The Slow Motion Evergrande Wreck

Commentary Corporate bankruptcies in the United States work under very well-defined laws and procedures about who gets paid, in what order, and based upon contractual or implied understanding. In China, bankruptcies remain the largely wild rule of the jungle matters that can take years of behind-closed-door fighting to divvy up corporate carcasses. Evergrande and the entire real estate sector in China is becoming the case study for Chinese and Western investors. Evergrande and China’s entire real estate sector is highly indebted. Couple in falling consumer demand for second and third apartments—as well as high basic commodity input prices—and the housing market in China looks decidedly weak. Government revenue from land sales is off nearly 30 percent from a year ago, and the government has decided to delay the long-awaited much-heralded property tax. This is not a healthy, robust market. The more recent worries stem from the Guangdong government’s review of Evergrande. Announcing that an expected turnaround plan will be completed by July, the government-appointed auditors have declared that Evergrande is “significantly insolvent.” Not just insolvent but “significantly insolvent.” Despite Evergrande’s emphasis to investors that it is returning to normal, completing units, and divesting projects to buyers to help it accumulate cash, the outlook is not positive. Evergrande, however, is only a tree in the forest. Chinese developers are being downgraded and warned of defaults. Developer Sunac is merely the latest that has warned it will be unable to make good on bond payments in the days ahead, prompting downgrades from bond rating agencies. The entire Chinese real estate development industry remains very weak, with no turnaround in sight. The problems, however, run much deeper than the obvious. Most recently, auditing firms like PricewaterhouseCoopers (PWC) have taken to either resign their position or issue qualified opinions of firms based upon their inability to verify their clients’ financial statements. For many firms, this effectively makes them uninvestable for international asset flow. A crane stands at the construction site of Evergrande Cultural Tourism City, a China Evergrande Group project whose construction has halted, in Suzhou’s Taicang, Jiangsu Province, China, on Oct. 22, 2021. (Aly Song/Reuters) PWC did not take this position due to new-found business ethics but from a calculating review of potential legal liability if these firms collapse. Already, lending banks are talking litigation after domestic Chinese banks seized $2 billion in deposits from Evergrande that had been pledged as security but was not listed in its financials as promised. Like everyone else, PWC is wondering what else is out there that it does not know about. This presents China and investors with a couple of significant problems. Even beyond the fundamental problem of excess leverage, all of the issues investors could ignore when they made money suddenly seem essential and harder to ignore. For instance, low-quality and unreliable financial statements are harder to ignore. Even though Evergrande and others have produced annual audited statements, the auditors openly question their quality and leave investors wondering what unaccounted liabilities exist or whether assets are really viable assets. When everything is going up, investors worry less about the risks, but they worry about those factors immensely on their way down. The lack of any clear unpoliticized rule of law process to manage an Evergrande bankruptcy worries all parties. Evergrande and Beijing have said that stakeholders should refrain from making aggressive actions to enforce their claims. Investors have widely interpreted this as a threat from Beijing not to seize assets or file litigation unless approved by the state. This makes the seizure of $2 billion in cash deposits by major Chinese banks so problematic by many. This is interpreted as having received a tacit nod from the Chinese regime after it warned others to refrain from aggressive action. Lacking a predictable rule of law system to manage corporate bankruptcies, the politicized management of the jungle system is a significant liability for investors seeking predictability. Investors want growth opportunities to help their money grow, but they also value a fair legal system and open accounting records. With wobbly firms, the legal and accounting risks only magnify the financial viability risks that investors are looking at. Though it would be encouraging to close up an analysis of the real estate sector by offering up reasonable reforms and approaches that China could take to address the economic, corporate, legal, and accounting risks covered, the reality is Beijing is likely to try and delay dealing with the problems that years of reckless lending have encouraged. This means Evergrande and real estate restructuring is likely to be stretched out over the years with questions about

The Slow Motion Evergrande Wreck

Commentary

Corporate bankruptcies in the United States work under very well-defined laws and procedures about who gets paid, in what order, and based upon contractual or implied understanding.

In China, bankruptcies remain the largely wild rule of the jungle matters that can take years of behind-closed-door fighting to divvy up corporate carcasses. Evergrande and the entire real estate sector in China is becoming the case study for Chinese and Western investors.

Evergrande and China’s entire real estate sector is highly indebted. Couple in falling consumer demand for second and third apartments—as well as high basic commodity input prices—and the housing market in China looks decidedly weak. Government revenue from land sales is off nearly 30 percent from a year ago, and the government has decided to delay the long-awaited much-heralded property tax. This is not a healthy, robust market.

The more recent worries stem from the Guangdong government’s review of Evergrande. Announcing that an expected turnaround plan will be completed by July, the government-appointed auditors have declared that Evergrande is “significantly insolvent.” Not just insolvent but “significantly insolvent.”

Despite Evergrande’s emphasis to investors that it is returning to normal, completing units, and divesting projects to buyers to help it accumulate cash, the outlook is not positive.

Evergrande, however, is only a tree in the forest. Chinese developers are being downgraded and warned of defaults.

Developer Sunac is merely the latest that has warned it will be unable to make good on bond payments in the days ahead, prompting downgrades from bond rating agencies. The entire Chinese real estate development industry remains very weak, with no turnaround in sight.

The problems, however, run much deeper than the obvious. Most recently, auditing firms like PricewaterhouseCoopers (PWC) have taken to either resign their position or issue qualified opinions of firms based upon their inability to verify their clients’ financial statements. For many firms, this effectively makes them uninvestable for international asset flow.

Epoch Times Photo
A crane stands at the construction site of Evergrande Cultural Tourism City, a China Evergrande Group project whose construction has halted, in Suzhou’s Taicang, Jiangsu Province, China, on Oct. 22, 2021. (Aly Song/Reuters)

PWC did not take this position due to new-found business ethics but from a calculating review of potential legal liability if these firms collapse. Already, lending banks are talking litigation after domestic Chinese banks seized $2 billion in deposits from Evergrande that had been pledged as security but was not listed in its financials as promised. Like everyone else, PWC is wondering what else is out there that it does not know about.

This presents China and investors with a couple of significant problems. Even beyond the fundamental problem of excess leverage, all of the issues investors could ignore when they made money suddenly seem essential and harder to ignore.

For instance, low-quality and unreliable financial statements are harder to ignore. Even though Evergrande and others have produced annual audited statements, the auditors openly question their quality and leave investors wondering what unaccounted liabilities exist or whether assets are really viable assets. When everything is going up, investors worry less about the risks, but they worry about those factors immensely on their way down.

The lack of any clear unpoliticized rule of law process to manage an Evergrande bankruptcy worries all parties. Evergrande and Beijing have said that stakeholders should refrain from making aggressive actions to enforce their claims. Investors have widely interpreted this as a threat from Beijing not to seize assets or file litigation unless approved by the state. This makes the seizure of $2 billion in cash deposits by major Chinese banks so problematic by many. This is interpreted as having received a tacit nod from the Chinese regime after it warned others to refrain from aggressive action.

Lacking a predictable rule of law system to manage corporate bankruptcies, the politicized management of the jungle system is a significant liability for investors seeking predictability.

Investors want growth opportunities to help their money grow, but they also value a fair legal system and open accounting records. With wobbly firms, the legal and accounting risks only magnify the financial viability risks that investors are looking at.

Though it would be encouraging to close up an analysis of the real estate sector by offering up reasonable reforms and approaches that China could take to address the economic, corporate, legal, and accounting risks covered, the reality is Beijing is likely to try and delay dealing with the problems that years of reckless lending have encouraged.

This means Evergrande and real estate restructuring is likely to be stretched out over the years with questions about how assets are divided, creditors repaid, and the firm’s actual assets and liabilities.

The goal is not a high-quality legal system or economic efficiency but sustaining the Chinese Communist Party.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.


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Christopher Balding was a professor at the Fulbright University Vietnam and the HSBC Business School of Peking University Graduate School.He specializes in the Chinese economy, financial markets, and technology. A senior fellow at the Henry Jackson Society, he lived in China and Vietnam for more than a decade before relocating to the United States.