Double Edged Sword: How China’s Infrastructure Spending Has Landed It In A Soup

Earlier this week, the Evergrande default crisis spooked the global markets. Evergrande, which is China’s second-largest real estate company, is facing a liquidity crisis. The company owes around $300 billion to creditors.

Engine For The Economy

One of China’s main engines for growth has been its property sector. The rapid urbanisation allowed developers to build houses and sell them at a rapid pace. Today, the sector contributes to 30 per cent of the country’s gross domestic product (GDP). Raising debt to finance these projects was not a concern as the government, which controlled the banks, was ready to funnel money into the sector.

The property boom has continued almost unabated until recently. Property has become a speculative asset that has outperformed the Chinese stock markets, according to a report by CFA Institute. People have even gone as far as getting fake divorces to be able to circumvent laws that prevent families from buying second homes.

However, smaller cities have seen a slowdown in growth, even oversupply, as millions of homes lie vacant — the infamous ‘ghost cities’ of China. The rapid debt-fuelled party in the property sector has lasted for more than two decades despite facing years of criticism. The total credit shelled out to non-financial companies in China has formed 160 per cent of the country’s GDP as of September 2020. This is almost twice that of American corporations, whose debt to GDP value has lingered around 60 per cent to 80 per cent. The highly leveraged nature of the economy makes it quite fragile.

Three Red Lines

However, the Chinese Communist Party (CCP) has realised its folly and is now trying to rein in the boom. In order to make the economy more resilient, the CCP embarked on a project to curb heavy borrowing in the sector. The ‘three red lines’ referred to conditions placed on property developers to rein in their credit, and stop the economy’s heavy dependence on infrastructure and real estate.

The three conditions included a limit on net debt to equity, liabilities to assets and cash to short term debt. Depending on the company’s metrics in relation to each of these conditions, banks would decide the incremental amount of debt. Any company that failed on all metrics would not be issued more debt.

The Evergrande Group had failed on all of these metrics, according to the figures in the financial reports released by the company for its Cayman Islands investors. The failure to meet the financial standards, prompted the company to sell stakes in group companies and get them listed on the exchanges.

However, it was unable to list the subsidiary, resulting in a cash crunch. Previously, the China Fortune Land Development Group had defaulted on its payments just a few months after the introduction of the three red lines. The default has also coincided with a decline in demand in the Chinese property market.

Beyond The First Order Effects

While financial engineering, combined with sales of company assets could allow the bond financiers to recover at least a part of their money, another group of creditors is a major cause of worry. This group comprises of small investors, employees, suppliers, flat owners and other angry stakeholders.

The Evergrande Group owes $142 billion to suppliers alone. People have been protesting at the Evergrande headquarters. Around 1.2 million property owners had booked flats with Evergrande, but are now worried about receiving their money back. The company has around 800 unfinished projects that seem to be stuck indefinitely. It had also created several wealth products to channels household wealth into funding the group’s projects.

However, with the current cash crunch, it is unlikely that investors will see their money anytime soon. As a means to prevent the liquidity crisis, employees were forced to buy the wealth management products.

For CCP, the crisis is not limited to the economy, but has socio-political consequences as well. Reigning in growth in the sector implies lower rates of growth and lower job availability.

In addition, the social unrest due to the default could have larger repercussions in the political sphere. The Chinese economy has already slowed down in recent years, and the lack of funding could put it in decline. The property sector also supports several other industries such as cement, iron, steel, wire producers, glass, tiles, pipes and others

Global Growth Concerns

The growth concerns are not just limited to China but the rest of the world as well. China is one of the largest consumers of several commodities like iron ore, copper, oil, aluminium and others. Iron ore prices have already fallen 60 per cent from multi-year highs in anticipation of a slowdown. China is also the world’s second largest consumer market. The ripple effect in case of a slowdown will be felt widely. Back in 2015-16, China’s growth concerns resulted in a bear market that almost lasted a year.

Years of debt-fuelled infrastructure growth now faces a period of uncertainty as demand struggles to keep pace with supply. So far, most stock markets have recovered from the shock and have even seen an upward movement.

In contrast, the bond market yields for Asian issuers have moved up, while Evergrande’s bonds still show yields of 50 per cent, indicating that the bond markets are expecting a default.