The debt crisis of China Evergrande is likely to mark the beginning of the end of China’s old economic model with its heavy reliance on the property sector. And while China Evergrande, the nation’s second-largest privately owned property company, is widely regarded as “too big to fail”, Beijing’s shift away from property as the driver of economic growth is likely to continue as it accelerates reforms amid the continuing US-China trade conflict.
The game-changing policy shift came to light during an August 20 seminar hosted by the People’s Bank of China (PBoC) and China’s Ministry of Housing and Urban-Rural Development. The seminar set out strict restrictions, dubbed “the three red lines”, effective in 2021, aimed at countering the property industry’s unbridled borrowing with a 70% debt-to-asset ratio cap (excluding prepaid revenue), a 100% net debt-to-equity cap, and a 100% debt-to-cash cap. Additional interest-bearing debt will be restricted to property developers and the level of restriction depends on how many of these red lines are crossed.
In China Evergrande’s case, the property giant has crossed the line on all three restrictions and, therefore, can no longer increase its debt book, which stood at 1.98 trillion yuan (US$290 billion) as of June 30 2020. In other words, to remain solvent, the only options left on the table for the property giant are the acceleration of property sales at discount, sale of its assets, and equity financing.
The firm says it actively responded to the new policy in September when it announced the early redemption of its US$1.565 billion bond due in 2020 and extended its nationwide residential property sales campaign at 30% discount until the end of China’s Golden Week holiday.
The developer also sees another source of liquidity in the green light it obtained from the Hong Kong Stock Exchange for its property management services subsidiary initial public offering (IPO), which is estimated to generate HK$18 billion (US$2.3 billion). The firm also attracted HK$23.5 billion in its latest pre-IPO round of fundraising from various strategic investors that included Citic and Tencent.
While the above-mentioned measures are seen as logical and reasonable, China Evergrande’s strategic move into the electronic car industry is seen as bold and smart.
On the policy front, China is supporting the technology sector aiming to lower its economic dependence on the property market. A research report from China Securities estimated that the property sector contributed 14.6% of China’s total GDP in 2015, taking into account related industries such as industrial and financial services.
In the long run, while China’s property market has become a zero-sum game where market players can only take market share from each other, the technology sector is seen as China’s next growth engine to “bake a bigger cake” for China’s economy.
Over the past five years, directing capital to real economy, instead of the property market and cycling in the financial system (脱实向虚), has been the top priority of the PBoC. According to Chinese media, state-owned banks recently received window guidance to reduce the mortgage proportion of new loans to below 30%.
Hence, for Chinese financial regulators, the aim is to see capital flow into new economy sectors through direct financing, especially as the escalating US sanctions target leading Chinese technology companies. In this regard, entering the new energy vehicles business is not just a “politically correct” decision but the perfect financing solution for the cash-strapped China Evergrande.
Since the Shanghai Stock Exchange’s technology-focused STAR market was officially launched in 2019, it has gained traction among a number of high-profile Chinese technology companies like AI chipmaker Cambricon and China’s fintech leader Ant Group. On September 25, Evergrande Auto announced its A-share offering plan on the STAR market to raise a potential 34 billion yuan.
Going forward, as banks become more cautious in granting new loans to property developers, state-owned developers with lower debt pressure like Vanke are expected to maintain their land acquisition pace while gaining market share from privately-owned developers like China Evergrande and Country Garden.
Liang Yu, chairman of Vanke, summed up the situation back in 2014: “China’s property industry has passed its golden time. However, it is not a Titanic crushing into an iceberg.”