China Evergrande: How would liquidation impact the economy?

China Evergrande, a troubled property developer, announced on Monday that it will continue its operations despite a court order in Hong Kong to liquidate the company as a result of legal action taken by some of its foreign creditors.

Top Shine, an investor in one of Evergrande’s subsidiaries, among others, initiated the legal proceedings.

High Court judge Linda Chan declared that the company’s failure to make progress in presenting a viable restructuring proposal was evident, leading to the deemed appropriateness of the winding-up order.

China’s crackdown on real estate speculation three years ago resulted in a severe property crisis, leaving Evergrande with a debt of $300 billion (€277 billion).

Months later, the company defaulted on its offshore debt obligations, and creditors recently rejected a proposal to restructure its debt.

Evergrande’s lawyers successfully argued for the postponement of the winding-up hearing scheduled for December. They contended that none of the creditors were seeking the liquidation of the firm, which holds $240 billion in assets.

What is the current situation for China Evergrande?

The initiation of the order marks the beginning of a lengthy process that aims to liquidate Evergrande’s assets outside of China and replace its management.

However, it remains uncertain how this ruling will impact the company’s extensive operations within mainland China.

Shawn Siu, the executive director of Evergrande, expressed disappointment with the decision but assured that the company’s operations will persist.

Many widely regard this case as a test to determine whether mainland China will acknowledge a liquidation order issued in Hong Kong.

Foreign creditors often prefer Hong Kong’s common law system, which has remained intact since the territory’s return to China in 1997, when it comes to recovering debts in mainland China.

Two years ago, Beijing agreed to recognize Hong Kong insolvency orders in the Chinese cities of Shenzhen, Shanghai, and Xiamen.

However, in practice, executing liquidation orders has proven challenging due to China’s opaque legal system.

To date, mainland courts have acknowledged only one such order and have discretionary power to decide whether to warrant recognition.

On Monday, it was anticipated that Chan would actively place Evergrande under the control of liquidators, assigning them the task of selling off its assets to repay creditors.

If the liquidators determine that the company possesses sufficient assets, they may propose a new debt restructuring plan to offshore creditors.

Additionally, they will investigate the company’s affairs and may refer any suspected misconduct to Hong Kong prosecutors.

The Chinese Economy: Anticipating Impact Factors

What would be the potential consequences for the Chinese economy? The potential liquidation of Evergrande’s assets in mainland China could pose a significant setback for the world’s second-largest economy, which is already grappling with the challenges of recovering from a stringent zero-COVID policy that imposed lockdown measures across the country during the pandemic.

For the past two decades, China’s real estate sector has played a crucial role in driving economic growth, enabling the leaders in Beijing to achieve double-digit growth rates on occasion.

In contrast, the Chinese economy experienced a modest growth of only 5.3% last year, primarily due to factors such as weakened exports and domestic demand, elevated youth unemployment, and the deepening real estate crisis.

In recent years, several other property developers have faced bankruptcy, while construction firms have witnessed a consistent annual decline in spending by 10% for two consecutive years.

Furthermore, the sales of new homes from the 100 largest real estate firms plummeted by over a third to 451.3 billion yuan ($64 billion, €59 billion) last year.

Local governments heavily rely on land sales to boost their budgets, but significant debt burdens have resulted in spending cuts.

Evergrande, owing around $300 billion, primarily consists of deposits made by ordinary Chinese citizens for new apartments. It remains uncertain whether authorities will prioritize these citizens over foreign creditors in case of liquidation.

Economists predict that China’s growth in 2024 will be slower, and a deteriorating real estate crisis could further dampen demand and destabilize the nation’s financial system. Oxford Economics estimates that completing all unfinished residential properties will take between four to six years.

What are the reasons behind the challenges faced by China’s real estate sector?

China has a high rate of homeownership, with approximately 80% of households owning their homes. Additionally, more than 20% of urban households own multiple properties.

Over the past two decades, Chinese consumers have heavily invested their savings in the real estate market, leading to a significant increase in profits for developers.

However, this speculation has driven real estate prices to unaffordable levels. As of 2021, the average cost of a new urban dwelling unit is nearly 10 times the average salary.

Many economists argue that the Chinese government allowed the real estate bubble to grow unchecked for too long before taking action.

In August 2020, amidst the pandemic, Chinese President Xi Jinping introduced new restrictions on the amount of debt that developers like Evergrande could accumulate.

These restrictions, known as the “three red lines,” required firms to ensure that their liabilities did not exceed 70% of their assets, that net debt remained below 100% of equity, and that financial reserves were maintained at 100% of short-term debt.

These new measures exposed the extent of Evergrande’s operation, which has been likened to a massive Ponzi scheme. For years, the company had been using deposits from future real estate projects to finance ongoing construction endeavors.