On Monday, many investors couldn’t help but wonder if the liquidation order China Evergrande Group received from a Hong Kong court was a “Lehman moment.”
Not quite. More likely, the milestone here is of a very different nature: a move that catalyzes Beijing to get serious about ending its property crisis once and for all.
It matters that neither markets in Shanghai nor Hong Kong tanked on the news. At the same time, that hardly means Chinese leader Xi Jinping’s Communist Party is out of the woods with global investors.
Staving off a deeper selloff in mainland stocks requires bold, urgent and transparent action by Xi’s government to treat the underlying cracks in Asia’s biggest economy, not just the symptoms. In recent days, the People’s Bank of China moved to address the latter concerns. It’s lowering the reserve requirement ratio (RRR) by 50 basis points, effective February 5.
This “quite unprecedented” step should “free up around 1 trillion yuan (US$140 billion) in liquidity, which will be put toward supporting new loan growth,” says economist Carlos Casanova at Union Bancaire Privée.
The PBOC’s “haste in announcing the cut denotes urgency on behalf of policymakers, following an extraordinary rout in Chinese equities in January,” Casanova adds.
It’s far more important, though, that Xi’s team pivots immediately from prioritizing security to economic upgrades. Over the last two years, Xi’s team has ricocheted from pledge to pledge to devise a strategy to take toxic assets off property developers’ balance sheets and sharply reduce their ranks.
One possibility about which investors have long buzzed is Beijing adopting a Resolution Trust Company-like model the US used to address the savings and loan crisis of the 1980s. That could avoid a Japan-like lost decade as a sector that can generate as much as a quarter of China’s GDP gets a new lease on life.
Doing so would afford Xi’s reform team an opportunity to confound the naysayers and reinvigorate China Inc. It would make good on Xi’s pledges to prioritize the quality of growth over the quantity. And it would change the narrative of China repeating the mistakes Japan made in the 1990s amid its bad loan crisis.
Since March, Xi has entrusted the cleanup to his new premier, Li Qiang. The overarching goal has been for financial institutions to try their hand at repairing balance sheets themselves without giant public bailouts that might create fresh “moral hazards.”
Yet a lack of quantifiable progress in addressing the crisis caused trillions of dollars of capital to flee Chinese stocks in 2023. Chinese stocks have lost over $6 trillion in the last three years.
Monday’s court ruling was handed down by Judge Linda Chan following a June 2022 lawsuit by an investor in an Evergrande unit. Repeatedly, Chan delayed proceedings to afford Evergrande time to cement a restructuring deal. In her ruling, Chan cited a “lack of progress on the part of the company putting forward a viable restructuring proposal” along with Evergrande’s “insolvency.”
Chan told a packed courtroom “I consider that it is appropriate for the court to make a winding-up order against the company, and I so order a winding-up order.”
The next step is for the court to settle on a liquidator to manage Evergrande and then to figure out how to divvy up the developer’s interests, most of them in the mainland. As of now, its roughly 1.74 trillion yuan ($242 billion) of assets are exceeded by 2.39 trillion yuan ($333 billion) of liabilities.
Questions abound in terms of what all this means for bondholders. An obvious one is what pushback the Hong Kong ruling might receive from Beijing. Many investors have a hard time believing that the court would have acted without alerting Beijing ahead of time. The perception for now is that the court had Beijing’s tacit blessing.
Still, it’s unclear how China will proceed. Since so many Evergrande projects are operated locally by mainland units, it’s unclear how far Hong Kong’s jurisdiction extends into Xi’s economy. And it’s not as if construction projects entailing the completion of homes and flats are about to stop on a dime.
In fact, Beijing would be wise to provide the liquidity needed to allow other developers to finish what they have sold. Doing so could have a positive effect on domestic confidence, both for businesses and households, and support GDP.
Of course, all this, analyst Ken Cheung Kin Tai at Mizuho Bank explains in a note, could spook investors worried about China’s property sector more than it comforts them. Indeed, this Evergrande liquidation “milestone” might be a price-clearing event that further shakes investor confidence with a bottom that has yet to be found for property and asset values.
The silver lining, though, from the Evergrande “shock” is how Monday’s events signal Xi’s economic team is rolling up its sleeves to end China’s dueling debt crises.
The property meltdown is the immediate pressure point as other giant developers like Country Garden Holdings hit a wall. At times in 2023, Allianz, Apollo Asset Management, Banque Lombard Odier, BlackRock, Deutsche Bank, Fidelity, HSBC, JPMorgan Chase, NinetyOne UK and a who’s-who of other global institutions had Country Garden exposure.
The last thing Xi wants in 2024, with US elections looming, is for China to be blamed for Lehman-ing a global economy already on edge.
As analyst Rosealea Yao at Gavekal Dragonomics notes, Xi’s reformers “have not yet abandoned the aim to reduce the economy’s reliance on property over the long term, meaning some aggressive stimulus options are still off the table.”
The pros and cons of this balancing act are playing out in real-time. In 2023, for example, Beijing mulled rollbacks of other housing purchase restrictions in first-tier cities. The strategy: do enough to stabilize property sales without incentivizing bad behavior.
One oft-cited risk here is avoiding Japan’s lost-decade troubles. Too often, China, like Japan, “fails to get the most from its immense investments,” says economist Richard Katz, author of “The Contest for Japan’s Economic Future.”
A big factor, Katz says, is the continued dominance of state-owned enterprises. Compared to private companies, SOEs get about only half as much output for every yuan they invest.
“In the 1990s,” Katz says, “Beijing greatly reduced the role of SOEs, but they’ve rebounded under Xi. Worse yet, to prop up economic demand in the face of weak consumer income, China keeps pouring money into infrastructure whether or not it is still needed.”
Katz says that “while much is marvelous, like the cell phone towers one sees all over rural mountaintops, an increasing share resembles Japan’s famous ‘bridges to nowhere.’ The same goes for all the money poured into new housing, much of it financed with debt, still vacant, and bought by citizens hoping to gain from a price hike – as in Japan’s 1980s property bubble.”
The upshot, Katz says, is that “back in 1995, China could increase its GDP by 1% if it hiked its stock of capital by 2%. Now, to get the same 1% expansion of GDP, it has to hike its capital stock by 6%. Consequently, just to maintain the same rate of GDP growth, it has to devote ever-larger shares of annual GDP to investment.” This, Katz adds, “is unsustainable and is a big factor in why China is in such trouble today.”
Another vital step is diversifying growth engines. Since March, Premier Li has been focused on creating deeper and more trusted capital markets so that households invest in stocks and bonds in addition to property. Li also has been charged with building broader social safety nets to encourage household consumption over savings.
The other gaping crack in China’s financial system is local government finances. Just as Beijing needs to cleanse property developers’ balance sheets, it must devise credible mechanisms to prevent a $9 trillion mountain of local government financing vehicle (LGFV) debt from collapsing.
“LGFVs and local governments are likely to remain under financial pressure as a result of the ongoing weakness in property,” says Jeremy Zook, lead China analyst at Fitch Ratings. “Policy support related to LGFVs is likely to remain targeted to addressing refinancing risks to preserve financial stability. In this baseline, LGFV debt is likely to migrate gradually onto the sovereign balance sheet, as local governments issue refinancing bonds to manage LGFV risks.”
UBP’s Casanova adds that it is safe to assume that policy easing will continue to be “desperately needed to ensure the economic recovery is secured in 2024. However, the onus will be on fiscal. Due to pressures on the foreign exchange front and concerns around the sustainability of LGFV debt, we think that monetary policy support will likely take a background role in 2024” to policy reforms.
The good news, Fitch points out in a recent report, is that recent events have “further increased refinancing pressure on the LGFVs over the long term by widening the duration mismatches because their project durations are typically between three and five years.”
Fitch adds that “transaction costs could also add up if LGFVs issue more frequently with shorter-term bonds to refinance long-term debt, given that 364-day bonds currently account for less than 3% of LGFVs’ outstanding offshore US dollar bonds.”
A big reason foreign investors debate whether China is now “uninvestable” is chronic opacity at the highest levels of government.
It’s a problem that “one knows how” Beijing plans to “rebalance its economy” after all too many “botched rescues,” says economist Nicholas Spiro at Lauressa Advisory. It’s high time, Spiro notes, that China tackles its “deep-seated structural problems” transparently and credibly.
Doing just that could dovetail with expected shifts in global interest rates. Case in point: how rate cuts by the US Federal Reserve versus a stable yuan might increase demand for Chinese debt.
“With US rates off their peak, we expect foreign inflows into China bonds to continue next year,” Ju Wang, rate strategist at BNP Paribas SA.
Rescue efforts appear to be accelerating in sync with signs of structural reforms. Beijing is moving to limit short selling, officially this time. This week, the China Securities Regulatory Commission said there will be a “complete suspension of the lending of restricted stocks” and that it will limit the “efficiency of securities lending” beginning March 18.
This could mean further limitations on securities lending to come. The measures, the CSRC said, are designed to “create a fairer market order.”
Meanwhile, state-run Xinhua Finance News reports that Beijing is working to merge three of China’s largest bad debt managers into the sovereign wealth fund China Investment Corp.
It would be its own milestone for financial institutions reform as China Cinda Asset Management, China Orient Asset Management and China Great Wall Asset Management are incorporated into CIC.
Xinhua noted that the transaction would take place in the “near future,” a move akin to how China acted to stabilize bad debt managers in 1999 in the aftermath of the Asian financial crisis.
Yet it is the idea that China is finally serious about fixing its property sector and reining in local government borrowing that’s getting the headlines this week. Xi and Li would be wise to lean into a news cycle that could help change the longer-term narrative toward China doing what it takes to get back on its feet.
Follow William Pesek on X at @WilliamPesek