Originally published at Project-Syndicate | September 29, 2021
A looming default by the Chinese property developer Evergrande has sent shock waves through global capital markets. The Chinese government and central bank have the means to prevent a full-blown financial crisis, but they need to communicate their strategy now in order to calm jittery investors.
NEW YORK – Many have attributed the recent decline in major global stock market indices to concerns about the heavily indebted Chinese property development group Evergrande. To restore investor confidence and minimize economic damage, the Chinese authorities must eliminate any doubt that they will do what is necessary to contain potential spillovers from an Evergrande default.
Evergrande specializes in building and selling residential apartments in second- and third-tier Chinese cities, although it also dabbles in other businesses, including manufacturing electric vehicles. The firm’s total liabilities are estimated to be about CN¥2 trillion (roughly $300 billion), which is equivalent to approximately 2% of China’s GDP in 2020.
On one level, the actual financial problem is substantially smaller than this number suggests. Evergrande owns many tangible assets, including land (technically, the right to build on it), completed apartments that have not yet been sold, and partly constructed apartment buildings. According to the company, the value of its assets exceeds that of its liabilities.
But on another level, the potential negative shock of an Evergrande default for the Chinese economy could amount to much more than a $300 billion loss. For starters, the company has a series of loans and bonds falling due in the coming weeks and months. Meeting these repayments will require cash, not illiquid real estate. If the group is forced to dispose of assets in a fire sale, it will face a substantial financial haircut.
Three other sources of uncertainty could greatly magnify the negative impact of an Evergrande default on the rest of the Chinese economy. First, there would be a psychological spillover to many other property developers that, like Evergrande, use debt to finance their operations. If potential lenders to these companies are worried about the property sector’s demise, many firms may find that their funding dries up. As fears of a chain of bankruptcies in the sector become self-fulfilling, a large number of these firms will go under, too.
Then there is the spillover from Evergrande to China’s financial system. While the extent of the firm’s borrowing from banks and non-bank financial institutions is easy to discover and document, the channels and the size of various indirect effects are more uncertain. For example, if Evergrande goes under, many of its steel, cement, and equipment suppliers also may have trouble repaying their bank loans. Banks’ outstanding loans to other property firms could become non-performing as well.
Separately, Evergrande has also aggressively tapped into China’s shadow banking sector to finance its operations, and some of this borrowing is managed by non-listed parts of the group that do not disclose their balance sheets fully. There is no transparent and audited account of the size of these borrowings.
The third and perhaps most important source of uncertainty is whether the Chinese authorities can prevent a full-blown financial meltdown if the Evergrande problem develops into a systemic crisis. Because China has a much lower government-debt-to-GDP ratio (about 70% in 2021) than the United States (133%), Japan (257%), and France (115%), the government still has the fiscal capacity to deal with a potential crisis. And the People’s Bank of China has the tools and ability to inject liquidity into the economy to address any potential credit freeze.
What is less certain is whether the authorities have the will to take such steps. Evergrande is not a state-owned entity, and the government might be reluctant to help the firm’s multi-billionaire founder and controlling shareholder, Hui Ka Yan, in view of its current “common prosperity” campaign.
The Chinese authorities can take two steps to prevent a bank run and calm capital markets. The first is to communicate clearly that they can save Evergrande’s many stakeholders (other than Hui). These include its lenders and employees, and households that have paid the company for an apartment but have not yet received one. This can be accomplished by facilitating other firms’ purchases of construction projects and other assets from Evergrande.
Second, the government can announce a contingency plan involving quick and decisive steps to stop the various spillovers in the event that Evergrande goes bankrupt. Policymakers should document and disclose each lender’s exposure to the company, and emphasize the government’s will and capacity to use a combination of fiscal and monetary measures to ensure that Chinese financial institutions will be able to fulfill all their obligations, come what may.
The authorities may well be looking into these steps now. But publicly announcing such a plan can remove the uncertainty about the government’s readiness and ability to act, and thus can go a long way toward ending the market panic.
Shang-Jin Wei: Former chief economist at the Asian Development Bank, is Professor of Finance and Economics at Columbia Business School and Columbia University’s School of International and Public Affairs.