Evergrande Group, China's second-largest property developer, appears on the brink of collapse. Stocks have fallen, protests have broken out, and the question now is: what sort of economic meltdown comes next?
For the past two decades, Evergrande has taken advantage of cheap credit to massively expand its real estate empire. The company reported $108 billion in annual sales and some $356 billion in assets. Its portfolio is massive: Evergrande owns over 1300 real estate projects across 280 cities in China, has a property services management arm involved in almost 2800 projects across over 310 cities in China, has other ventures across unrelated industries, and directly employs over 200,000 people.
The real estate titan is saddled with as much as $300 billion in debt that it’s no longer sure it can make good on. Banks are declining new loans to buyers of its incomplete projects. Credit ratings agencies have repeatedly downgraded the enormous firm, and Chinese authorities have already told major lenders not to expect upcoming repayments.
In a page out of the WeWork playbook, Evergrande fancied itself as more than a loss-leading, debt-burdened real estate business. The company turned its health care business unit into an electric vehicle company despite never making a single car. In July, Evergrande was considering an IPO for Evergrande Spring, its bottled water business (you read that right). At the same time, Evergrande was also considering an IPO for its tourism business and an incoherent theme park featuring fairytales from across the world. Guangzhou FC, China's most successful soccer team, is owned by Evergrande (with an Alibaba stake) for some reason.
The situation has grown so desperate for the cash-strapped firm that it demanded employees loan Evergrande money at a high interest rate in order to keep their bonuses, only to stop paying back those loans soon after. The situation has sparked protests led by home buyers waiting on unfinished homes and employees who have lost their life savings.
At least part of the genesis of this crisis can be traced back to last year, when China introduced "three red lines" for real-estate developers, or caps on the amount of debt a firm could leverage, that prohibit new loans when surpassed. Evergrande has breached all three red lines already.
That Evergrande breached these limits on debt isn’t too much of a surprise. Over the past two decades, the company has managed to grow its market capitalization (and debt) by aggressively borrowing cash to rapidly develop property, selling the properties before they were finished, and offering a steep discount to keep cash flowing. Research firm Capital Economics estimates that some $200 billion of Evergrande's debt is actually cash put down for 1.4 to 1.6 million unfinished properties, and a huge number of justifiably furious purchasers of these unbuilt homes.
Evergrande is now so cash-strapped that it has even begun paying contractors with half-built properties and investors with discounted ones. The firm is also allowing consumers and staff to bid on discounted properties next week in an online auction as part of a desperate bid to raise funds to repay investors, Bloomberg reported.
In other words, Evergrande was borrowing from everyone in a scheme that looks suspiciously like a triangle. It borrowed half-built homes from homeowners, offered them to employees and contractors and investors, all of whom it has borrowed money from alongside some banks and hedge funds, all to pay back other employees, contractors, investors, hedge funds, and banks. And then, maybe, some of that money will be used to build (or finish) homes for the homeowners. It’s a mess.
At least a few people have been predicting Evergrande’s collapse for quite a while. Andrew Left, the activist short seller who drew the ire of retail traders pumping Gamestop's stock in January, was railing against the real estate firm back as far back as 2012, when he accused the company of fraud, insolvency, and corruption.
"Over the past 5 years, Evergrande has executed an untoward program of bribes aimed at local government officials in order to build its raw land industry,” Left wrote in a report that year. “To finance growing cash flow shortfalls related to these bribes, subsequent land purchases, and related real estate construction activities, Evergrande has employed a complex web of Ponzi-style financing schemes. These schemes are characterized by a reliance upon perpetually growing pre-sales, off-balance sheet partnerships, and IRR guarantees to third parties."
In 2017, Anne Stevenson-Yang, co-founder of research firm J Capital, also rang the alarm about Evergrande's business model and growing liabilities. In one interview, Stevenson-Yang focused on China's property bubble, fueled in part by a common story pitched by developers: workers who couldn't afford Beijing could instead live hundreds of miles outside of the city in areas that, once developed with schools and hospitals and so on, would see home values increase.
“Evergrande is highly leveraged and has like 270 projects all over the country. I have been, easily, to 40 of them yet I have only seen one that was fully occupied. Many of these projects are megalomaniac visions and totally empty,” Stevenson-Yang said. “Yet you go to these places and you see their sales room filled with young buyers. When I open my eyes I see crumbling stone, and empty jungles or deserts. What they see is a future with wealthy Europeanized people strolling on modern paths. It’s just amazing. It’s a mass illusion and Evergrande more than any of these developers plays to this illusion by building developments that are specifically positioned for the investor, not to live there but to buy for some future appreciation in price.”
Now, the rest of the world is left to wonder just how big of a crisis this will become, and the fear is certainly tangible, if plummeting stock prices were any indication on Monday. In the real estate sector, Chinese property developer Sinic Holdings saw its shares drop 87 percent and shave off $1.5 billion in market value before trading was suspended. There is concern globally as well, as many firms internationally have exposure to Asian markets that may take a significant dive if the crisis worsens. In Europe, for example, large financial companies are particularly overexposed and stocks slid there this week as it became clear Evergrande was teetering.
Some experts are already speculating about, well, which speculation-caused collapse this most closely resembles. A popular comparison is the collapse of the Lehman Brothers in 2008. Jon Authers, a Bloomberg columnist, asked on Monday if this will be a “Minsky moment”—a break in market confidence after prolonged speculation—or a LTCM Moment, a reference to hedge fund Long-Term Capital Management’s own implosion in 1998, after which the government intervened and facilitated a bailout.
All that, however, depends on a few things that aren't too clear right now, most of all whether the Chinese government will step in. Chinese markets don’t open this week until Wednesday, and while analysts expect authorities to intervene to prevent a collapse, it seems just as likely that China could try to use Evergrande’s fall to deflate its housing market bubble. Whether that means a controlled demolition, a restructuring of its debt to delay payments before refinancing and selling assets, or a state takeover remains to be seen.