Corporate bankruptcies in the United States work under very well-defined laws and procedures about who gets paid, in what order, and based upon contractual or implied understanding.
In China, bankruptcies remain the largely wild rule of the jungle matters that can take years of behind-closed-door fighting to divvy up corporate carcasses. Evergrande and the entire real estate sector in China are becoming the case study for Chinese and Western investors.
Evergrande and China’s real estate sector are highly indebted. Couple in falling consumer demand for second and third apartments—as well as high basic commodity input prices—and the housing market in China looks decidedly weak. Government revenue from land sales is off nearly 30 percent from a year ago, and the government has decided to delay the long-awaited much-heralded property tax. This isn’t a healthy, robust market.
The more recent worries stem from China’s Guangdong provincial government’s review of Evergrande. Announcing that an expected turnaround plan will be completed by July, the government-appointed auditors have declared that Evergrande is “significantly insolvent.” Not just insolvent, but significantly insolvent.
Despite Evergrande’s emphasis to investors that it’s returning to normal, completing units, and divesting projects to buyers to help it accumulate cash, the outlook isn’t positive.
However, Evergrande is only a tree in the forest. Chinese developers are being downgraded and warned of defaults.
Developer Sunac is merely the latest that has said that it will be unable to make good on bond payments in the days ahead, prompting downgrades from bond rating agencies. The entire Chinese real estate development industry remains very weak, with no turnaround in sight.
However, the problems run much deeper than the obvious. Most recently, auditing firms such as PricewaterhouseCoopers (PwC) have taken to either resign their position or issue qualified opinions of firms based upon their inability to verify their clients’ financial statements. For many firms, this effectively makes them uninvestable for international asset flow.
PwC didn’t take this position because of newfound business ethics, but from a calculating review of potential legal liability if these firms collapse. Already, lending banks are talking litigation after domestic Chinese banks seized $2 billion in deposits from Evergrande that had been pledged as security, but wasn’t listed in its financials as promised. Like everyone else, PwC is wondering what else is out there that it doesn’t know about.
This presents China and investors with a couple of significant problems. Even beyond the fundamental problem of excess leverage, all the issues investors could ignore when they made money suddenly seem essential and harder to ignore.
For instance, low-quality and unreliable financial statements are harder to ignore. Even though Evergrande and others have produced annual audited statements, the auditors are openly questioning their quality and leaving investors wondering what unaccounted liabilities exist or whether assets are really viable assets. When everything is going up, investors worry less about the risks, but they worry about those factors immensely on their way down.
The lack of any clear unpoliticized rule of law process to manage an Evergrande bankruptcy worries all parties. Evergrande and Beijing have said that stakeholders should refrain from making aggressive actions to enforce their claims. Investors have widely interpreted this as a threat from Beijing to not seize assets or file litigation unless approved by the state. This makes the seizure of $2 billion in cash deposits by major Chinese banks so problematic to many. This is interpreted as having received a tacit nod from the Chinese regime after it told others to refrain from aggressive action.
Lacking a predictable rule of law system to manage corporate bankruptcies, the politicized management of the jungle system is a significant liability for investors seeking predictability.
Investors want growth opportunities to help their money grow, but they also value a fair legal system and open accounting records. With wobbly firms, the legal and accounting risks only magnify the financial viability risks that investors are looking at.
Although it would be encouraging to close up an analysis of the real estate sector by offering up reasonable reforms and approaches that China could take to address the economic, corporate, legal, and accounting risks covered, the reality is that Beijing is likely to try and delay dealing with the problems that years of reckless lending have encouraged.
This means Evergrande and real estate restructuring is likely to be stretched out over the years with questions about how assets are divided, how creditors are repaid, and the firm’s actual assets and liabilities.
The goal isn’t a high-quality legal system or economic efficiency, but to sustain the Chinese Communist Party.
