks in the housing market, onshore institutions are still highly subject to strong-arming by mainland regulators, who want to ensure that at least some credit continues to flow. By contrast, the offshore dollar market is largely market-driven. Ensuring that the offshore market continues to function therefore requires limiting the damage to offshore investors.
