“Oh what a tangled web we weave, when first we practice to deceive”

(Sir Walter Scott: Marmion – A tale of Flodden Field)

Marketwatch does not normally resort to quoting poetry, but there is almost something poetic about the tale he is about to tell. And this month we are returning to China for a story of gambling and recklessness, all packaged up in the fortunes of one company. So settle down, and we will take a trip through the fortunes of a property company called Evergrande Real Estate, China’s second largest property developer.

In 1997 Xu Jiayin founded Evergrande at a time when the Chinese were starting to seriously develop their cities. Xu had a rural upbringing and eventually obtained a university degree. After moving around the country primarily in the iron and steel industry, he founded the Evergrande Group.

In 2008 Xu wanted to list Evergrande on the Hong Kong stock exchange to raise funds for his rapidly expanding company. The Global Financial Crisis put paid to that and because he had already expanded his operations, Evergrande faced a very significant funding shortfall.

By then Xu had become friends with Joseph Lau, one of China’s wealthiest businessmen who, together with other wealthy people, came regularly to Hong Kong to play poker. Over time, and countless hands of poker, Xu found favour with this group who helped him get his fundraising back on track. As a thank you, Xu gifted hundreds of millions of Evergrande shares to his poker friends who also profited handsomely from the company’s high yield offshore bonds.

Much of Evergrande’s continuing expansion depended on issuing bonds which carried high rates of interest. As we have seen before, investors often are blinded to risk when they are offered high rates of interest. As an example, Evergrande has approximately US$19 billion in US bonds paying an average interest rate of 10.3%. The company hid tens of billions of interest expenses every year by capitalising its interest bill so it would not show on its profit and loss account. Although this is common practice in Chinese real estate companies, Evergrande took it to extremes and between 2017 and 2020 hid US$2.7 billion using this method. This had the effect of distorting their financial statements which showed far higher profits than really existed. The higher profits led to higher dividends being paid and guess who was the main beneficiary? Yes, none other than Xu Jiayin.

But the company had other ways of borrowing money. It raised money in part by preselling units to home buyers for cash upfront who then waited for the buildings to rise. Its creditors include buyers of 1.4 million apartments that Evergrande presold and promised to build but hasn’t yet completed, estimates research firm Capital Economics. It also pressured employees to lend the company money almost making it a condition of employment.

It expanded beyond real estate, getting into mineral-water production and buying a professional soccer club. It ventured into healthcare through the formation of Evergrande Health which operates a wellness park and retirement community.

In 2017, it entered the theme-park business, launching 15 projects nationwide involving more than $100 billion in total investment, according to Journal calculations based on local-government numbers. Around that time, Dalian Wanda Group, a conglomerate that had vowed to out-compete Disney parks in China, said it was retreating from the business after running up too much debt.

It also joined the electric-vehicle industry with China Evergrande New Energy Vehicle Group Ltd. Which was the result of re-badging the health group. The market capitalization once hit $87 billion, more than most global auto makers at the time. Yet it had not produced a single vehicle. In 2019 it acquired a 51% stake in National Electric Vehicle Sweden AB to give it the air of respectability. Later the stake was increased to 100%.

The company launched the Hengchi car brand and signed contracts with 15 top international designers to work on individual models.

When Evergrande Auto released its interim results on Aug. 10, it admitted that it had suspended some of its car projects because of cashflow problems and that it was “proactively” working to introduce new investors who would be able to provide fresh capital. It warned that unless it received a capital injection in the short term, the timetable for mass production of its vehicles would have to be delayed. Early in October, the company advised the stock exchange that it had made “no material progress” and warned that without a further capital injection, its ability to pay operating costs would be impacted.

What really hurt Evergrande was the decision of the Chinese government in mid-late 2020 to introduce the “three red lines” policy. The government was becoming increasingly concerned at the level of indebtedness in the property sector. Property is an immensely popular form of investment for the Chinese people and the property sector is an important contributor both to the economy and to the coffers of local government which has limited taxation powers and relies on sales to developers for revenue. Real estate contributes about 29% of economic output if its wider influences are taken into account.

The “three red lines” are ratios which cap the level of borrowings which property developers can undertake. Evergrande, as the most indebted company is experiencing significant difficulties. It seems more than likely that the money from pre-sales has been used to fund operations. So it needs to complete 1.4 million apartments but does not have the cash flow because it cannot borrow money. Already it is struggling to pay suppliers and is offering apartments as payment. The company now has US$300 billion in liabilities and has missed scheduled interest payments on its bonds which may lead to a default. That doesn’t include the unfinished apartments which are estimated to cost US$200 billion. There are so many debt recovery actions against them that it has been decided to have them all centralised into one court in the country.

Standard & Poors, a rating agency, estimate that the company has US$37 billion of bills and trade payable over the next 12 months. Evergrande’s latest financial report shows that it has just over half that figure in available cash.

So where did all the money go? Well, a fair bit went on forays into other areas such as health and cars. And we mustn’t forget the move into life insurance and banking. Whatever made a property developer think it could successfully manage a portfolio of activity so far removed from their main business. The mind boggles at the recklessness of it.

The Chinese government have not, as yet, shown their hand. There is an indication that they are monitoring the situation to see if Evergrande can be broken up in an orderly fashion. This is a tricky one for them, and they will be particularly concerned about the people waiting for their apartments.

And of course, we must not forget Xu Jiayin. Well, for one thing, he got paid about US$5 billion over the past 3 years in dividends. Then there are the bond interest payments received and other payments. At least someone benefitted from this sorry saga although that is of little comfort to all those people who put their savings into apartments that may never be built.

One final footnote. It is estimated that in China there are already enough vacant properties, mostly apartments, to house 90 million people. To put that into perspective, fairly populous country, such as the UK and Germany, have smaller populations than this. More of this in a later article.

The colder weather we are experiencing at least makes a comforting glass of red a welcome addition to the evening. Marketwatch like to try and move outside the usual shiraz and cabernet offering, great though they are. Interestingly, Australia is one of the main producers of Durif, known as well as Petite Sirah. Its worth trying The Heritage Trail, a Durif from South-Eastern Australia. Its always taking your palate out for a spin and try something different. Enjoy.