The Chinese Lehman, more dangerous than they tell us

“I’m going off the rails on a crazy train”. Ozzy Osbourne.

The bankruptcy of the Chinese real estate company Evergrande is much more than a “Chinese Lehman”. Lehman Brothers was much more diversified than Evergrande and better capitalized. Evergrande’s total assets that are on the brink of bankruptcy exceed the figure for the entire US subprime bubble.

The problem with Evergrande is that it is not an anecdote, but a symptom of a model, the Chinese, of leveraged growth and seeking to inflate GDP at all costs with ghost cities, unused infrastructure and wild construction. Evergrande’s chained debt model is very common in China. To go into massive debt to build a promotion that later does not sell at all or almost nothing, and refinance that debt by adding more debt for new projects using unsaleable or already leveraged assets as collateral. Evergrande’s total debt, loan commitments, is more than double the official figure published (more than 2 trillion yuan, almost 0.3 trillion euros).

Evergrande’s financial hole is equivalent to almost a third of Spain’s GDP

Their annual income does not reach 70,000 million euros, and it is more than questioned if these income are real since a relevant part is payment commitments of doubtful collection of mortgaged citizens who cannot pay. Even if they were real, they are not enough to meet the bond repayment needs, which exceed 300,000 million euros in the short term.

Why Evergrande is so much more dangerous than it sounds:

First, because all “Keynesian” solutions that you are listening to these days have already been implemented. Massive injections of liquidity, low rates, full implicit and explicit support from the Chinese government … Let’s not forget that Evergrande was the largest issuer of commercial paper (debt) in China, 32 billion dollars issued in 2020, an increase of 390% from 2015, according to Reuters.

Since 2014, Evergrande has been generating very little cash and financing all of its growth by fattening up debt and hiding toxic assets.

Evergrande’s is a model that many Chinese developers have followed, and that Evergrande accounts for more or less 4% of the country’s market. The ten largest property developers account for 34% of the market and aggressive leverage practices are widespread.

The real estate sector is huge in China. Its direct and indirect weight, according to JP Morgan, is 25% of GDP, more than double what it weighed in Spain in the real estate bubble. The sector has been growing with an indebted model at 15% per year for the last three years. The Chinese government has introduced regulations to reduce the glut, but as it benefits from rising GDP and job creation, it has maintained a benign position on the corporate debt model.

Chinese real estate companies, according to JP Morgan, have “reduced” their indebtedness to 92% of assets from a savage 140% in 2018, with a profit margin of 9 to 13%. But that figure is still simply brutal and much worse than the one we met in the Spanish property bubble. Most Chinese property developers have asset value credit commitments of 50% or less according to JP Morgan. The problem is that the value of the assets, and the ability to sell them, is more than questionable.

The implications of Evergrande are much greater than what they tell us

Domino effect in a very aggressive sector, very leveraged and large in GDP. Impact on all banks exposed to China and emerging markets, where China has financed ruinous projects at all costs in recent years. And also impact on global growth and the countries that export to China in the face of the more than evident slowdown.

Direct impact on the solvency of the financial system despite the fact that trillions of liquidity continue to be injected. A solvency problem cannot be solved with liquidity.

Impossibility of plugging the hole via politics. The hope that the government will solve everything contrasts with the magnitude of the hole. Be that as it may, the negative effect cannot be minimized in sectors highly exposed to real estate growth, infrastructure, electricity, services, and in the hundreds of thousands of citizens who have paid a ticket for flats that are not going to be built.

Evergrande is not an anecdote or a cause, it is a symptom

The problem with China is that the entire economy is a huge indebted model that needs almost 10 units of debt to generate one of GDP, triple than a decade ago. And that all this catastrophe was already more than evident for months, but the market assumed that, because it is China, the government was going to hide it. Even worse, the Evergrande puncture only shows what is a dangerous reality in various Chinese sectors: excess indebtedness without income or real assets support it.

Finally, the fact that the government has attacked companies and imposed strong regulatory measures on different sectors in recent weeks makes a solution more difficult because international investors are already very concerned about corporate governance and intervention in China.

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