Market volatility sparked by fear of property developer Evergrande Group’s (恒大集团) financial collapse has underlined how far political and commercial risks in China have risen. Companies should understand that the principal threats are now political, and should adapt quickly to protect their commercial interests.

Background

Concern had risen that Evergrande, China’s second largest property developer, would default on USD83.5 million on 23 September 2021, as well as a further USD47.5 million due on 29 September 2021. Indeed, China’s Ministry of Housing and Urban Planning had warned that the company might not pay up.

After all, Evergrande is struggling with a liquidity crisis, with potential implications for China’s entire property market. The developer’s liabilities in the coming year may amount to USD89 billion, and, overall, may be as high as USD302 billion.

Severe domestic exposure

Evergrande’s onshore obligations include wealth management products (about USD6.2 billion outstanding), and liabilities on pre-sales of apartments (about USD30 billion). Other obligations relate to suppliers, and financial instruments and the full extent remains unknown.

Evergrande’s plight will likely damage the broader economy – meaning that some kind of restructuring (even if not declared) is likely. After all, the Chinese Communist Party (“CCP”) prioritises stability, and risks of a Lehman-style collapse are just too high to permit such an event.

So far, the Chinese government has yet to comment in full. Even so, any restructuring exercise will likely follow a well-trodden path, as with the reorganisation of bad banks in the late 1990s, or of the HNA Group and Anbang Insurance more recently.

Then, the government took control of the stricken businesses (sometimes indirectly), and carved them up, injecting capital into some units, and letting others fold – over a lengthy period, so as to manage any contagion.

The scale of Evergrande’s liabilities mean such an approach is likely here. Those waiting for apartments may have their losses covered; but those invested in wealth management products may not fare so well.

Offshore “bonds”

Investors in offshore debt, such as HSBC, BlackRock and Ashmore, are more at risk.

The first risk is commercial. Evergrande must still meet interest payments of circa USD660 million, in the next year. Even if the company scrapes through for now, Evergrande could yet default – not least as moving funds out of China requires government approval.

A second risk is political. The Chinese government is mindful that bond structures mean foreign investors have limited scope for recourse. For instance, an Evergrande bond issued in November 2018 by Scenery Journey, a British Virgin Islands company, had payment confirmed through a “keepwell” deed – which explicitly does not amount to a guarantee.

Other bonds do rely on guarantees, but even these will prove hard to enforce in practice. Accordingly, foreign debt investors may find that the paper they hold offers little legal protection.

In this context, debt investors may have to reclaim payment in other ways. Key steps should include seeking offshore assets, targeting decision makers’ interests directly, and exercising pressure on Evergrande’s potential business plans.

SVA has much experience of assisting clients in such initiatives. We have aided governments and corporations alike in undertaking international asset searches, and stand ready to help in this trying period.

Implications for the wider economy

The implications for the broader economy are not yet clear, but surely will be large.

After all, the government wishes to rein in speculation, albeit without provoking a collapse in housing prices. CCP General Secretary Xi Jinping recently noted that “houses are for living in, not for speculating”, and is championing a “common prosperity” drive.

As such, this shift is no “flash in the pan”. The People’s Bank of China launched its “three red lines” policy in August 2020, in order to scale back debt. Lending to property has fallen rapidly; and non-performing loans in the sector rose 30% in the first half of 2021.

More regulatory initiatives will follow. The Chinese Ministry of Housing on 13 September 2021 announced a three-year inspection campaign to improve regulation. No doubt, supervisors will discover many improprieties.

This policy now seems liable to slow not only the broader property market, but also the wider economy, given property accounts for perhaps 28% of GDP. All foreign investors will face a much tougher commercial environment in the coming months.

Political implications

A major consideration is mainland politics. Evergrande’s plight is a neat illustration of the “grey rhinos” (in terms of financial risk) warned of by Xi Jinping; Evergrande’s weak finances have already resulted in public protests.

Government action against certain executives is probable. Evergrande founder Xu Jiayin has links to Jack Ma, and political ties at the highest level. He may now come under pressure to divulge details of prior dealings, so as to provide leverage ahead of the 20^th CCP Congress in the autumn of 2022; and associated lower level anti-corruption investigations will undoubtedly follow. This will make the lead up to the 20^th Party Congress a period of intense activity and cause some disruption to business.

Implications for business

Evergrande’s debt crisis thus highlights how political risks have intensified. SVA recommend that companies should act to protect their interests, by:

• Reassessing political risks in the property sector, to take account of the changing investment climate, and of the policy priorities of the Chinese government.
• Monitoring for new measures, and ensuring swift compliance. Compliance efforts must take a strategic view of the risks, and not focus only on technical issues. They should be overseen by senior management and be assisted by outside or independent resources such as SVA.
• Planning for further investigations, which could well spill into other sectors, or markets, such as Hong Kong.
• Conducting early analysis to establish which other sectors may come under future political pressure.
• Taking account of whether company investments in shares or bonds in China rest on shaky, “work-around” structures and to conduct independent reviews of the actual situation.
• Considering alternative means to reclaim funds, such as: asset searches outside China; actions against senior personnel directly; and pressure on other commercial initiatives. SVA can assist in this respect.
• Ensuring that future due diligence processes take account of the heightened risks and are not left in the hands of lawyers alone.
• Considering whether to restructure operations, so as to separate business lines, or to shift away from affected partners.
• Educating staff about the need to alter practices, such as eschewing political activities and statements.

SVA (www.stevevickersassociates.com) is a specialist risk mitigation, corporate intelligence and risk consulting company. The firm serves financial institutions, private equity funds, corporations, high net-worth individuals and insurance companies and underwriters around the world.

SVA has a great deal of experience, both in political risk and in assisting clients recoup investments in China, and around the region, and, in particular, in handling complex multi-jurisdictional asset search investigations. SVA can also assist in inquiries aimed at gaining greater understanding of the nature of political and other liabilities facing key counterparties.

We stand ready to support companies faced with these challenges. Our consultants are available to assist, advise and execute as necessary.

SVA is based in Hong Kong and is the only firm with the local and senior expertise drawn from intelligence, operations and research functions of the former Royal Hong Kong Police Force.