Vijay Kumar Gaba

Whether we like it or not, China is a key factor in India’s policy making function. The China factor materially influences our economic policies, foreign policy, and defense policy. This may be true to a material extent for US, Japan and Korea policy making functions also.

Inarguably, the Chinese economy has been one of the key driving forces for the global economy in past three decades. Chinese have labored hard for over five decades, since beginning of cultural revolution in 1966, to emerge as a potent global force. In past three decades they have subsidized the global economy by providing cheap labor and capital; and funded a large part of the US and EU fiscal deficits since early 2000s. The Chinese support was a key factor in keeping the global market afloat during the global financial crisis. It would not be entirely wrong to say that China also helped the developed economies in protecting “their environment” by letting them relocate most of their polluting industries to China.

In the process, China perhaps digressed a little too further from its core ideology of Marxism. The selective capitalism allowed many “depravities of the West” to permeate the Chinese system, e.g., rampant corruption, flagrant inequalities and conspicuous consumerism. “Growth at any cost”, has perhaps costed too much to the Chinese society and the system. There have been reports of growing dissent amongst citizens for a variety of reasons. The citizens exposed to the global economy and society naturally desired more freedom (especially of expression) tat was denied. The demographic control policies (one child, immigration to cities etc.) also created imbalances and dissent.

In past few years, the Chinese government has sought to change the course of its polices to address some of these issue. For example, -

First, China sought to move into higher orbit by asking to be treated at par with developed countries. They claimed global acceptability for their currency; bigger role in the multilateral institutions like World Bank; dominant role in global trade and commerce through “Belt and Road” and other Initiatives; bigger role in global geopolitics etc. Besides, China has also made substantial strategic investments in Asia, Africa, Latin America and European continents to garner wider support.

USA, that has been dominating the world since the collapse of USSR, obviously did not like the idea and an overt trade war ensued.

Second, China cracked down massively on its polluting industries by shutting huge capacities. This impacted the global supply chains and forced the global corporation to seek alternative supply sources. (India has been one of the major beneficiaries)

Third, to correct its growing demographic imbalances, China abolished its one child policy and allowed upto 3 children per family.

Fourth, Chinese authorities made a paradigm shift in policy towards businesses; and took punitive/restrictive actions against likes of Internet major Alibaba, food delivery leader Meituan, ride hailing app Didi, popular micro blogging app Weibo, and numerous private tuition entities to signal the change in the direction of of winds in China.

Fifth, it prescribed strict financial prudence norms for its real estate sector to ensure that there is no hard landing of the economy. Many prominent developers failed to meet these norms and were forced to take corrective action.

Sixth, and most important, the premier Xi Jinping, proposed a new economic policy framework (“New Development Concept”), comprising of three key concepts –

(i)    “Dual circulation economy,” which seeks to reduce China’s future dependency on export-driven growth, and instead have Chinese domestic consumer demand become the principal growth driver;

(ii)   “Common Prosperity,” which emphasizes income redistribution away from China’s billionaire class to low- and middle-income earners;

(iii)  New “industrial policy,” led by a revamped state-owned sector, giving top priority to new technology platforms as the drivers of the 21st century global economy, including semi-conductors, artificial intelligence, quantum computing, and new forms of advanced manufacturing.

The changes obviously would have far reaching impact on China, as well as the global economy. There are many popular view prevalent about the nature and extent of this impact. One popular view is that like Japan in 1980-1990, China will allow systematic undisruptive dismantling of the froth that has developed in its economy (soft landing). The other view is that 2020-2030 will be the decade of socio-economic revolution in China, as against the decade of cultural revolution (socio-political) during 1966-1976.

In my view, China is working on a new model in which the core ideology of Marxism (uncorrupted and equal society) shall become a guiding force; communist party will remain fully in control of markets; and China becomes a great global power. Arguably, it will involve significant geopolitical and trade conflict. Signs iof which are clearly visible to us in China Sea, Afghanistan, and Ladakh.

It remains to be seen how far Xi Jinping would be successful in implementing this new design. Nonetheless, the actions so far speak of the full commitment to the new policy framework. It is in this background that we need to assess the recent developments in China and global markets.

Evergrande – scarecrow or black swan?

One of the basic law of physics is that the higher an object is propelled into the atmosphere, the faster it returns to the earth; unless the propeller lends enough velocity to the object to help it transcend beyond the gravitational orbit of the Earth.

This principle of physics can be applied to the businesses also. A business that is propelled higher using the fuel of debt, risks crashing down to the ground zero, if the business model is not strong enough to take the business out of the debt spiral and place it in the orbit of sustainability. However, in cases where the fuel itself is contaminated (unsustainable debt); the fuel tank (management) is leaking, or the velocity is inadequate (unsustainable business model), the chances of business crash landing increase manifold.

In past one decade, we have seen many examples of this phenomenon in India. The businesses that grew remarkably in the decade of 2000s with the help of easily available credit, but had leaking tanks (unscrupulous management,) contaminated fuel (unsustainable debt) and/or inadequate velocity (poor business models) came crashing down in the decade of 2010s. JPA Group, Suzlon, ADAG, DHFL, Yes Bank, SREI, Bhushan Steel, are only few example. Globally, Lehman Brothers, which crash-landed in 2008, has become epitome of this phenomenon.

Chines real estate sector – symbol of malaise

The Chinese real estate development sector has been under scrutiny for more than a decade now. The sector has been at the core of phenomenal growth of Chinese economy in general and the financial sector in particular for past two decades. The real estate sector development apparently contributes more than one fourth of GDP of China and constituted over three fourth of the Chinese household wealth.

Nonetheless, numerous fables of ghost towns, unsustainable debt, window dressing of lenders’ books have been very popular in the past decade or so. Most bankers, investors and money managers have been worrying about this; though not many might have taken steps to reduce their exposure to Chinese enterprises materially. Perhaps, they were too confident that the Chinese authorities would not let any large business fail, lest it may deter the global investors from investing in Chinese businesses.

The things however have begun to change dramatically since past one year, with the Chinese authorities making a paradigm shift in its policy towards businesses. Though, the punitive/restrictive actions of Chinese authorities against likes of Internet major Alibaba, food delivery leader Meituan, ride hailing app Didi, popular micro blogging app Weibo, and numerous private tuition entities have been signaling the change in the direction of of winds in China, the scare of failure of real estate major Evergrande has drawn greater attention of the entire global markets towards the developments in China.

Evergrande in that sense has become the symbol of malaise prevalent in China, just like Lehman symbolized the malaise in US financial sector during the global financial sector.

For an Indian investors, it is pertinent to understand the Evergrande episode independent of the price action of the past week in the stock markets. Remember, panic is more likely to mislead than guide to a safe haven.

What is Evergrande?

Evergrande, a Guangzhou based real estate developer founded in 1996, is one of the largest real estate developer in China. As per the website of the group, it owns more than 1300 real estate projects (about 780 under construction) in close to 300 Chinese cities; has interest in many other businesses, including sports, media, electric mobility etc.

Evergrande, with over US$300bn in assets (close to 2% of Chinese GDP) is also one of the world’s highest indebted developers with more than US$300bn in dues to lenders and operating creditors. Out of this about US$129mn in interest was due for payment this week and US$850mn of principal repayments are due in next 3months.

Reportedly, the Chinese government has chalked out a bail out for Evergrande. In the arrangement, Evergrande may be virtually nationalized. This should provide some immediate relief to the markets, but it is not important in a larger context. This arrangement just kicks the can a little further to allow soft landing.

What’s the problem?

The rating agency Fitch recently downgraded a host of Chinese developers, including Evergrande; and warned about a “probable default” by the troubled developer. This warning has sent shock waves across the markets, as it was feared that a default by Evergrande may impact the entire real estate development and financial sectors in China directly; and commodities and consumer sectors indirectly.

It is estimated that a crash in real estate sector may hurt lot of homebuyers who have made substantial part payments, and thus impact their financial status materially. It is also estimated that material slowdown in real estate sector, may slow down overall Chinese economy materially, leading to substantially lowered demand for industrial commodities like steel and copper. This may have serious repercussions for global commodities markets; and also impact the consumption demand for things like iPhones in China.

The stocks and bonds of Evergrande and other major real estate developers like SIMIC crashed by 35% to 80%. While the Chinese homebuyers might lose money, if Evergrande projects are not completed in time or are abandoned completely; the global investors who had invested in stocks and bonds of Chinese developers have already lost substantial money. In that sense, the global investors are equally part of this problem.

In fact, the current problem may be more intense for the global investors who are over leveraged in the Chinese high yield bonds and have large unhedged exposure to Chinese real estate developers and their lenders, than for the Chinese enterprise and Chinese authorities themselves.

What caused the problem?

Prima facie, managing US$1bn of Evergrande’s payments due in near term, was never a material problem for Chinese government, which virtually owns the entire banking system and has huge surplus in reserves. After all, Indian government with almost one sixth GDP of China, and much smaller banking sector, could manage much larger problems (IL&FS and Yes Bank) with relative ease.

The problem in fact lies in the changing policy paradigm in China.

To implement far reaching reforms in the delinquent real estate sector, the Chinese government outlined three parameters to be followed by all the developers, viz., (i) The liabilities of any developer must not exceed 70% of its asset value (L/A < 70%); (ii) the net debt of developers must not exceed its net worth (net leverage < 100%); and (iii) all developers must have cash which is more than their short term debt (cash to ST debt > 1).

Apparently, the objective of stipulating these conditions was to preempt a systemic crisis that could potentially drag the entire financial system into a deep crisis. Last year a large number of entities failed the test.

The bigger problem was however identified in the business model followed by the developers like Evergrande. They apparently bid for land at very high prices. The local authorities were obviously very happy with these bids as it augmented their revenue substantially. The higher land prices were then passed on to the home buyers with inflated property prices.

This made bankers happy as they could lend more to homebuyers due to higher notional value of the collateral property; but resulted in substantially higher household debt and unaffordable home prices.

The household savings thus got diverted to inflated housing sector rather than the capital starved high technology sector which had to increasingly rely on the foreign capital. It also impacted the private consumption, frustrating the government efforts to make Chinese economy domestic consumption driven from the presently export driven.

To correct all these issues, Chinese authorities took a series of measures, including curbs on VC investment in real estate, and checking the corrupt practices in real estate sector.

Consequently, the real estate developers saddled with unsustainable debt and inflated assets are feeling the pressure. But it is important to note that it is not the real estate alone, but the entire high yielding Chinese debt that is feeling the pain. Also Evergrande may have become face of the problem, but it is certainly not the only one in problem. Many other like it, e.g., SIMIC, Fantasia, Suna, etc are also in trouble.

What are the implications?

A series of defaults in Chinese real estate sector could potentially have multidimensional implications. For example

(a)   It could lead to serious wealth erosion for the Chinese home buyers. To mitigate some of this impact, the Chinese authorities are resorting to transferring the assets of troubled real estate developers to the lenders, who shall get it completed and sell to the home buyers. A variant of this model is being tried in India also with assets of JP Associates, Amarpali, Supertech etc.

As stated earlier, beleaguered Evergrande Group has apparently negotiated a settlement with the lenders for a short tern respite. Besides, the Chinese authorities are ensuring adequate liquidity in the market to stem repeat of post Lehman market freeze and global contagion.

(b)   The bond and stock prices of troubled developers have already seen severe losses. The global investors holding these securities have already weathered the loss. However, it is hard to believe that after having experienced Lehman collapse, these investors had not hedged their risk.

(c)    The developments in Chinese real estate market could lead to material slowdown in the Chinese economy, and therefore the global economy, threatening the fragile recovery from the pandemic. The demand for commodities could collapse leading to sharp correction in prices.

It is pertinent to note that the signs of slowdown in global economy were already emerging  three months ago, with World Bank, ADB, IMF etc downgrading their growth estimates. China had anticipated slowdown in demand for commodity prices and accordingly started liquidating its strategic reserves of steel and copper. The commodity prices mostly peaked three months back. Most central bankers have recognized this trend, terming the commodity inflation as transitory; and refrained from acting on elevated price conditions.

Further, a slower Chinese demand may actually ease pressure on the global logistics and supply chain bottlenecks, thus providing a short term relief to the struggling industries worldwide.

Implications for Indian investors

The Indian investors must see the current developments in Chinese economy and markets as continuation of the trend that started with Trump-Xi trade war. This will only accelerate the move towards China+1 policy of global businesses; which is widely expected to of great benefit for Indian businesses.

In the near term we may see minor outflows from Indian markets, as the global investors with significant exposure to Chinese developers seek to rebalance their portfolios due to losses and redemption pressure. However, in mid to long term this could actually result in higher allocation (China+1) to India by investors also.

The Evergrande episode is expected to refrain the Central Bankers from rushing into monetary tightening; while PoBC continues to ease liquidity. This has obviously alleviated some of the near term concerns of the markets.

The most visible impact for Indian investors would however be the likely easing of inflationary pressures, providing some easing room for RBI.

It is less likely that the Chinese investors would seek to withdraw material investments from India, under the current circumstances, especially when the rules regarding fresh investment from China require much greater scrutiny.

However, beyond the immediate events, we need to keep a close watch on the developments of wider import occurring in China.

Evergrande – scarecrow or black swan?

In media, the Evergrande episode has been termed as sighting of the proverbial Black Swan, a rare event that may disturb the status quo materially.

Black Swan events are, by definition, completely unexpected events of large magnitude and consequences and usually mark a watershed in the history.

No surprises that the prospects of a default, and its perceived potential repercussions sent the global markets into tailspin earlier this week. Traders anticipating a repeat of Lehman moment in Evergrande default, rushed to close their positions. It was feared that failure of Evergrande will have a strong spiral impact on the global financial system and markets. It may result in collapse of China property development market, leading to sharp fall in property prices and erosion of collateral value for banks. The collateral damage will also be felt in metal markets, as China property developers have been a key drivers for the metal demand.

But it is pertinent to note that China real sector, its importance, challenges, problems and threats have all been analysed threadbare in past one decade. There is nothing that is not known to global investors and analysts. It is only the lure of high yield and confidence in Chinese authorities (they would not let it fail) that keeps the investors’ interest alive in this market. China and all its enterprise face close scrutiny of the global community, despite scant availability and low reliability of the information. To be honest very few investors and analysts would not expect the available information to be mostly manipulated. Everyone therefore is always on their guards in relation to anything connected with China. Therefore, Sighting a Black Swan in Chinese context itself is a Black Swan event.

I would therefore like to believe that Evergrande is a scarecrow that has been shown to the global investing community as a warning of the risk of investing in high yield bonds by over leveraging.

It is also a harbinger of the things that are likely to come over next few years. A decade of readjustments in China may require many adjustments in most corners of the world.