On Tuesday, March 22, 2022, China Evergrande announced that it will not be able to publish its annual financial results on time. This was the latest setback for the property developer, which is now struggling to pay its lenders and is seemingly on the verge of bankruptcy. This begs the question: how did a company that was China’s biggest real estate developer suffer such a massive fall from grace?
Evergrande’s problems can be traced to the aggressive expansion policies that they adopted in the years prior to their downfall. They ventured into electric vehicles, theme parks, energy, and many other sectors. They made leveraged investments including Ocean Flower Island, a $15.5 billion project to build an artificial island on the north shore of Hainan near Yangpu in the South China Sea, plans to spend over $7 billion between 2019 and 2021 on electric vehicle development, and ownership of Guangzhou F.C., China’s richest football club.
The implementation of such an aggressive policy required massive borrowings, which led to Evergrande raising money from both institutional and retail investors. The company especially borrowed heavily from retail investors (individual/non-professional investors) and used billions of dollars raised by selling wealth management products to retail investors to plug funding gaps and even to pay back other wealth management investors, according to executives of the company in Shenzhen. Wealth management products are uninsured financial products sold in China by banks and other financial institutions, typically offering a high rate of interest. Despite the fact that these products were highly risky and not ideally meant for the general public, they were heavily marketed and raised a lot of money for the company. These products were used as a form of supply chain finance according to one Evergrande financial adviser. This means that the money raised from the sale of the products was used to facilitate the repayment of suppliers. However, this meant that once sales numbers dropped, it was difficult for the business model to continue.
With this background, it is easy to understand how the Chinese government’s “Three red lines” policy caused a lot of issues for the Evergrande Group. The policy was an effort to better manage the property development sector, which historically has been heavily leveraged. Chinese regulators introduced drafts of rules dubbed the “three red lines” to formally limit the borrowing of real estate firms, mandating that developers maintain a debt-to-asset ratio of 70%, a 100% cap on net debt to equity, and enough cash on hand to satisfy short-term borrowing, debts, and liabilities. The Chinese government also introduced more regulations in 2021, including mortgage lending limits, rent caps in big cities, and land auction cancellations. This greatly reduced the sales of Evergrande; sales that it greatly needed to reduce its debt level and comply with the new government regulations regarding leverage.
A combination of an incredible amount of debt and new regulations imposed by the Chinese government have led to the downfall of a company many thought was too big to fail. It remains to be seen whether Evergrande can somehow get itself out of this crisis, but as of now, the situation looks bleak for a company that was once the biggest real estate developer in China.