the money game

Why Trouble at a Chinese Real-Estate Company Tanked the U.S. Stock Market

A halted Evergrande real estate project in the Chinese city of Suzhou. Photo: Vivian Lin/AFP via Getty Images

China was a very different place in June 2012, when activist short seller Andrew Left accused real-estate company China Evergrande Group of being “insolvent,” using “accounting shenanigans,” and paying outright bribes for land. For one, the current president, Xi Jinping, was waiting in the wings, still a few months away from succeeding Hu Jintao. Evergrande had already been singled out as a symbol of profligacy as far back as 2009, but Left’s accusations were far more serious. The company denied them, and China moved swiftly to stifle the report, calling it “reckless.” Left — whose company, Citron Research, makes some of its money by betting that share prices will fall — spent millions of dollars in legal fees on a losing battle against Hong Kong regulators that lasted until 2019, by which time he was already banned from trading in the Hong Kong markets.

How times have changed. On Monday, the Dow Jones Industrial Average shed 614 points, in Wall Street’s worst day since May, as Evergrande teetered on the edge of bankruptcy. Evergrande is now the most debt-saddled property developer in the world, owing upward of $300 billion to creditors, some of which is due as early as this week, and having no good way to pay them back. But what’s most striking about the current situation is how China pulled back on its fierce defense of the company, even though it’s led by a well-connected businessman and its obligations make up a fair chunk of the country’s GDP. While Wall Street scrambled to understand how an Evergrande bankruptcy would affect the global financial system, another narrative started to form: that Evergrande’s troubles are best read as yet another sign that Xi is dead serious about cracking down on the go-go culture of the last two decades, zeroing in on video games, tech, and the elite — including billionaire real-estate developers. This line of thinking also tends to lead to the seismic conclusion that all the U.S. companies pinning their long-term growth strategies on doing more business in China may soon have to do a major rethink.

“They are trying to regain control of their country,” Left said. “I’m talking about the culture of excess, the culture of the businessman as a celebrity. You see what China’s doing culturally with celebrity — they’re canceling their big movie stars. They don’t want Elon Musk. Not one person is bigger than the system.”

On Wall Street, some investors were quick to compare Evergrande (pronounced with a silent final “e,” unlike a Starbucks order) to Lehman Brothers, the investment bank whose collapse marked the low point of the global financial crisis in 2008. But others were just as quick to knock down that comparison. “The big question is, could this be the first domino to fall, sparking a systemic risk scenario, similar to when Lehman Brothers went under 13 years ago this week? The good news is we don’t think so,” Ryan Detrick, LPL Financial’s chief market strategist, wrote in a note. A rough consensus emerged that China wouldn’t let its own economy spiral out of control, and would easily be able to absorb Evergrande’s outstanding debts if it had to step in — effectively keeping any worries of financial contagion at bay.

“Contagion is a policy choice,” Michael Antonelli, market strategist at R.W. Baird, told Intelligencer. “You either decide to let it unravel or you don’t.”

So Wall Street is left to ponder how the culture around business in China is changing and changing very fast. Last year, Xi announced the effective end of some 40 years of laissez-faire growth, and called for the “prevention of the disorderly expansion of capital.” Regulators launched an antitrust investigation into Alibaba, and Jack Ma, the company’s founder, was suddenly in the state’s sights. China soon kneecapped an IPO for Ant Group, the fintech company controlled by Ma, denying him further billions in riches. China has since made other aggressive moves that, in one way or another, curb a culture of individualism and promote one that strengthens the state, including limiting video games to three hours a week for children and tamping down competitiveness in schools. All this could affect U.S. companies’ earnings, even if an Evergrande bankruptcy turns out to not be such a big deal. Global corporations like McDonald’s and Caterpillar have been planning to tap China’s vast wealth and 1.4 billion people to fuel their growth, and any change in state policy toward consumption could mean a market pullback here at home, said one analyst. If investors are expecting hefty profits out of China in the future, and those are now in some doubt, share prices will come down to reflect that new uncertainty.

“All these things are — I wouldn’t say they’re all interrelated, but they are part of a narrative that they’ve gone too far too fast, and they need to take a step backwards,” the analyst said. “But it’s also hard to put the genie back in the bottle.”

While China’s tech and e-commerce companies have tended to attract the bulk of international attention, the country’s real-estate industry is one of its true powerhouses. In 2019, the total size of China’s housing market rose past $52 trillion, according to Goldman Sachs research, making it double the size of the U.S. property bubble at its pre–financial-crisis peak. That made for a market where houses sold out in minutes, and the rampant state of construction was seemingly never enough to satisfy demand. Xi went so far as to chastise speculators for driving up the price of units.

Evergrande is one of the three largest companies behind that boom. Led by Hui Ka Yan, one of China’s richest and most politically connected men, its main business is building apartment buildings for the country’s exploding middle class. The Chinese real-estate industry in general has been one of the major driving forces in the country’s economy, and Evergrande has more than 1,300 project sites in 280 cities across China. Each project requires a huge amount of money up front and it can take years to recoup those expenses — hence the outsize debt. But Evergrande has also ventured into all kinds of seemingly unrelated businesses of varying profitability, including a soccer club, a soccer stadium, a bottled water company, and most recently, and an electric vehicle maker (which reportedly never produced a car). This all happened during an 18-year boom period when China’s annual GDP growth never fell below about 6 percent.

Last year, in the midst of the coronavirus pandemic, things started to change. The first cracks between the Chinese government and Evergrande emerged, with Xi’s government putting out a new policy of “three red lines,” a troika of rules that essentially pushed real-estate companies to become less indebted.

Evergrande has since struggled to get a hold of more cash, proving Left’s central thesis, if nine years late: All along the company was inflating the true value of its assets while downplaying its liabilities. At one point, Evergrande essentially extorted its own employees into loaning the company money, at the risk of losing their bonuses, in order to pay its debts. This week, with the Chinese government signaling that it won’t step in to save the company, Evergrande looks poised to default on $80 million of payments.

Evergrande’s stint at the precipice of solvency comes at a bittersweet time for Left. Next month, the Chinese government should lift his ban on trading in Hong Kong markets. He joked that the only way to save the real-estate company now is for him to short it, prompting a swell of investors to pump up the shares in an attempt to squeeze him out — just like what happened with GameStop.

“Do I feel vindicated? I mean, yes and no,” Left said. “I knew it the whole time and the investment community people knew it the whole time. Maybe I’d be vindicated if I got my millions of dollars of legal fees back, and those many sleepless nights. Then I’d be pretty vindicated.”

Why Trouble at a Chinese Company Tanked the Stock Market