Economist Brian Easton reviews the Chinese property development sector woes, sees accounting reports masking real issues, and compares them to what happened in the GFC and our own similar collapses

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

If China’s second largest property developer implodes, the Chinese financial system may be compromised, while the booming property market is so central to the Chinese economy, its staggering would impact internationally, including on New Zealand.

For some time I have had on my to-write list the giant Chinese property company, Evergrande. In that time it has been struggling, as I relate below, but it is still there. One is reminded of Keynes’ remark that ‘The market can stay irrational longer than you can stay solvent.’

I could claim to have a reasonable record in predicting previous financial collapses, but this is not a boast because it underlines how little I understood. For instance, my (now defunct) Listener columns tracked the beginnings of the Global Financial Crisis for over a year before the bankruptcy of Lehman Brothers in September 2008. But I did not understand how subprime lending worked. Ian Cross identified me as one of the two commentators who presaged the 1987 sharemarket crash, but I was observing that the share price-to-earnings ratio was too high and did not realise how corporation profits were grossly overstated, which meant the situation was even worse than I thought.

It was not until the collapse of the giant American energy corporate Enron in 2001 that I realised how creative audited corporate accounts can be. At my school one never associated the accounting students with creativity (off the sporting field), although, coming to think of it, two of my year were convicted of accounting fraud.

The China Evergrande Group is the second largest property developer in China by sales. It has liabilities of over US$300 billion; it says it has assets whose values exceed its liabilities. Their accountants will verify those numbers but in the one case I have seen referred to, others were valuing some of the company’s properties at half what they are in its accounts.

Since last September, Evergrande has repeatedly failed to make several large bond payments to its creditors on time. It has said they were paid late, but not all instances are documented. The total payments are less than US$1 billion which might suggest that the company is facing a cash flow crisis rather than its liabilities exceeding its assets (if you believe the valuations).

However, property developers have to supplement the cash flow from their current sources with borrowings from the financial sector because some of the assets are part-built properties that need cash to be completed. If interest obligations are not paid, those borrowings are likely to dry up. The funds they get from deposits on unbuilt properties will also cease. Property developers also ‘borrow’ – add to their liabilities – by not paying subcontractors and suppliers or issuing them with promises-to-pay (commercial bills) but that option cannot go on indefinitely, especially for new business. A further complication is that a Chinese property company can (sort of) borrow from local authorities many of which, however, are skint. It is a salutary reminder that Chinese financial arrangements may not be the same as the West’s.

Presumably new projects are being put off while ongoing projects are not being completed. It is like what happened in our finance sector a decade ago, except on a grander scale. Evergrande is involved with almost 800 projects in more than 230 cities. To an outsider this is a crash waiting to happen (and there are smaller Chinese property companies in similar financial difficulties); it would crash if this was happening in a Western economy.

The Chinese financial authorities are probably already involved. One factor is that in 2020, in an effort to rein in the highly indebted property-development sector, the Chinese government enacted a ‘three red lines’ rule to regulate the leverage taken on by developers, so that part of Evergrande’s difficulties is trying to meet the tighter debt-to-cash, debt-to-equity, and debt-to-assets metrics. (In the 1970s, a number of financially weak New Zealand companies  crashed following a tightening of the regulations.)

The government may well think that the company is too integral to the country’s property sector which, it is said, accounts for about 30 percent of national output; that it is ‘too-big-to-fail’. If a large property company were to crash, subcontractors and suppliers to sound companies would become more hesitant. Moreover, the sector’s intricate relation with local authorities is likely to compromise their already weak finances.

(Evergrande’s main shareholder, Hui Ka Yan – he holds about 60 percent of the shares – has been selling personal assets to fund the interest payments. This may not be a rational thing to do; in similar situations, New Zealand’s property developers cut and run. Perhaps the Chinese Government, less sensitive to private property rights, is twisting Hui’s arm.)

Can the Chinese officials manage a financial crisis? They are probably smart enough but they may not have enough experience or history to handle the complexity. Ben Bernanke, who led the American Federal Reserve through the GFC, was an expert on the Great Depression. On the other hand, the Chinese might contemplate policy options that private-enterprise-dominated America would reject. When in the late nineteenth century a couple of New Zealand banks failed, our response was a partial nationalisation. (As an aside, the Colonial Treasurer, Joseph Ward, who supervised the legislation, proved to be a major debtor of one of the banks and had to resign; that didn’t stop him from twice becoming New Zealand’s Prime Minister – we are a forgiving nation.)

The likelihood then, is there will some disruption to the Chinese financial system and – since it borrows offshore – to the world, although we do not know how big or catastrophic. There is likely to be a major impact on the construction sector, which will dampen the Chinese economy. But we don’t know when or how soon.

That will certainly impact on New Zealand’s export of building and raw material supplies. The size of the impact on New Zealand export food suppliers is more problematic. The Chinese government may take measures to sustain household consumption; in a middle-income country that includes food. Even so, I wish we were not so exposed to the Chinese market including the other major commercial partners which trade extensively with China. We have had a long-term strategy of diversification but it has proved hard to implement.

And there is the even greater political imponderable: the impact of a financial crisis (with people losing their savings) and an economic slowdown (rising unemployment?) on the political leadership. President Xi’s position may be secure but he may have to trim the nation’s direction. I leave others to suggest the possibilities; do not rule out intensified external aggressiveness, using nationalism in order to distract the public from economic hardship.

It looks as though Evergrande is going to remain on my to-write list for some time.

PS. The news flash headline as this goes to press is World’s worst-performing bank lent billions to China Evergrande.

Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.