Why China May Not Bail Out Evergrande

Conventional wisdom suggested the Chinese Communist Party would have intervened at the company level to stem the adverse effects on the economy. After all, earlier this year, the Chinese government ordered Chinese banks to provide loans to state-owned China Huarong Asset Management to stem the risk of market contagion and stabilize its cash flow. Huarong’s offshore U.S. dollar bonds declined in value when it failed to release its 2020 financial results, and the company suspended trading of its shares in April.

Why, then, has the Chinese central government not intervened to rescue Evergrande?

The answer lies in the sector. For strategic sectors, such as banking and  telecommunications—perceived as key for the national technology base, national security imperatives, and domestic industry competitiveness—the Chinese Communist Party tends to centralize and reinforce state control in market coordination and property rights arrangements. For less strategic sectors, the Chinese central government has shown a willingness to deregulate and decentralize market governance to local governments, business and sector associations, and other market actors. I call this “bifurcated capitalism.”

Still, even without a looming liquidity crisis, in many ways, real estate is your typical strategic sector. It is the basis of political stability and a third of the local government income. Additionally, all agricultural and urban land in China is legally owned by the state, either directly or through rural collectives.

Precisely because real estate property is already owned by the state, in the early reform era, the state introduced competition and permitted local authorities and private interests to develop use, exchange, and profit generations. As a result, several decades later, Evergrande and others like it are firmly rooted in the decentralized and deregulated parts of the Chinese economy.

A number of these local state and market stakeholders governs competition in real estate, which accounts for 29 percent of the economy. Local government-business bargains negotiated by Evergrande and its subsidiaries had totaled 778 projects in progress across 223 Chinese cities.

Sectors’ perceived strategic value influences the governance of markets, but the central government responds to internal and external pressures, which change with situational circumstances. Moreover, existing institutions regulating an industry shape how the central government responds and makes decisions.

In other less strategic and decentralized sectors, such as textiles, responses to heightened economic and political pressures have in the past led to central state intervention at the company level. To stem over-expansion during the East Asian financial crisis, Beijing resurrected dismantled central-level bureaucracies and entered textile mills to cut spindles.

The fall of the property giant fits the Chinese Communist Party’s new narratives.

Chinese economic troubles may come far faster than the markets expect.

More recently, in October 2020, the Chinese government ordered cotton mills to stop purchasing supplies from Australia. This occurred at the height of diplomatic tensions between China and Australia over allegations of Chinese intervention in Australia’s domestic affairs and the Australian prime minister’s call for a probe into the COVID-19 pandemic’s origins.

With a majority of the most indebted property developers based in China, the Chinese central government has reined in risky lending, with such rules as the “three red lines”—a 70 percent ceiling on liabilities, 100 percent cap on net debt to equity, and cash to short-term borrowing ratio of at least one. The state has also eased credit to homebuyers to support healthy developers.

But the provincial governments and localities are the ones that have banned or removed Evergrande as a viable developer in local projects. This included Huaibei Mining Group, which requested court termination of construction projects with Lu’an Hengda Real Estate, an Evergrande subsidiary. Evergrande is also involved in legal disputes with contractors and suppliers.

Other regional authorities have negotiated bargains, such as the sale of Evergrande’s stake in the state-owned Shengjing Bank based in Shenyang in Liaoning Province. Global investors have contended the sale of this stake as “preferential treatment” for some lenders over others.

However, this interpretation misses the nuances of Chinese-style capitalism in less strategic sectors where business and politics are local. To settle local debts, Evergrande is transferring its stake in a Shenyang municipal government-owned bank to the bank’s subsidiary.

The story of Evergrande illustrates the institutional foundations of Chinese capitalism that continue to shape China’s globalization trajectory and development outcomes. Beijing introduced competition in less strategic sectors beginning in the 1980s and decentralized market coordination to local governments and commerce bureaus throughout the 1990s.

Empowered with economic decision-making, local governments and commerce bureaus approve market entry, which in many cases are completely liberalized. These decentralized authorities, including sector and business associations, act as economic stakeholders in a fiercely competitive landscape.

Private enterprises, many of which were restructured from town and village enterprises collectively owned and operated by local authorities or divested from state-owned companies, or are foreign-invested contend with the vagaries of local politics, regulatory arbitrariness, and lack of central will and regulatory capacity in enforcing macroeconomic rules.

Fiscal policies, which centralize tax revenue control that Beijing then divvies up to the provinces, incentivize local authorities to rely on the sale of land use rights as well as borrow used land as collateral to fund local projects and services. Hyper-competition and battles over land reign. Forced demolitions and evictions by local governments have only worsened under Chinese President Xi Jinping’s “rural revitalization” policy.

Decentralization without the necessary regulatory institutions to tax and manage competition, in addition to uneven local regulation enforcement, have created and worsened economic, social, and political problems that now challenge China’s authoritarian regime. These problems include deficient regulatory capacity to enforce rules concerning human and animal health and safety as well as the environment. They also include growing corruption at all levels of government and across the economy.

Private entrepreneurs drive China’s economic growth. They have also participated in the country’s over-expanded and saturated real estate markets, building “ghost cities.” They are eager to stay in business and not upset the country’s political order. Indeed, the most successful businesspeople, including Evergrande’s founder, Xu Jiayin, are invited to serve as representatives of the local and national People’s Congress system.

Telecommunications value-added services that operate on top of state-owned communications infrastructure is a sector comparable to real estate development with the diverse ownership arrangements of its varied market stakeholders. Perhaps the most known example of this is the online wealth management and banking platform Ant Group, founded by Jack Ma. For years, Ma and his businesses operated without much state intervention and scrutiny. If anything, the state courted foreign direct investment and then reregulated to benefit the domestic sector’s growth and development.

Yet the stakes changed when Ma pushed the envelope by questioning the state’s handling of regulatory issues. Ant Group’s monopoly position came to be perceived as disrupting state control of banking, telecommunications, and, importantly, Communist Party rule.

For now, global investors should remain alert and not expect the type of state interventions the world has become accustomed to from Xi and Beijing. The best due diligence for business decisions is to understand the political logic of Chinese capitalism’s institutional foundations.