This article first appeared in Forum, The Edge Malaysia Weekly on September 27, 2021 - October 3, 2021

It is difficult not to compare Evergrande with Lehman. Exactly 13 years ago and also in mid-September, Lehman Brothers, the US’ fourth-largest investment bank, filed for bankruptcy, brought down by its exposure to real estate through investment in subprime loans.

Lehman’s collapse tipped the US and the world into what then came to be known as the global financial crisis. Today, Evergrande, China’s second-largest real estate developer, is teetering on default. More than real estate exposure, it is the leverage, reliance on debt, that is at the root of both firm’s problems. Debt and real estate, it seems, can be combustible anywhere in the world.

Evergrande’s problems are indeed grand. It has some US$300 billion (RM1.2 trillion) of debt and more than US$100 million of coupon/interest payments due immediately, which it is obviously in no position to pay. Two of its subsidiaries have already defaulted on payments.

Year to date, Evergrande’s Hong Kong-listed stocks have fallen 85% and its US dollar-denominated bonds are selling at about 30 cents on the dollar. Some US$7.4 billion and US$9.8 billion in debt servicing are due in 2022 and 2023 respectively. All this matters because of the potential systemic problems that it can cause.

With more than 2,000 subsidiaries across several industries and an estimated RMB2 trillion (RM1.3 trillion) balance sheet, the company is said to account for 2% of China’s GDP and 16% of outstanding Chinese high-yield dollar bonds. Its borrowings are from more than 120 trusts/financial institutions and have the usual cross-default clauses. As a proportion of the overall Chinese economy, real estate accounts for 25%. So, the magnitude of the problem is indeed large and failure can be truly messy.

Evergrande’s problems, which have been simmering awhile, began when the government tightened bank lending to real estate firms. China’s debt-fuelled real estate bubble was clearly worrying its policymakers. Ironically, it is the regulation itself that may now be setting off the kind of problems it was meant to avoid.

Outside of China, the main worry is contagion. This unravelling is happening at a time when, for several reasons, the global economic environment is highly vulnerable to shocks. First, is the massive overhang of debt. Thanks to the ultra-loose monetary policies of central banks, global debt is approaching US$300 trillion, with China’s accounting for close to 20% of that — not the largest but second largest after the US.

China’s debt-to-GDP is near 330%. This debt-fuelled growth has seen several recent blow-ups — including those of Huarong, an asset management firm with massive debt and equally massive losses; China Fortune Land, a developer that failed recently.

Second, rising inflation with consumer prices at 15-year highs in the US and Europe, owing partly to supply shocks and energy prices, means that monetary policy cannot be accommodative for much longer. Third, after years of easy money and artificially low interest rates, the impending tightening will affect growth and the regime shift itself can be highly destabilising. Recall the taper tantrum of 2013.

Finally, the blow-out earnings that the US and other corporates have been reporting, and which have kept the stock indices at stratospheric highs, could be coming to an end. Earnings momentum appears to be waning and the consensus margin estimates are falling for many Standard & Poor’s 500 companies. While, there never is a good time for a company like Evergrande to be failing, for a pandemic-stricken global economy that is still trying to recover, this cannot be good.

The market expectation now appears to be for the Chinese government to carefully manage the Evergrande situation and minimise, if not avoid, any contagion. But this is easier said than done. Yes, the Chinese economy is tightly controlled and orchestrated but, as previous experience elsewhere shows, ring-fencing a large corporate failure and controlling the fallout is never easy — especially one with a footprint as large as Evergrande.

When there are hundreds of lenders and creditors as is the case here, the main hindrance to a proper resolution is the incentive of debt holders to front-run others, to grab whatever they can of their stake and run. The cross-default clauses make this easier. Unlike equity holders who would have little choice but to patiently negotiate a restructuring, creditors would hit the exits when adverse shocks occur.

Even if the government can lean on the banks, handling the individual customers/investors, the suppliers, the suppliers of the suppliers and the many mutual funds that hold the company’s shares and bonds is not going to be easy. There are too many uncontrollable factors.

When a mutual fund or hedge fund caught with now illiquid Evergrande instruments tries to unload other assets to meet withdrawals, a cascading process begins. When a supplier with unpaid invoices has to default on his own payments, yet more cascading happens. It is these types of cascading that lead to the avalanche and potential full-blown crisis.

Ardent proponents of the Chinese economic model may be inclined to brush off the Evergrande episode as a potential non-event. They point to China’s massive financial clout and the fact that the country’s debt, though large, is mainly domestic. While there is no doubting its financial clout, such thinking ignores history.

China today is where Japan was a little earlier. Japan was booming, dominating global trade and conquering one industry after another. All that came to an end when Japan allowed a massive debt-fuelled real estate bubble to build. That bubble burst in December 1989 and, for the next two decades, a Japan that could do no wrong became a Japan that could not get anything right. Incidentally, Japan’s debt too was almost entirely domestic, it too seemed as invincible then as China seems today.

History is replete with great nations that have been humbled by debt. The track record of Chinese policymaking has thus far been good — a lot of wisdom, good foresight and very pre-emptive moves. Whether they can deflate this bubble without bursting is yet to be seen.

Whatever it is, for the world’s financial markets, the seat-belt sign has just come on, there is turbulence ahead. Buckle up, there is just no telling how nasty it is going to be.

Dr Obiyathulla Ismath Bacha is professor of finance at the International Centre for Education in Islamic Finance (INCEIF)

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