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China targets debt sustainability over economic growth as Evergrande reels

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Chinese real estate company Evergrande's total liabilities exceeded $300 billion at the end of the second quarter. The company is responsible for a wide range of projects, including high-rise apartment buildings in Wuhan.
Source: Getty Images AsiaPac

China is focused on reducing its companies' massive debt loads even as the country's credit-fueled growth is starting to stutter and the financial challenges facing China Evergrande Group are exposing new corporate vulnerabilities, analysts and economists say.

Evergrande is scrambling to secure capital after missing a mid-September interest payment on one of its bonds, according to media reports. The company declined requests from S&P Global Market Intelligence for comment.

Beijing has not stepped in to aid Evergrande, which carried more than $300 billion in total liabilities at the end of the second quarter, according to Market Intelligence data. That hands-off approach reinforces the Chinese government's new attitude of bringing down total corporate debt, which accounts for almost 160% of the country's GDP. It also means the world's second-largest economy is betting on growth slowing from its pre-pandemic pace, experts say.

"In recent times, the emphasis coming out of Beijing seems to be on 'common prosperity' and reducing inequality, over returning to the massive growth numbers we've seen in the recent past," Vishrut Rana, an economist at S&P Global Ratings, said in an email.

Ratings revised its 2021 GDP forecast for China to 8% from 8.3%, while the expected annual growth rate for the next few years is around 5%, well below the average of 7.7% between 2010 and 2019.

Even with those cuts, Beijing appears steady on its current course.

"China cares about high-quality growth rather than fast but low-quality growth," Iris Pang, chief China economist at Dutch bank ING Groep NV, said in an email. "We think that Beijing is starting to fine-tune policy to balance de-risking and stabilizing growth."

Tackling debt

Evergrande was not alone in borrowing heavily during China's boom years.

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Chinese nonfinancial companies carried a combined debt load equal to 159.2% of the country's GDP as of the first quarter, the most recent figure available, according to the Bank for International Settlements. In the U.S., the total was 85.4%, while other major economies Germany and the U.K. were at 73.4% and 77.8%, respectively.

In its quest to rein in corporate debt, Beijing has been particularly keen to restrain real estate. The sector was a key driver of the traditional Chinese growth model of borrowing to build.

Evergrande's excessive leverage caught up with it in September, when Ratings reported the group was likely to default on an interest payment. Investors fled, which sparked a collapse in price of the company's bond maturing in February 2022 to a low of $24.08 from a par value of $100 in May.

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The company also failed three red lines — thresholds for debt and liquidity — imposed by the People's Bank of China in 2020 that determine whether property developers could tap markets to raise capital.

Share prices of other major real estate developers have tumbled in recent weeks while Fantasia Holdings Group Co Ltd, a smaller developer, missed a payment on a bond on Oct. 4. The potential that suppliers and creditors to Evergrande would be caught out in the meltdown led to some speculation in the media that this could be China's Lehman Brothers moment — a reference to the first domino to fall in the financial crisis that engulfed the U.S. in 2008.

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"Evergrande matters for one important reason: contagion," Robin Usson, credit analyst at the international business of Federated Hermes, said in an email, warning that shadow banking and off-balance-sheet liabilities may produce unexpected casualties.

Ratings took negative ratings actions on nearly 15% of rated real estate developers in China as investor sentiment for the sector weakened. Yet the rating agency believes contagion within the real estate segment is unlikely, as capital markets remain accessible for the largest, more financially conservative developers.

Growth problem

China's economy is a bigger cause for concern for its leaders, particularly as it is struggling to grow in line with the past, experts said.

"While China's economic growth rate has been slowing for several quarters, the evolving situation will undoubtedly harden the landing," Usson said.

China's economic growth decelerated from a peak of 18.3% year over year in the first quarter of 2021 to an expected 3.6% in the fourth quarter, according to Oxford Economics. The property sector is playing a part in that slowdown.

Real estate accounted for 7.3% of China's GDP in 2020, according to the National Bureau of Statistics of China. Analysts estimate that figure is closer to 30% when demand for related upstream and downstream industries such as steel and labor are included.

The reliance of China's economy on the sector is a major threat to the country's future growth, according to Kenneth Rogoff, former chief economist at the International Monetary Fund and noted chronicler of financial crises.

"China's real estate sector has become so large that absorbing a significant housing slowdown would significantly impact overall growth," Rogoff wrote in a Sept. 21 paper.

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New home sales were down 22.5% year over year in August while land sales fell 21.7% and were dropping even further in the first half of September, according to Japanese bank Nomura Holdings. Land sales account for 46% and 84% of the fiscal revenue of central and local governments, respectively, while property-related taxes account for 20% of China's total tax income, according to Bruce Pang, head of macro and strategic research at China Renaissance Securities.

Weaker construction reduces demand for industrial metals and the massive steel sector. A weaker real estate market also likely would dampen Chinese consumer sentiment and dent household spending, as property assets account for 40%-50% of China's household wealth, Bruce Pang said.

The broader measures to clamp down on the private sector have also raised concerns. Beijing has tightened oversight of the education and tech sectors, and consultations are ongoing in Macau that may tighten gaming law. Analysts at the bank Jefferies warn that the measures are curbing enthusiasm for underwriting IPOs and capital market activities, meaning capital expenditure and investments will be reduced.

A more sustainable future

Others suggest the move is a victory for sustainable growth.

"A successful deleveraging campaign that breaks a vicious circle of property speculation and credit expansion, if with higher transparency, could lay the groundwork for a healthier and stronger economy with less shaky foundations in the future despite near-term economic discomfort," Pang said.

And while growth may suffer in the near term, Beijing has many levers to pull if required.

"We expect a more active role for the PBOC if warranted by deteriorating domestic financial conditions," John Lau, head of Asian equities at investment firm SEI, said in an email, noting "President Xi Jinping is not going to sit idly by if a broader panic begins to pose a threat."