The Federal Reserve is warning that spillover effects from a worsening debt crisis in the Chinese real estate sector could roil global financial markets and damage economic growth, including that of the United States.
The warning Monday came in the Financial Stability Report, issued twice a year by the U.S. central bank. Previous versions of the report have noted concerns about high levels of debt among Chinese companies.
But the most recent report specifically mentions China Evergrande Group, a heavily indebted real estate conglomerate that late Tuesday appeared to have narrowly avoided what could have been a catastrophic default on bonds issued to international investors.
Evergrande has become the symbol of an ongoing effort by the Chinese government to force large companies to shed heavy debt burdens. The government has created new restrictions that make it difficult or impossible for companies like Evergrande to “roll over” their debts as they come due by simply taking out new loans. As a result, many are trying to sell off assets to pay down their debts.
Although construction on many of its dozens of projects across China has been halted as laborers and suppliers go unpaid, Evergrande has put a brave face on its predicament. In a note to employees published on WeChat, management said, “All employees of the group swear to ensure the construction of the project with the greatest determination and strength, and complete the delivery of the real estate with the highest quality and quantity.”
Risk of miscalculation
Forcing large Chinese firms to deleverage is, on the whole, considered a worthy goal. Many analysts believe that the excessive debt of Chinese businesses, much of which is carried on the books of Chinese banks, has injected far too much risk into the Chinese economy.
However, experts consulted by the Fed said they were concerned that the Chinese government might miscalculate, cracking down too tightly and precipitating a crisis that Beijing cannot control.
“Several noted that the Chinese authorities appear willing to countenance more volatility than in the past as they pursue their deleveraging and regulatory goals, while worrying that officials could misjudge the scale of instability and contagion emanating from the campaign,” the report said.
‘Tip of the iceberg’
“It’s tempting to use metaphors like ‘tip of the iceberg’ to describe what’s going on in China’s real estate sector,” Doug Barry, spokesperson for the U.S.-China Business Council, told VOA in an email exchange. “But that we’re even tempted is itself disconcerting, given we’re talking about the world’s second largest economy – one linked to most of the others including the United States’.”
Barry noted that many Chinese banks are considered “zombies” by most analysts – meaning that they are carrying so much bad debt on their books that they are essentially insolvent and are only being propped up by government support.
“Time now for China’s leaders to get their macroeconomic policy house in order, which is consistent with the mantra-like message of reforming and opening-up,” Barry added. “Help is available from many quarters including the US government and business community. How to help should be on the Biden-Xi summit agenda. We all lose if the iceberg finds its mark.”
Global consequences
According to the Fed report, if the crisis in China were to get out of control, the impact on the rest of the world could be serious.
“Given the size of China’s economy and financial system as well as its extensive trade linkages with the rest of the world, financial stresses in China could strain global financial markets through a deterioration of risk sentiment, pose risks to global economic growth, and affect the United States,” the report found.
A narrow escape
Evergrande has been in the news in recent months because it has been unable to make payments on bonds it has issued. On Wednesday, it was expected to make a late payment of $141.8 million on three different bonds, just as a 30-day grace period was due to expire and plunge the company into default.
Evergrande came up with the money by orchestrating what appeared to be a last-minute sale of a $144 million portion of its interests in HengTen Networks Group, a Hong Kong-based internet company, according to the South China Morning Post.
The expected payments do not mean that Evergrande is out of trouble. The company still has more than $300 billion in outstanding debts, with regular payments coming due every few weeks into 2022.
Signs of spreading contagion
Evergrande’s share price has already plummeted, and the rates that investors are demanding on existing bonds have skyrocketed. If the effects were limited to Evergrande, that might be manageable. But there is increasing evidence that the “contagion” infecting the company and other large real estate firms is spreading.
Investors are now selling off bonds issued by other Chinese real estate giants that are considered to be much less risky than Evergrande, such as Country Garden Holdings and Vanke Inc., the largest and second-largest real estate firms in the country, respectively.
Worse yet, there are signs that investors are getting jittery about companies well outside of the real estate sector. A Bloomberg index tracking investment-grade bonds issued by Chinese firms indicates that the impact is being felt across multiple sectors of the Chinese economy.
For example, Tencent Holdings, an entertainment conglomerate that owns TikTok and WeChat, among other popular services, saw a sharp decrease in its bond prices over the past two days.
Restructuring expected
In general, investment analysts following the developments in China’s property market expect that Beijing will, at some point, step in to prevent a major crisis. But that may not happen in the immediate future.
In a research note published Monday, economists Ting Lu and Jing Wang of the investment bank Nomura International (Hong Kong) wrote, “We expect most of Beijing’s property curbs will remain in place for a while, with the worst likely yet to come for both China’s property sector and macro-economy.”
They added, “Beijing’s policy makers may opt to ramp up support to prevent worsening defaults in coming months.”
It is unclear exactly what a government-led restructuring of Evergrande would look like, but most experts believe it would involve investors in the company’s dollar-denominated bonds facing a significant “haircut.” That is, they would be forced to accept less than they are owed by the company in final payment of its obligations.
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