The Risk Management Committee (RMC) appointed by the Chinese Communist Party (CCP) is now in charge of Evergrande. The RMC consists of nine members, six appointed by the CCP, one from one of the state-run businesses, and the remaining members from Evergrande.
Last year, China announced the “Common Prosperity for All” program aimed at improving the standard of living for all the Chinese people while limiting the wealth of the upper class. To do this, the CCP changed all the rules for the property developers like Evergrande. The CCP set up a triple-test, called the 3 Red Lines, to make sure that property developers weren’t over-leveraged to add credibility to the thirty-some property builders in China. Unfortunately, all of the larger property developers, including Evergrande, failed the 3 Red Lines test! Remember, these companies are worth/in debt to the tune of $2 Trillion!! And, they are all failing. One of the outcomes of failing the 3 Red Lines test was the restriction of debt, i.e., cash, to the failing companies. This caused a tremendous slow-down in the Chinese real estate market.
As I said in my previous blog on Evergrande, the CCP has only allowed its people to invest in real estate. And, boy did they invest. The market has been going up and up and up. Until this last problem. Evergrande is in debt to the tune of $300 billion.
Now, China has a massive oversupply of real estate. The opposite of what’s happening in the rest of the world.
The CCP’s Solution: State-Owned Enterprises
China has basically guaranteed the solvency of State-Owned Enterprises, i.e., commercial organizations that are dominantly owned by the state. State-owned Enterprises are not subject same rules as other property developers, i.e., State-Owned Enterprises are allowed to “purchase” properties from troubled property developers like Evergrande, without being subject to the 3 Red Lines tests. This represents a nationalization of the assets of failing property developers. Also, State-Owned Enterprises have not been floating bonds to the international market so few people are familiar with them. They have been borrowing money from internal Chinese lenders because the CCP essential tells the banks to lend money to the State-Owned Enterprises. This is the CCP’s solution to property developers like Evergrande, Sunac, Shimao, Agile, etc.
3 Red Lines Tests
What are the 3 Red Lines Tests? They are based on following debt to income ratios:
- Liability/asset ratio < 70%;
- Net Gearing ratio < 100%; and
- Cash to short term debt ratio > 1x
Every one of the property developers in China would fail these tests!!
Nationalization by a Different Name
Normally, one company buys the assets of another company that’s failing. But, when the company buying assets is a State-Owned Enterprise these purchases are a form of nationalization. The CCP changed the rules such that any debt taken on by a State-owned Enterprise is excluded from the 3 Red Lines Tests. Thus, the State-Owned Enterprises have been given carte-blanche to acquire as much of troubled companies assets as they want. Allowing them to take all of the best assets from these property developers without regard to incurring more debt.
Over the last week, we’ve seen almost six deals announced transferring assets from distressed property developers to State-Owned Enterprises totaling $4.7 billion. This is just the beginning of the transfers that will take place over the next several months.
Some bondholders outside of China are beginning to take legal action. It looks like China isn’t going to guarantee anything to businesses outside of Chine. The hope is that legal action will force companies like Evergrande into liquidation. The only announcement from Evergrande is a request for more time. In conference call on January 26th Evergrande was explained their plan of action to bondholders with $19billion invested. Basically, they asking for a six-month delay. With that said, they’ll delay more and come back to the table with all the best assets removed from Evergrande. Say goodbye to the $19billion.